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Explain why free cash flow to equity can serve as the basis of a valuation

CFA® Level I · Equities · Discounted Cash Flow (DCF) and Growth Models · EQ.1.d

The idea

Free cash flow to equity is what could be paid to shareholders after operating expenses, interest, taxes, working capital and capital expenditure, and after net borrowing. It is usually the better basis when a company pays no dividend, pays one unrelated to its capacity, or is being valued from a control perspective where the acquirer would set the payout. Discounted at the required return on equity it gives the same conceptual answer as a dividend model would if payout matched capacity - the difference is that it does not depend on a board's distribution policy.

Formulas

Free cash flow to equity

FCFE = CFO − FCInv + net borrowing

CFO
cash flow from operating activities
FCInv
investment in fixed capital, the capital expenditure
net borrowing
debt raised in the period less debt repaid

What could be paid out to shareholders after the business is funded, which is why it values a company that pays no dividend or pays one unrelated to what it earns. Discount it at the required return on equity, not the WACC.

A practice question

From the question bank, with the reason each wrong option is wrong.

At what rate is free cash flow to equity discounted?

  1. The weighted average cost of capitalWhy not: That is the rate for free cash flow to the firm, which belongs to debt and equity together.
  2. The required return on equity - correct
  3. The risk-free rateWhy not: Equity cash flows are not risk free, and discounting them as though they were would value every company far too highly.

Discount rate must match who owns the cash flow. FCFE (free cash flow to equity) belongs to shareholders only, so it is discounted at the required return on equity, the return shareholders ask for given their risk. Formula: Equity value = FCFE / (1 + r)^1 + FCFE / (1 + r)^2 + ... The weighted average cost of capital is for cash flows that belong to debt and equity together. The risk-free rate ignores the risk, and would make every company look far too valuable.

A harder one

Which item is deducted in arriving at free cash flow to equity but not free cash flow to the firm?

  1. Capital expenditureWhy not: Deducted in both. Maintaining the asset base is a cost to every capital provider.
  2. The change in working capitalWhy not: Also deducted in both, for the same reason.
  3. Interest paid, net of tax - correct

FCFF is free cash flow to the firm, the cash available to all providers of capital, so it is counted before paying lenders. FCFE is free cash flow to equity, what remains for shareholders. Formula: FCFE = FCFF - interest x (1 - tax rate) + net borrowing. Example: FCFF $100 million, after-tax interest $20 million, net new borrowing $10 million gives FCFE = 100 - 20 + 10 = $90 million. Capital expenditure and working capital changes are deducted in both.

The hardest tier

Why can free cash flow to equity be negative for a valuable fast-growing company?

  1. Because its interest cost exceeds its operating cash flowWhy not: Possible for a heavily levered firm, and not what the question describes. The same pattern appears with no debt at all.
  2. Because investment in growth outruns operating cash flow - correct
  3. Because growing companies pay higher taxesWhy not: Tax follows profit, and a growing company's tax bill is rarely what turns its free cash flow negative. Investment is.

Formula: FCFE = Cash flow from operations - Capital expenditure - Investment in working capital + Net borrowing. A fast-growing company spends heavily on new plant and on stock and customer credit to support its growth. In the early years that spending can be larger than the cash its operations produce, so FCFE is negative. This can happen with no debt at all. A negative figure in growth years just describes heavy investment, which can pay off later. It does not mean the company has no value.

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