Explain why free cash flow to equity can serve as the basis of a valuation
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
When is free cash flow to equity preferred to a dividend discount model?
- When the company's dividend is stable and predictableWhy not: That is where the dividend model works best — a dividend that tracks the firm's capacity is exactly what it needs.
- When the company pays no dividend or pays one unrelated to its capacity — correct
- When the company has no debtWhy not: Debt affects how the two free cash flow measures differ from each other, not whether either beats the dividend model.
The dividend model requires a dividend that reflects economics. Where policy and capacity diverge, cash flow measures what shareholders could receive.
A harder one
Which item is deducted in arriving at free cash flow to equity but not free cash flow to the firm?
- Capital expenditureWhy not: Deducted in both. Maintaining the asset base is a cost to every capital provider.
- The change in working capitalWhy not: Also deducted in both, for the same reason.
- Interest paid, net of tax — correct
Free cash flow to the firm is available to all capital providers and is therefore measured before payments to lenders. The equity measure is after them, and after net borrowing.
The hardest tier
Why is free cash flow to equity often negative for a rapidly growing company that is nonetheless valuable?
- Because growth consumes cash before producing it — correct
- Because growing companies are always loss-makingWhy not: Many are highly profitable. The negative figure is about cash consumed by investment, not about accounting losses.
- Because interest expense rises faster than revenueWhy not: It may if the growth is debt-funded, but the effect described happens in an unlevered company too.
Working capital and capital expenditure come ahead of the cash flows they generate. Investment precedes return, so a negative near-term figure is a statement about timing, which is why the forecast must extend far enough for the pattern to reverse before a terminal value is applied.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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