7.9  Free Cash Flow to Equity (FCFE)

Since we are interested in the intrinsic value of a stock, we need to calculate how much of the FCFF could be paid as an economic dividend to shareholders.  That is, we are interested in checking which of the two possible cases a stock falls into:

Are cash dividends and treasury stock covered by free cash flow to equity or not?

If the firm's dividend policy is covered by FCFE this is clearly more desirable than if it is not.  For the latter this implies that the firm is funding its dividends from either new debt or from existing capital.  As a result, assessing free cash flow to equity is important when evaluating the financing and dividend activities of a firm.

From the above, FCFE is designed to measure the dividend a firm could pay out to equity holders as opposed to the dividend the firm actually pays out to its equity holders.  FCFE can be greater than, equal to, or less than FCFF and this relationship is given by:

FCFE = FCFF – Interest*(1 – Tax Rate) + Net Borrowing

Net Borrowing is new debt issued minus existing debt repaid.  This information is usually obtained from the Consolidated Statement of Cash Flows, which provides “Cash Flows from Financing Activities.”  However, Cash Flows from Financing Activities needs to be further adjusted to compute the net effects from debt related activities to exclude net effects from equity related activities.

Cash Flow Statement Example:  Financing Activities

In the above table taken from a cash flow statement, columns 2-4 refer to years and the row labels are provided in column 1.  The first three rows pertain to debt and the remaining rows pertain to equity.  As a result, the net borrowings for column 2 are positive and equal:  8055 – 6522 + 817 = 2350.

In this example the Free Cash Flow to Equity is greater than Free Cash Flow to the Firm so long as interest expense net of tax does not exceed 2350.

Once FCFE is computed then the stock’s dividend policy can be checked against the estimate of FCFE.  If total dividends paid exceed FCFE, then dividend policy is partly funded by net borrowings when net borrowings are positive.  If net borrowings are not sufficient to cover this shortfall between FCFE and dividend policy, or if net borrowings are negative, then dividend policy is being funded by the firm’s capital which includes retained earnings from past periods.

A Note on Working with the SEC Filings: International Stocks

It is easy to calculate the Free Cash Flow from information filed with the SEC in the 10-Q and 10-K reports.  You can also study non-US stocks using SEC data for companies that choose to list their stocks on US exchanges.  These stocks are known as American Depository Receipts (ADR’s).  Formally, these are "receipts" for shares of stocks of non-U.S. companies held by U.S. banks and traded by investors in the US.  There are three levels of ADR’s.  Level I is the lowest level and can be traded over-the-counter with minimal reporting requirements to the SEC.  Level II is listed on a US Stock Exchange and traded in the secondary stock markets.  A level II firm must file the equivalent of a 10-K and 10-Q with the SEC.  The equivalent forms for ADR’s are 20-F and 6-K respectively for the 10-K and 10-Q forms.  Level III is the highest level which carries additional SEC reporting requirements because this firm can issue stock in the US primary stock markets.

ADR’s that file a 20-F and 6-K can report under the International Financial Reporting Standards (IFRS) or they can choose to file a 10-K and 10-Q directly.  In other words they have the choice of filing under either set of standards to the SEC.  However, because nearly 100 countries now embrace IFRS, including the European Union, Australia, China, Japan, Korea and South Africa most ADR’s file a 20-F under IFRS.  Furthermore, in December 21, 2007 the SEC eliminated the requirement that 20-F filers reconcile their financial statements to US GAAP.  This throws much more work back to the analyst who must attempt to perform their own reconciliation when evaluating firms that are reporting under different accounting standards.  A brief overview of some of the differences an analyst needs to consider in relation to estimating free cash flows is provided next.