In this article, I will show you how to calculate and interpret free cash flow to equity (FCFE), also known as levered free cash flow (LFCF). Understanding FCFE is essential for investors as it provides insight into a company's financial health, revealing the cash available to equity shareholders after fulfilling all operating expenses, non-cash expenses like depreciation and amortization, capital expenditures, and non-cash working capital requirements, and after servicing its debt obligations. It's particularly relevant for equity valuation because it focuses on the cash flow that could be distributed to shareholders or reinvested by the company.
This article will explain FCFE, describe its differences from free cash flow to the firm (FCFF), present all the formulas for calculating FCFE, and provide a real-world example of calculating and interpreting FCFE.
Free Cash Flow to Equity (FCFE) Explained
Free cash flow to equity (FCFE) is the cash flow available to common stockholders after covering operating expenses, including non-cash expenses like depreciation and amortization (D&A), investments in capital expenditures (CapEx), and non-cash net working capital (NWC), as well as after servicing net borrowing. Since FCFE represents cash flows available specifically to equity holders, distinguishing it from free cash flow to the firm (FCFF), which accounts for cash flows to all funding providers, it's also known as levered free cash flow (LFCF).
FCFE is a critical measure for equity valuation, especially within the framework of the discounted cash flow (DCF) model tailored for equity valuation. This model projects FCFE into the future and discounts these cash flows back to the present using the cost of equity, rather than the weighted average cost of capital (WACC) used in FCFF-based valuations. The sum of these discounted free cash flows and the terminal value, gives the equity value of the company directly.
This valuation process estimates the company's equity value, highlighting future dividend and share buyback potentials. While FCFE offers equity-specific insights, FCFF is often preferred for its relative simplicity and broader scope. Despite being an unlevered figure that includes debt impacts, unlike FCFE, FCFF is simpler to work with as it sidesteps the complexities of forecasting the company's debt activities. This relative simplicity makes FCFF a more reliable option for valuations, providing a comprehensive view of cash flows available to all capital providers before debt obligations.
FCFE provides a nuanced view of a company's ability to generate cash specifically available to its equity holders, taking into account its debt obligations and operational investment requirements. It's an important metric for investors focusing on dividend or buyback potential, as it directly relates to the cash that could be distributed to shareholders. If dividends or buybacks are not issued (both of which are optional), then this FCFE will just increase the company's cash balance, thereby increasing the value of the company.
Free Cash Flow to Equity (FCFE) vs. Free Cash Flow to the Firm (FCFF)
When considering a firm's financing options, it can raise capital primarily through debt or equity investors, a choice available to both private and public entities. This leads to two primary categories of free cash flow: free cash flow to equity (FCFE) and free cash flow to the firm (FCFF).
FCFE, or levered free cash flow (LFCF), is the cash flow available to equity shareholders after meeting all financial obligations, including debt payments. It represents the net cash flow remaining for equity investors after accounting for operating expenses, including non-cash expenses like D&A, CapEx, non-cash NWC changes, and net borrowing. FCFE focuses on the cash flow that can be distributed to shareholders or reinvested by the firm after fulfilling debt-related obligations.
In contrast, FCFF, also known as unlevered free cash flow (UFCF), encompasses the total cash flows available to both equity investors and lenders, before considering debt payments. It measures the cash generated by the firm's core operations that is available for expansion, debt repayment, or distributions to shareholders and lenders, without the impact of financing structure.
Thus, the primary distinction between FCFE and FCFF lies in their consideration of debt. FCFE offers a focused perspective by including the impact of debt, whereas FCFF provides a broader view by excluding the effects of financing decisions. To derive FCFE from FCFF, the formula can be adjusted as follows:
FCFE = FCFF - Interest Expenses × (1 - Tax Rate) + Net Borrowing
This formula modifies FCFF (cash available to all capital providers) by subtracting after-tax interest expenses (indicating cash outflows that are exclusive to debt holders) and adding net borrowing (reflecting additional cash from new debt or cash used for debt repayments). This results in FCFE, which specifically measures the cash flow available to equity shareholders after accounting for debt payments and borrowings, providing a focused insight into the cash distributable to equity investors.
How to Calculate Free Cash Flow to Equity (FCFE)
This section discusses the standard free cash flow to equity (FCFE) formula and explains its formula components in-depth.
Free Cash Flow to Equity (FCFE) Formula
The Net Income to FCFE formula is shown below:
FCFE = Net Income + D&A - CapEx - Change in Non-Cash NWC + Net Borrowing
where:
- FCFE = free cash flow to equity (aka levered free cash flow (LFCF))
- Net Income = profit after taxes and interest
- D&A = depreciation and amortization
- CapEx = capital expenditures
- Change in Non-Cash NWC = change in non-cash net working capital
- Net Borrowing = new debt issued - debt repayments
Net Income to FCFE Formula Explanation
There are multiple methods investors can use to calculate free cash flow to equity (FCFE). The most commonly used method starts with the company's net income, which is the profit after interest and taxes have been deducted. This figure already accounts for the cost of debt financing, thus representing earnings available to equity shareholders.
To adjust for non-operating expenses that do not impact the company's cash flow, non-cash charges like depreciation and amortization (D&A) are added back to net income. These non-cash charges reduce taxable income but do not reduce the company's actual cash flow, making them important adjustments to reflect the true cash available to shareholders.
The FCFE calculation then requires subtracting capital expenditures (CapEx), which represent the cash spent on investments to maintain or expand the firm’s asset base. These expenditures are necessary for the company's sustainability and future growth but reduce the cash available to equity shareholders.
Next, the formula adjusts for changes in net working capital (NWC) to account for the cash impact of managing short-term assets and liabilities. More specifically, the focus should be on non-cash NWC changes in the FCFE calculation to assess the company's use of non-cash assets for financing operations and meeting short-term liabilities.
Here's how an increase/decrease in NWC can be interpreted:
- Increase in Non-Cash NWC: Suggests that a company is investing more cash into its short-term operational needs, such as inventory or receivables. This results in less cash being available for equity shareholders because the company uses more of its operational cash flows to support its day-to-day business activities rather than distributing it to shareholders or using it for other purposes.
- Decrease in Non-Cash NWC: Indicates that a company is freeing up cash from its operational activities, possibly by efficiently managing its inventory and receivables or increasing its payables. This leads to more cash being available for equity shareholders in the FCFE calculation, as less cash is tied up in managing the company's short-term operational needs, making more available for distribution or other uses.
Net borrowing is the final component of FCFE, and the primary distinction of FCFE from FCFF. It represents the difference between new debt issued and debt repayments during the period. The reason debt borrowed is included, as opposed to just the debt paydown, is that the proceeds from the borrowing could be used to distribute dividends or repurchase shares. Both of these can be found under the "Financing Activities" section of a cash flow statement. The net borrowing figure is added to FCFE because it reflects external financing available to equity shareholders after servicing existing debt, directly impacting the returns to equity shareholders.
Here's how an increase/decrease in net borrowing can be interpreted:
- Increase in Net Borrowing: Indicates that a company has taken on more debt during the period than it has repaid. This typically means the company is raising additional funds through debt financing, which can be used for various purposes such as expanding operations, investing in new projects, or refinancing existing debt. An increase in net borrowing contributes positively to the FCFE calculation, as it represents additional cash available to equity shareholders after accounting for the company's operational and investment activities.
- Decrease in Net Borrowing: Signifies that a company has repaid more debt during the period than it has incurred. This reflects a reduction in the company's leverage, indicating that the firm is paying down its debt obligations, possibly to improve its balance sheet health or reduce interest expenses. A decrease in net borrowing reduces the FCFE, as it represents a cash outflow, reducing the amount of cash available to equity shareholders after fulfilling the company's operational and investment needs.
When calculating FCFE, there's nuance about how to handle net borrowing. You can include all debt issuances and repayments, just focus on the repayments, or only look at the mandatory ones. The general approach is to account for all debt activities to fully understand how borrowing and repaying debt affects the cash available to shareholders. This gives a complete picture of a company's approach to managing its debt.
If you only consider repayments, or specifically just the required ones, you highlight the cash going out to cover debt, which shows the immediate money obligations impacting what's available for shareholders. The method you choose depends on what aspect of the company's finances you want to focus on, showing different sides of how a company handles its debt and finances.
Alternative Free Cash Flow to Equity (FCFE) Formulas
The two alternative FCFE formulas, EBITDA to FCFE and CFO to FCFE, provide different approaches for estimating a company's free cash flow available to equity shareholders. These formulas offer different insights into a firm's capacity to generate cash that could potentially be distributed to equity shareholders after all operating expenses, capital expenditures, and debt obligations have been met.
EBITDA to FCFE Formula
The EBITDA to FCFE formula is an approach that starts with the company's EBITDA (earnings before interest, taxes, depreciation, and amortization), offering a measure of operational profitability before the effects of financing structure, tax environment, and capital expenditure decisions.
The EBITDA to FCFE formula is shown below:
FCFE = EBITDA × (1 - Tax Rate) + (D&A × Tax Rate) - CapEx - Change in Non-Cash NWC + Net Borrowing
where:
- FCFE = free cash flow to equity (aka levered free cash flow (LFCF))
- EBITDA = earnings before interest, taxes, depreciation, and amortization
- Tax Rate = effective tax rate applied to company's taxable income (income tax expense / earnings before tax (EBT))
- D&A = depreciation and amortization
- CapEx = capital expenditures
- Change in Non-Cash NWC = change in non-cash net working capital
- Net Borrowing = new debt issued - debt repayments
The EBITDA to FCFE approach is useful for analyzing companies across industries or with different financing and tax structures because it evaluates cash flow from operations before interest, taxes, depreciation, and amortization are considered. Beginning with EBITDA therefore may provide a clearer comparison by assessing operational earning power directly. This method is particularly valuable for capital-intensive industries or companies undergoing significant changes in financing or taxation, as it focuses on the business's core ability to generate cash, setting aside the effects of its capital structure and tax strategies until later in the calculation.
However, the EBITDA to FCFE method struggles with companies that have complex financing or significant debt. This issue stems from its generalized tax adjustment, which doesn't account for the intricacies of different debt types or repayment terms. While it incorporates interest and taxes, negative tax rates from carryforward losses or substantial deductions can skew the FCFE figures. Its approach to debt's tax shields, treating them uniformly, may not accurately reflect the true impact on cash flow in scenarios of high leverage or unique tax situations, leading to imprecise outcomes and requiring deeper analysis.
Cash From Operations (CFO) to FCFE Formula
The CFO to FCFE formula provides a relatively straightforward way to estimate FCFE directly from the company's operational cash flows, emphasizing cash generation from core business activities.
The CFO to FCFE formula is shown below:
FCFE = CFO - CapEx + Net Borrowing
where:
- FCFE = free cash flow to equity (aka levered free cash flow (LFCF))
- CFO = cash from operations
- CapEx = capital expenditures
- Net Borrowing = new debt issued - debt repayments
This approach begins with cash from operations (CFO), which inherently includes adjustments for non-cash expenses and changes in working capital, thus reflecting the cash generated by the company's core business operations. From this, it subtracts CapEx to account for the cash spent on investments in long-term assets crucial for the firm's growth. It then adds net borrowing, capturing the net cash inflows or outflows from financing activities related to debt, to isolate the cash flow available to equity shareholders.
A key advantage of the CFO to FCFE formula lies in its use of actual cash flows from daily operations, which tends to be more accurate than starting from net income or EBITDA. This is because CFO is less susceptible to accounting maneuvers that can affect earnings figures, such as aggressive revenue recognition or manipulation of expenses, providing a clearer, more reliable measure of the cash truly generated by core activities. Beginning with CFO also emphasizes the company’s operational efficiency, tying performance directly to shareholder value.
The primary limitation of the CFO to FCFE method is that cash from operations (CFO) might include items classified as non-cash expenses, such as stock-based compensation, or changes in net working capital items that are not truly non-cash, both crucial for accurate FCFE calculations. These inclusions could distort the true cash available to equity shareholders. However, this can be mitigated by carefully adjusting the CFO figure to exclude such items, ensuring a more accurate representation of FCFE.
Free Cash Flow to Equity (FCFE) Examples
In this section, we'll demonstrate how to calculate free cash flow to equity (FCFE) for Amazon (AMZN), a leading global e-commerce and cloud computing company. We'll show the calculation for the conventional FCFE formula and compare it with the alternative FCFE formulas discussed above for the company's 2023 fiscal year (FY).
Net Income to FCFE Formula Example
To begin the conventional EBIT to FCFF calculation, we need to obtain the company's income statement and cash flow statement either from the investor relations section of its website or from the SEC's website, using the most recent 10-K annual report.
You can download the file below, which presents Amazon's income statement, balance sheet, and cash flow statement in a formatted manner, alongside the FCFE calculation models discussed in this article:
For the net income to FCFE calculation, every number can be found on the cash flow statement (CFS), as the formula below shows (described earlier):
FCFE = Net Income + D&A - CapEx - Change in Non-Cash NWC + Net Borrowing
Net Income & Non-Cash Expenses
Begin by locating net income, which will typically be the first line item on a cash flow statement. Then, identify the company's non-cash expenses. These items are outlined in the image below:
As you can see, the net income in FY 2023 is $30,425M.
In terms of non-cash expenses, we've included all the non-cash items for Amazon in FY 2023, except for stock-based compensation, which, while typically located in the non-cash items section of the cash flow statement (to adjust net income to cash from operations), is more of an "in-kind" expense than a real non-cash expense. In other words, because stock-based compensation reflects the cost of equity financing and uniquely impacts shareholder value, it should be treated differently than other non-cash adjustments. Total non-cash expenses for FY 2023 are therefore $42,039M ($48,663M - $748M - $5,876M).
Changes in Non-Cash Net Working Capital (NWC)
Below the non-cash items, you'll see the changes in working capital section. You want to focus on non-cash net working capital (NWC), not just NWC, because it provides a clearer picture of the cash generated by core operations. These non-cash NWC items are outlined in the image below:
In the case of Amazon, all of their changes in working capital are considered non-cash, like inventories, accounts receivable, accounts payable, etc., because these changes represent adjustments for items that impact the cash flow without an immediate cash exchange. Thus, the total non-cash NWC in FY 2023 is just the total, -$11,541M. Depending on the company you're analyzing, you may see items like "short-term debt," "other long-term assets," and "other long-term liabilities." In these cases, you'd need to exclude them from the non-cash NWC total.
Capital Expenditures (CapEx)
Next, you need to deduct the company's capital expenditures (CapEx) from the FCFE formula. This is where you'd look under the "Investing Activities" section of a cash flow statement and identify all the cash outflows that would be considered CapEx. These CapEx items are outlined in the image below:
Here, the "Purchases of Property and Equipment" are just another way to say CapEx, or Plant, Property, and Equipment (PP&E), which, in most cases unless otherwise stated, all mean the same thing. This is -$52,729M in FY 2023.
Notably, the acquisitions line item of -$5,389M in FY 2023 is also included in the total CapEx consideration, making the total -$58,568M (-$52,729M + -$5,389M). This inclusion is justified because, even though acquisitions are not traditionally viewed as CapEx, they are cash outflows that directly affect FCFE. Including them provides a clearer picture of the cash available to equity holders.
On the other hand, proceeds from property, plant, and equipment (PP&E), and sales and purchases of marketable securities should not be considered in the CapEx total because they represent inflows or transactions not directly related to the core operational investments of the company. These figures typically reflect financing or investment activities rather than capital expenditures aimed at maintaining or expanding the firm's operational capacity.
Net Borrowing
Finally, the main distinguishing factor of FCFE from FCFF is its consideration of debt, specifically net borrowing, which needs to be added back to complete the FCFE calculation. For this, look under the "Financing Activities" section of the cash flow statement to identify any new debt issued and any debt repayments. These items are outlined in the image below:
When it comes to determining net borrowing, first, determine how much cash the company raised by issuing debt. In Amazon's case, this would just be the line items with the name "proceeds," because "proceeds" means the amount raised from issuing new debt. Amazon had no proceeds from long-term debt in FY 2023, so this amount would just be $18,129M in FY 2023, equal to the amount of proceeds from short-term debt (and other).
Then, consider the cash the company spent on paying off debt. These are all the cash outflows that have the names repayments or principal repayments, effectively representing the cash outflows that reduce the company's total debt obligations. For FY 2023, this amounts to -$34,008M in total (-$25,677M + -$3,676M + -$4,384M + -$271M).
Lastly, if we subtract the cash the company spent on repaying its debt obligations from the cash the company raised from issuing new debt, we'll get the company's net borrowing. In FY 2023, this would be -$15,879M ($18,129M - $34,008M). This negative net borrowing figure signifies that Amazon paid back more debt than it issued, reducing its leverage.
Calculate Net Income to FCFE
Now that we have all components of the net income to FCFE calculation, we can calculate it for Amazon's FY 2023 as follows:
FCFE [AMZN] = $30,425M + $42,039M - $58,568M + $11,541M - $15,879M --> $9,558M
Thus, Amazon's FCFE in FY 2023 is $9,558M, which represents the cash available to all common stock shareholders after accounting for all operational expenses, investments, and debt financing activities.
One final note -- If there is an effect from foreign exchange (forex) items, typically found at the bottom of the cash flow statement, it can be included in the FCFE calculation, especially if it is significant and recurring. For Amazon, the forex impact was $403M in FY 2023, which isn't substantial. However, adding this to the FCFE results in a more precise figure of $9,961M ($9,558M + $403M). This refined total more accurately reflects the cash available to Amazon's equity holders, taking into account the impact of foreign exchange movements during FY 2023.
These deductions from net income to FCFE can be visualized in a waterfall chart, as shown below:
Consolidating these items into a waterfall chart helps explain Amazon's activities in FY 2023. The company retained $30,450M in net income, adjusted for $42,039M in non-cash expenses and $11,541M in non-cash NWC. Then, after deducting reinvestments of $58,568M in total CapEx and the decreases in net borrowing of $15,879M, and adjusting for forex cash changes of $403M, what remains is the cash available to shareholders, the FCFE of $9,961M.
EBITDA to FCFE Formula Example
Now, we can calculate FCFE for Amazon starting from EBITDA, using the formula below (described earlier):
FCFE = EBITDA × (1 - Tax Rate) + (D&A × Tax Rate) - CapEx - Change in Non-Cash NWC + Net Borrowing
For the EBITDA to FCFE formula, it's necessary to consult the income statement as well, not just the cash flow statement. All items in the EBITDA to FCFE formula have been identified previously, except for the company's EBITDA and tax rate. These can be found or calculated from the income statement.
EBITDA may be explicitly provided as a line item. If not, it's the sum of the company's operating income (EBIT) and its depreciation and amortization (D&A). For Amazon in FY 2023, this is $85,515M ($36,852M (EBIT) + $48,663M (D&A)).
The company's tax rate, or effective tax rate, is typically detailed in the "Notes to the Financial Statements" section of a 10-K annual report. It can also be calculated using the formula below:
Effective Tax Rate = Provision for Income Taxes / Pre-Tax Income (EBT)
Thus, the effective tax rate is the division of the company's tax expense by its pre-tax income, often labeled as "Income Before Tax" or "Earnings Before Tax" (EBT) on the income statement.
In Amazon's case, the effective tax rate for FY 2023 is -19.0% (-$7,120M (Provision for Income Taxes) / $37,557M (EBT)). This negative effective tax rate suggests that Amazon benefited from tax incentives, deductions, or credits, leading to a tax benefit rather than a tax expense.
The EBITDA to FCFE calculation for Amazon's FY 2023 can now be calculated as follows:
FCFE [AMZN] = $85,515M × (1 + 0.19) + ($42,039M × -0.19) - $58,568M + $11,541M - $15,879M --> $30,851M
This FCFE of $30,851M indicates that Amazon had significant cash available to equity holders after accounting for operational expenses, investments, debt financing, and benefiting from its negative tax rate. Such a negative tax rate shows that the company received more in tax benefits than it owed in taxes, likely due to specific deductions, credits, or other tax incentives.
Using this approach with a negative tax rate may not be ideal for multi-year comparisons or forecasting future cash flows, which usually assume positive tax rates. To mitigate this, normalizing the tax rate, for example, through averaging, is suggested. Alternatively, FCFE can be calculated assuming a 0% tax rate and then adjusted by adding the tax benefit (the absolute value of the tax provision) as reported in the company's 10-K. Opting for the net income to FCFE or CFO to FCFE formulas is also advisable since they inherently account for income taxes, simplifying the analysis.
Cash From Operations (CFO) to FCFE Formula Example
Lastly, we can calculate FCFE for Amazon starting from cash from operations (CFO), using the formula below (described earlier):
FCFE = CFO - CapEx + Net Borrowing
For the CFO to FCFE formula, you only need the cash flow statement. We've already identified the company's total CapEx and net borrowing for FY 2023. Thus, all that remains is to identify the company's cash from operations (CFO) number, which results from the company's net income for the period plus any non-cash adjustments and changes in working capital. This can be directly obtained from the cash flow statement. For Amazon in FY 2023, their CFO was $84,946M.
However, for a more accurate calculation, we'd net out items from CFO that we identified as not being actual non-cash expenses or non-cash NWC items. In Amazon's case, we'd exclude stock-based compensation expense, as it's not considered a non-cash expense. We'd also want to exclude any working capital items not considered non-cash, like other long-term assets and liabilities. For Amazon, stock-based compensation is the only figure needing exclusion. Thus, the adjusted CFO for FY 2023 is $60,923M ($84,946M (CFO) - $24,023M (Stock-Based Comp.)).
Given this, we can calculate FCFE as follows:
FCFE [AMZN] = $60,923M - $58,568M - $15,879M --> -$13,524M
Here, our result is -$13,524M, which indicates that Amazon experienced a negative free cash flow to equity in FY 2023. This signifies that after accounting for capital expenditures and net borrowing, the cash available to equity shareholders was negative, reflecting the company's cash outflows exceeded its inflows from operations and financing activities during the period.
Net Income to FCFE vs. CFO to FCFE
Notably, the CFO to FCFE calculation yields -$13,524M, and the net income to FCFE (excluding forex changes) gives $9,558M due to different treatments of non-cash adjustments and working capital changes. The net income method adds back non-cash expenses and non-cash NWC, resulting in a positive FCFE after subtracting CapEx and net borrowing. The CFO method starts with operational cash flow, adjusting it down by excluding stock-based compensation, leading to a negative FCFE. The discrepancy arises from the net income approach's explicit subtracting of changes in non-cash NWC, unlike the CFO method, where it's already included.
The CFO to FCFE calculation, adjusted to exclude stock-based compensation (in our case), directly reflects the actual cash flow from operations, making it potentially more representative of the true cash available to equity shareholders. This method prioritizes operational cash flow, adjusting for financing activities and investments, and offers a pragmatic view by focusing on cash that can be distributed to shareholders or reinvested.
Conversely, the net income to FCFE approach, with its detailed breakdown including non-cash expenses and working capital changes, allows for a granular analysis of operational profitability's impact on shareholder cash availability. However, the adjusted CFO to FCFE method provides a clearer picture of immediate cash availability, making it slightly more accurate for evaluating the cash truly available to equity shareholders after all operational and financing activities.
The Bottom Line
Free cash flow to equity (FCFE) is a measure of how much cash is available to the equity shareholders of a company after all expenses, debts, and investments have been accounted for. Unlike free cash flow to the firm (FCFF), which looks at cash flows available to both debt and equity holders, FCFE focuses specifically on shareholders. It's useful for explaining past financial performance, including its application in price multiples, and plays a relevant role in valuation models like discounted cash flow (DCF) and comparable company analysis (comps) to assess intrinsic value.
The conventional method to calculate FCFE starts from net income, adjusting for non-cash expenses, capital expenditures (CapEx), changes in non-cash net working capital (NWC), and net borrowing. Two alternative approaches include starting with EBITDA or CFO, offering different perspectives on operational profitability and cash generation. The EBITDA-based method evaluates operational efficiency before financing and tax effects, while the CFO-based approach provides a direct look at cash generated from operations, differing mainly in their initial adjustments and focus.
In closing, understanding FCFE is key for investors aiming to gauge the cash available for dividends or buybacks, reflecting a company's financial flexibility and shareholder value.