In How to Value Stocks, I concluded:
The value of a stock is the present value of future dividends. Some investors use free cash flow to equity as a proxy for dividends, but this method ignores the effect of share repurchases and free cash flow retained on the balance sheet.
Since I really only wrote a paragraph on free cash flow to equity (FCFE) in that post, I thought it’d be helpful to provide additional explanation on the difference between FCFE and dividends.
Defining FCFE
FCFE is the cash available to pay dividends. It equals the cash produced each year after all expenses, reinvestment in the business, and net debt repayments.
Using the income and cash flow statements, FCFE can be calculated as net income, plus depreciation and amortization, minus capital expenditures, minus change in non-cash working capital, plus debt raised minus debt repaid. The cash produced each year after “all expenses” is net income, the “reinvestments in the business” are capex minus D&A plus the change in non-cash working capital, and “net debt repayments” is the debt repaid minus debt issued.
FCFE = NI + (D&A - Capex - Δ non-cash WC) + (Debt Issued - Debt Repaid)
FCFE = Cash Produced Each Year After
All Expenses, Reinvestment in the Business, and Net Debt Repayments
FCFE = NI - Reinvestment in Business - Net Debt Repayments
Therefore, net income (earnings) can be defined as:
Earnings = FCFE + Reinvestment in Business + Net Debt Repayments
For a company with no debt, such as the lemonade stand in What Drives Earnings Growth, earnings is therefore equal to FCFE before reinvestment:
Earnings = FCFE + Reinvestment
Therefore, FCFE can be defined as earnings minus reinvestment:
FCFE = Earnings - Reinvestment
FCFE = Earnings * (1 - Reinvestment Ratio)
If all earnings not reinvested are paid out as dividends, then FCFE and dividends are the same.
Dividends = Earnings * (1 - Reinvestment Ratio) = FCFE
Therefore, when earnings not reinvested are fully paid out, FCFE will equal earnings times the payout ratio.
1 - Reinvestment Ratio = Payout Ratio
Dividends = Earnings * Payout Ratio = FCFE
The problem is that many companies don’t pay 100% of FCFE as dividends. Instead, they use it for share repurchases, retain it as cash or cash equivalents, or or make non-capex investments.
Divergent Examples: Alphabet, Netflix, and Berkshire Hathaway
For example, take Alphabet, Google’s parent company. Alphabet has been a free cash flow to equity machine, but for many years it didn’t use the FCFE to either pay out dividends or repurchase shares. Instead, it just let it build up on the balance sheet as cash, cash equivalents, and low-risk marketable debt. So, dividends and FCFE clearly diverged. Since a stock is worth the present value of future dividends, valuing Alphabet’s stock using FCFE would produce a distorted result. Specifically, since Alphabet has put most of its FCFE in low-return investments (lower than shareholders’ cost of capital), then using FCFE to value Alphabet will overstate the fair value of the stock.
At the opposite end of the spectrum is a company like Netflix. Throughout its history, Netflix has never paid a dividend, but used 100% of FCFE to repurchase shares. Here, again, dividends and FCFE are clearly not the same and using FCFE to value Netflix produces a distorted result. Since shareholders collectively only ever get cash back in dividends, accurately valuing Netflix requires estimating how many shares they will repurchase until they start paying out dividends and get to a steady state. If the shares are repurchased at an attractive rate of return (when the stock is undervalued), using FCFE to value Netflix will understate the fair value of the stock.
In between Alphabet and Netflix is Berkshire Hathaway. Berkshire has invested most of its FCFE by buying new businesses or buying treasuries with the hope of buying new businesses later. As long as the rate of return on buying these new businesses now or in the future is greater than Berkshire Hathaway’s investors’ cost of capital, Berkshire’s decision to use FCFE to buy new businesses is preferable to paying out a dividend (when also considering taxes) and using FCFE to value Berkshire would understate fair value.
Conclusion
Free cash flow to equity is the cash that can be distributed to the shareholders after all expenses, reinvestments in the business, and debt repayments. When FCFE is not used to pay a dividend, and instead used for share repurchases, set aside as cash, or invested outside the business in a debt or equity investment, then valuing a business using FCFE will be inaccurate. Therefore, to get an accurate picture, the effect of the alternative uses of FCFE has to be explicitly modeled. As explained in How to Value Stocks, the simplest way to do this is to estimate earnings per share once the company gets to a steady state and then apply an appropriate earnings multiple.
Further Reading
Aswath Damodaran wrote a helpful chapter on FCFE in Investment Valuation, 2nd edition. In addition, he has webpages on FCFE here and here, and a similar chapter on FCFE in The Little Book on Valuation.