Free cash flow to equity (FCFE): formula and calculation

Free Cash Flow to Equity (FCFE) is the residual cash flow available to shareholders once the company has paid its operating costs, taxes, capital expenditure, working capital needs and debt service. The FCFE formula, starting from net income, reads: FCFE = Net income + Depreciation and amortisation - Capex - Increase in working capital + Net borrowing (new debt raised minus repayments). Discounted at the cost of equity, FCFE gives the equity value directly, without passing through the enterprise value bridge. FCFE is best suited to companies with stable financing policies; where leverage changes materially over the plan, the FCFF and WACC approach is generally preferred. Consistency between the cash flow definition and the discount rate is essential to avoid double counting the effects of debt. Its projection also underpins dividend capacity analyses for shareholders and lenders.

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The bridge from FCFF (free cash flow to firm) is: FCFE = FCFF - Interest expense × (1 - tax rate) + Net borrowing. The two aggregates must never be mixed: FCFF belongs to all capital providers and is discounted at the WACC, whereas FCFE belongs to shareholders only and is discounted at the cost of equity. Discounting FCFE at the WACC, or FCFF at the cost of equity, is one of the most frequent errors uncovered in DCF models during due diligence. FCFE is the natural metric for valuing banks and insurers, where debt is an operating input rather than a financing choice, and for testing the dividend capacity of a holding company or of a target in a leveraged buy-out.

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Worked example: a Swiss services company posts net income of CHF 1.8 million, depreciation of CHF 0.7 million, capex of CHF 0.9 million, a working capital increase of CHF 0.1 million and net borrowing of CHF 0.2 million (CHF 0.5 million drawn, CHF 0.3 million repaid). FCFE = 1.8 + 0.7 - 0.9 - 0.1 + 0.2 = CHF 1.7 million. Valued as a growing perpetuity at a 10.5% cost of equity with 1.5% long-term growth, the equity value is 1.7 × 1.015 / (0.105 - 0.015) = CHF 19.2 million, directly comparable to the result of an enterprise value DCF after deduction of net financial debt.

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Hectelion uses FCFE in financial institution valuations and shareholder distribution capacity analyses, triangulating against enterprise-level DCF for consistency.