Free Cash Flow to Equity (FCFE) Discount Models

Free Cash Flow to Equity (FCFE) Discount Models are valuation models that estimate the intrinsic value of a stock based on the present value of its expected future free cash flows available to equity holders. FCFE represents the cash flow a company generates that is available to be distributed to its shareholders.

1. Free Cash Flow to Equity (FCFE):

• Definition: The cash flow available to a company's equity holders after all operating expenses, interest payments, debt repayments, and investments in working capital and fixed assets have been made.
• Importance: Used to value the equity portion of a company, especially when dividend policies are unstable or non-existent.
• Calculation:
  • Starting from Net Income:
    • FCFE = Net Income + Depreciation & Amortization - Capital Expenditures - Increase in Working Capital + Net Borrowing
  • Starting from Free Cash Flow to Firm (FCFF):
    • FCFE = FCFF - Interest Expense * (1 - Tax Rate) + Net Borrowing
  • Components:
    • Net Income: Profit available to shareholders.
    • Depreciation & Amortization: Non-cash charges that reduce net income but do not represent an outflow of cash.
    • Capital Expenditures (CapEx): Investments in fixed assets (e.g., property, plant, and equipment).
    • Increase in Working Capital: The change in current assets (e.g., accounts receivable, inventory) less the change in current liabilities (e.g., accounts payable).
    • Net Borrowing: The difference between new debt issued and debt repaid.

2. FCFE Valuation Models:

• General Formula: Equity Value = Σ [FCFE_t / (1 + Ke)^t] (Sum of present values of all future FCFE)

• Constant Growth FCFE Model:

  • Formula: P0 = FCFE1 / (Ke - g)
    • P0 = Current stock price (intrinsic value)
    • FCFE1 = Expected FCFE per share in the next period
    • Ke = Required rate of return on equity (cost of equity)
    • g = Constant growth rate of FCFE
  • Assumptions:
    • FCFE grows at a constant rate forever.
    • The growth rate (g) is less than the required rate of return (Ke).
  • Limitations:
    • Unrealistic assumption of constant growth forever.
    • Only suitable for mature, stable companies with predictable FCFE growth.

• Two-Stage FCFE Model:

  • Concept: This model assumes two distinct growth phases: an initial high-growth phase followed by a stable, constant-growth phase.
  • Formula:
    • P0 = [ Σ (FCFE_t / (1 + Ke)^t) ] + [ (FCFE_(n+1) / (Ke - gn)) / (1 + Ke)^n ]
    • Where:
      • FCFE_t = Expected FCFE per share in year t (during the high-growth phase)
      • Ke = Required rate of return on equity
      • n = Number of years in the high-growth phase
      • FCFE_(n+1) = Expected FCFE per share in year n+1 (the first year of the stable growth phase)
      • gn = Constant FCFE growth rate in the stable growth phase
  • Steps:
    1. Estimate FCFE during the high-growth phase (FCFE_t).
    2. Estimate the constant FCFE growth rate in the stable growth phase (gn).
    3. Discount the FCFE during the high-growth phase back to the present.
    4. Calculate the terminal value at the end of the high-growth phase using the Gordon Growth Model (FCFE_(n+1) / (Ke - gn)).
    5. Discount the terminal value back to the present.
    6. Sum the present values of the FCFE during the high-growth phase and the present value of the terminal value to arrive at the intrinsic value of the stock.
  • Applicability: More realistic than the constant growth model. Suitable for companies that are expected to experience a period of high growth followed by a period of stable growth.

Considerations:

• Negative FCFE: If a company has negative FCFE, the FCFE model may not be appropriate.
• Financing Policy: FCFE models assume that the company's financing policy (debt vs. equity) remains constant over time.
• Non-Operating Assets: FCFE models typically do not account for the value of non-operating assets, such as excess cash or marketable securities.
• Consistency: Ensure that the growth rates used for FCFE are consistent with the company's overall growth prospects and the assumptions used in estimating the cost of equity.

FCFE models provide a valuable alternative to the DDM, particularly for companies with complex dividend policies or significant non-cash charges. However, they are also subject to the same limitations as other DCF models, including sensitivity to assumptions and difficulty in forecasting future cash flows.