Chapter 8 - Free Cash Flow to the Equity Models

8.1. What is a Free Cash Flow to the Equity model?

This model can be seen as a simplified DCF analysis, connected to the valuation models for dividends. In this model, Free Cash Flows to the Equity (FCFE) are paid to the shareholders as dividends and no other form of cash capital is be made available, since there is be no cash left after payment of dividend reinvestment and the reinvestment necessity is also distributed to shareholders. The dividend cash-flow is substituted by FCFE in this model which creates two main limitations: there will be no future cash build-up in the firm, since the cash that is available after debt payments and reinvestment needs is paid out to shareholders each period and that the expected growth in FCFE will include growth in income from operating assets and not growth in income from increases in marketable securities.

8.2.

Why use the FCFE model?

Normally the numerous valuation models tackle some of the difficulties in valuing a company, each in their own way; some models are more suitable for certain kinds of companies, depending on their financial situation, markets or industry. The FCFE models is more commonly used when dividend policy is not a straightforward indicator for the level of FCFE, and companies consistently satisfy their reinvestment needs with debt issues. The FCFE model has also variants that allow it to adapt to different kinds of companies. For example, the 1-stage FCFE model is more suitable for companies that exhibit stable growth, since there is no need to adjust some of the inputs in the model; and the 2-stage and 3-stage FCFE model is more suitable for valuing companies that exhibit high growth. Also, since this model is a valuation model that focuses on FCFE and shareholder dividends, it is widely used as a method for valuing minority stakes (as shareholders in other companies.

8.3.

FCFE and dividends.

The conventional measure of dividend policy the dividend payout ratio provides the value of dividends as a proportion of earnings. In contrast, our approach measures the total cash returned to shareholders as a proportion of the free cash flow to equity.

The ratio of cash to FCFE to the shareholders shows how much of the cash available to be paid out to shareholders is actually returned to them in the form of dividends and stock buybacks. If this ratio, over time, is equal or close to 1, the firm is paying out all that it can to its shareholders. If it is significantly less than 1, the firm is paying out less than it can afford to and is using the difference to increase its cash balance or to invest in marketable securities. If it is significantly over 1, the firm is paying out more than it can afford and is either drawing on an existing cash balance or issuing new securities (stocks or bonds). The implications for valuation are simple. If we use the dividend discount model and do not allow for the build-up of cash that occurs when firms pay out less than they can afford, we will under estimate the value of equity in firms. The need to differentiate between dividends and FCFE is the fact that firms make the difference by not distributing all FCFE to shareholders, generally due to a desire for stability, for future investment needs, tax factors, signalling prerogatives and managerial self-interest. The desire for stability refers to the facts that dividends are generally sticky, so even if the FCFE increases, the firm is reluctant to increase dividend payment for fear of its inability to maintain a higher level of dividends and disappoint the shareholders next period. The alternative to keeping excess cash in funding future investments is issuing securities, which is expensive, so firms tend not to distribute all of the FCFE to shareholders so those future investment needs can be met without any additional costs. If dividends are taxed higher than capital gains, then the firm will not be willing to distribute all of the FCFE to shareholders as dividends, in order to have tax savings. Increasing and decreasing dividends are a sign to shareholders of the financial health of the company and this is reflected in share price, therefore signalling is also a reason for withholding cash from shareholders. Lastly, management can decide that a financial cushion might be necessary for future endeavours, for example, so this can also be a purely managerial decision.

8.4.

Estimating Growth of FCFE.

FCFE, like dividends, are cash flows to equity investors and the same approached is used as when calculating the fundamental growth rate in dividends per share.

The retention rate here described as the percentage of FCF that is not paid out as dividends and is reinvested into future firm projects. However, this does not state the difference between dividends and FCFE as cash-flow to be distributed to shareholders; therefore it is more consistent with the FCFE models to include a different rate, the Equity Reinvestment Rate, which measures the percentage of net income that is invested back into the firm.

The return on equity may also have to be modified to reflect the fact that the conventional measure of the return includes interest income from cash and marketable securities in the numerator and the book value of equity also includes the value of the cash and marketable securities. In the FCFE model, there is no excess cash left in the firm and the return on equity should measure the return on non-cash investments. You could construct a modified version of the return on equity that measures the non-cash aspects. Average Net Income below is an average of the last 5 years Net Income of AstraZeneca.

The product of the equity reinvestment rate and the modified ROE will yield the expected growth rate in FCFE.

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