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Just like we have the single stage Free Cash Flow to the Firm (FCFF) model, we also have the Free Cash Flow to Equity model. This model also is not used by analysts in advanced calculations. Rather it is used for the most rudimentary back of the envelope calculations for deriving the equity valuation of a given firm. However, this model also forms the basis on which more complex equity valuation models are built. Hence, it is important that we have a good understanding of the working of this model. We will make an attempt to gain the required understanding through this article.
The free cash flow to equity model is primarily used in the case of international valuations. The model becomes even more effective when the multinational company also conducts business is some countries which are prone to high inflation.
In this case, the inputs being used by the free cash flow to equity formula i.e. the cost of equity and free cash flow to equity are much easier to predict than compared to inputs used by other formulas.
The Gordon model, the single stage free cash flow to the firm (FCFF) growth model as well as the single stage free cash flow to equity (FCFE) model all look deceptively similar. The advantage of their similarity is that once you understand one of these models you understand all three. The disadvantage is that it is possible to get confused amongst the subtle differences that these models have.
The thumb rule is to remember that the relevant cash flow metric has to be discounted at the relevant discount rate. Let’s see how this works.
Notice that even though Gordon model and free cash flow to equity use different measures of cash flow, they use the same discount rate to discount them. Hence, we have three different measures of cash flow but only two different measures of discount rates. This maybe a possible source of confusion and students may want to pay attention here.
For instance, if a firm takes on a lot of debt, the free cash flow to the firm may not be affected that much. However, once you consider the interest payments and debt repayments that will accrue, the free cash flow to equity may exhibit a very different growth rate as a result of the leverage.
Formula:
The formula for calculating terminal value of a firm using free cash flow to equity is as follows:
Terminal Value of the Firm = FCFE (1) / ROE – g
Where
FCFE (1) is the cash flow that accrues to the firm in the first year post the horizon period
ROE is the return on equity that accrues to the equity shareholders
G is the long term growth rate
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