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New face of free cash flow

Free cash flow to equity, or FCFE, is an important metric for stock investors which tells how much cash is available to shareholders

New face of free cash flow

Most stock investors would have come across the term 'free cash flow'. The conventional free cash flow is also known as 'free cash flow to firms'. It is called so because it is the free cash flow available to all the stakeholders of a firm, including equity shareholders, debt holders and preference shareholders. Free cash flow is simply the cash flow available to firm after meeting all operating expenses, taxes and expenditures needed to support the firm's productive capacity.

From the investor's point of view, a parameter that is even more important is free cash flow to equity (FCFE). Free cash flow to equity is a metric of how much cash can be distributed to the equity shareholders of a company as dividends or stock buybacks after all expenses, capital expenditure and debt repayments are taken care of. Where dividend is the cash flows actually paid to shareholders, FCFE is the cash flow simply 'available' to shareholders.

How to calculate FCFE
There are two methods to calculate FCFE.
Method 1: From the profit-and-loss account
FCFE = Net profit + Non-cash expenses (depreciation, etc.) + Working capital changes - Capital expenditure - Net debt repayment

Method 2: From the cash-flow statement
FCFE = Cash flow from operations - Capital expenditure (from the cash flow from investing activities) - Net debt payment (debt paid minus new debt taken from the cash from financing activities)

It is easier to calculate FCFE through the cash-flow statement.

To put the idea of FCFE to use, we calculated the FCFE for BSE 500 companies with one modification. Since the new debt raised by a company ultimately needs to be paid in the future, we took 'debt repayment' rather than 'net debt payment'. This helped us be more conservative with our analysis. We kept oil and gas companies out of the list since they have fluctuating changes in working capital due to inventories.

New face of free cash flow

In BSE 500, there are only 61 companies which have generated positive FCFE consistently in the past five financial years. Out of these, we found only five companies which have increased FCFE year on year in the past five financial years.

Moreover, we wanted to eliminate real-estate companies due to their very nature of business, but no realty company was able to make it to the list of the 61 companies.

In the list of 61 companies, we have also identified the companies which have high FCFE as per cent of market capitalisation. Such companies are attractive in terms of valuation.

Though analysing FCFE may look like an effective way to study a company's financial strength and valuation, as a thumb rule, always remember that a single parameter is not enough to take the final investment call. Do consider other fundamental aspects as well.