TheFCFEmodeltreatsthestockholderinapubliclytraded
firmastheequivalentoftheownerofaprivatebusiness.The
lattercanlayclaimonallcashflowsleftoverinthebusiness
aftertaxes,debtpayments,andreinvestmentneedshavebeen
met.Sincethefreecashflowtoequitymeasuresthesamefor
apubliclytradedfirm,weareassumingthatstockholdersare
entitledtothesecashflows,evenifmanagersdonotchoose
topaythemout.Inessence,theFCFEmodel,whenusedina
publiclytradedfirm,implicitlyassumesthatthereisastrong
corporategovernance systeminplace. Evenif stockholders
cannotforcemanagerstoreturnfreecashflowstoequityas
dividends,theycanputpressureonmanagerstoensurethat
the cash that does not get paid out is not wasted.
Inputs to the FCFE Model
Freecashflowstoequity,likedividends,arecashflowsto
equityinvestors,andwecouldusethesameapproachthatwe
usedtoestimatethefundamentalgrowthrateindividendsper
share.
Theuse oftheretentionratio inthis equation implies that
whateverisnotpaidoutasdividendsisreinvestedbackinto
thefirm.Thereisastrongargumenttobemade,though,that
thisisnotconsistentwiththeassumptionthatfreecashflows
toequityarepaidouttostockholders,whichunderliesFCFE
models.Itisfarmoreconsistenttoreplacetheretentionratio
withtheequityreinvestmentrate,whichmeasuresthepercent
of net income that is invested back into the firm.