Estimate what a firm is worth with the free cash flow model or models that fit it
The idea
To value a company from FCFF, discount the forecast flows at the WACC, add a terminal value at the horizon, usually FCFF(n+1) ÷ (WACC − g), also discounted, then subtract the market value of debt, and of preferred shares if any, to reach equity, which divided by shares outstanding gives a per-share value. To value from FCFE, discount the flows at the required return on equity, with a terminal value of FCFE(n+1) ÷ (r − g). Non-operating assets such as surplus cash are added to operating value. Consistency matters: nominal flows with nominal rates, and each rate matched to its claimants. The classic traps are subtracting debt from an FCFE value and forgetting to subtract it from an FCFF value.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Contrast valuing a business by the free cash flow available to equity (FCFE) with valuing it by its free cash flow to the whole firm (FCFF)
- Explain whose point of view as owner the FCFE approach takes
- Explain which adjustments turn EBIT (pre-interest, pre-tax earnings), EBITDA, net income and operating cash flow (CFO) into FCFF and FCFE
- Work out FCFF and FCFE
- Set out ways of projecting FCFF and FCFE
- Explain how dividends, buybacks, new share issues and shifts in leverage can change future FCFF and FCFE
- Contrast the FCFE model with dividend discount models
- Assess using EBITDA and net income as stand-ins for cash flow when valuing a firm
- Explain how sensitivity analysis is used in FCFF and FCFE valuation
- Explain FCFF and FCFE models with one stable-growth stage, two stages and three stages, and argue which suits a given firm's characteristics
- Set out ways of working out terminal value in a valuation model with several stages
- Judge from a free cash flow valuation whether a stock is priced too high, too low or fairly