Free Cash Flow Approach

This is “Free Cash Flow Approach”, section 10.4 from the book Finance for Managers (v. 0.1). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. To download a .zip file containing this book to use offline, simply click here.

Has this book helped you? Consider passing it on:

Help Creative Commons

Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.

Help a Public School

DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

10.4 Free Cash Flow Approach

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

Calculate the valuation of a company based on FCFs and WACC.
Calculate the value of a share of stock using the FCF method.

The free cash flow (FCF) approach for valuing a company is very much related to the dividend discount model explained in section 2. The key difference is that we look at all of the cash flows available for distribution to the investors and use them to arrive at a value for the entire company. Since we are using the cash flows for all investors, we need to discount them not using just our expected return on equity, but on the weighted average cost of capital (WACC)An average of the returns required by equity holders and debt holders weighted by the company’s relative usage of each.. As the name implies, this is an average of the returns required by equity holders and debt holders weighted by the company’s relative usage of each. Arriving at the WACC will be the topic of a later chapter.

Equation 10.7 Value of Company Using Discounted FCF

\begin{array}{l} V_{C} = P V o f F u t u r e F C F s + P V o f T e r m i n a l V a l u e o f C o m p a n y \\ V_{C} = \frac{F C F_{1}}{{(1 + W A C C)}^{1}} + \frac{F C F_{2}}{{(1 + W A C C)}^{2}} + \dots + \frac{F C F_{n}}{{(1 + W A C C)}^{n}} + \frac{V_{T e r m i n a l}}{{(1 + W A C C)}^{n}} \end{array}

Finding the terminal value for a company has some of the same headaches as finding the future expected stock price. A common method is to assume a long-term growth rate for FCF, and use a variation of the perpetuity with growth formula:

Equation 10.8 Terminal Value of Company Using Discounted FCF

V_{T e r m i n a l} = \frac{F C F_{n + 1}}{W A C C - g} = \frac{F C F_{n} (1 + g)}{W A C C - g} {for g < W A C C}

This method can be extremely sensitive to the assumption used for the long-term growth rate. Once the value of the entire company is determined, we need to subtract the market values of our debt and preferred stock to arrive at the value of the residual due to common shareholders:

Equation 10.9 Value of Stock

Value of Company = Value of Debt + Value of Equity

= Value of Debt + (Value of Pref. Stock + Value of Common Stock) V_C = V_D + V_E = V_D + (V_ps + V_s) therefore V_C − V_D − V_ps = V_s

Once the value of the common stock is obtained, dividing by the number of shares outstanding should lead to an appropriate price per share.

Of course, a company might have a negative FCF currently but still be a good investment, if FCF is expected to turn positive in the future. This can happen particularly with corporations that are experiencing rapid growth, necessitating a large investment in capital to support future revenues. Since FCF for such companies tends to turn positive well before dividends are paid, this approach typically provides a superior estimate for stock value over the DDM.

Key Takeaways

Calculating the value of a company using the FCF method tends to be more accurate, so it is used in practice much more than the DDM.
The FCF method can be very sensitive to assumed long-term growth rates.

Exercises

Our company projects the following FCFs for the next 3 years: $5 million, $5.5 million, $6 million. Future growth is expected to slow to 5% beyond year 3. What is the terminal value of the company in year 3 if the WACC is 8%? What is the value of the company today? What is the company worth if the projected growth rate is only 3% beyond year 3?
If a company’s value is $250 million, and the company has $100 million market value of debt outstanding and no preferred stock, what is the value of its common stock? If there are ten million shares of stock outstanding, what is should be the price of one share of stock?