Free Cash Flow Valuation
Exam Focus
This topic review introduces the concept of free cash flow. The value of a firm’s stock is calculated by forecasting free cash flow to the firm (FCFF) or free cash flow to equity (FCFE) and discounting these cash flows back to the present at the appropriate required rate of return. FCFF or FCFE are the appropriate models to use when (1) the firm doesn’t pay dividends at all or pays out fewer dividends than dictated by its cash flow, (2) free cash flow tracks profitability, or (3) the analyst takes a corporate control perspective.
Make sure you see the parallels between the free cash flow framework and the discounted dividend framework (i.e., the basic free cash flow model is analogous to the Gordon growth model). Memorize the formulas for FCFF and FCFE. This is a very important test topic, as many analysts prefer free cash flow models to dividend discount models.
Recovered source visuals
Modules
- Module 19.1FCF ComputationCompare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation. · Explain the ownership perspective implicit in the FCFE approach.7 min · 2 LOS
- Module 19.2Fixed Capital and Working CapitalExplain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.5 min · 1 LOS
- Module 19.3Variations of Formulae5 min
- Module 19.4ExampleCalculate FCFF and FCFE.2 min · 1 LOS
- Module 19.5FCF Other AspectsDescribe approaches for forecasting FCFF and FCFE. · Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE. · Compare the FCFE model and dividend discount models. · Evaluate the use of net income and EBITDA as proxies for cash flow in valuation. · Explain the use of sensitivity analysis in FCFF and FCFE valuations. · Explain the single stage (stable growth), two stage, and three stage FCFF and FCFE models and justify the selection of the appropriate model given a company’s characteristics. · Estimate a company’s value using the appropriate free cash flow model(s). · Describe approaches for calculating the terminal value in a multistage valuation model. · Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model.20 min · 9 LOS