Stock Valuation

284 PART 2 Important Financial Concepts
However, in the free cash flow valuation model, instead of valuing the firm’s
expected dividends, we value the firm’s expected free cash flows, defined in Equation
3.3 (page 95). They represent the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after all other
obligations have been met.
The free cash flow valuation model estimates the value of the entire company
by finding the present value of its expected free cash flows discounted at its
weighted average cost of capital, which is its expected average future cost of
funds over the long run (see Chapter 10), as specified in Equation 7.5.
VC . . . FCF∞ (7.5)
(1 ka) ∞
FCF2
(1 ka) 2
FCF1
(1 ka) 1
where
V Cvalue of the entire company
FCF tfree cash flow expected at the end of year t
k athe firm’s weighted average cost of capital
Note the similarity between Equations 7.5 and 7.1, the general stock valuation
equation.
Because the value of the entire company, VC, is the market value of the entire
enterprise (that is, of all assets), to find common stock value, VS, we must subtract
the market value of all of the firm’s debt, VD, and the market value of preferred
stock, VP, from VC. VSV CV DV P
(7.6)
Because it is difficult to forecast a firm’s free cash flow, specific annual cash
flows are typically forecast for only about 5 years, beyond which a constant
growth rate is assumed. Here we assume that the first 5 years of free cash flows
are explicitly forecast and that a constant rate of free cash flow growth occurs
beyond the end of year 5 to infinity. This model therefore requires a number of
steps to calculate and combine the forecast values of the early-year free cash
flows with those of the later-year constant-growth free cash flows. Its application
is best demonstrated with an example.
EXAMPLE Dewhurst Inc. wishes to determine the value of its stock by using the free cash
flow valuation model. In order to apply the model, the firm’s CFO developed the
data given in Table 7.3. Application of the model can be performed in four steps.
Step 1 Calculate the present value of the free cash flow occurring from the end
of 2009 to infinity, measured at the beginning of 2009 (that is, at the end
of 2008). Because a constant rate of growth in FCF is forecast beyond
2008, we can use the constant-growth dividend valuation model (Equation
7.4) to calculate the value of the free cash flows from the end of
2009 to infinity.
Value of FCF2009 ∞
$
1 0 , 3 0 0 , 0 0 0 FCF2009
kag FCF
$600,000(1 0.03)
0.09 0.03
$618,000
0.06