This is “Free Cash Flow Approach”, section 10.4 from the book Finance for Managers (v. 0.1).
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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
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
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 StockValue of Company = Value of Debt + Value of Equity
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.