Free Cash Flow Valuation

by Obaidullah Jan, ACA, CFA

Free cash flow valuation is a method of business valuation in which the business value equals the present value of its free cash flow. It involves projecting free cash flows into future and then discounting them at the appropriate cost of capital.

There are two approaches to valuation using free cash flow. The first involves discounting projected free cash flow to firm (FCFF) at the weighted average cost of the capital (WACC) to find the total business value. The second involves discounting future free cash flow to equity (FCFE) at the required return of equity to find the value of the business equity.

Formula

The most basic free cash flow valuation models are similar to the dividend discount model. The following formulas are using to calculate business value and business equity value:

Using FCFF:

$$ Total\ Business\ Value = \frac {FCFF\ Next\ Year}{WACC − g} $$

Equity Value = Total Business Value − Market Value of Debt

Using FCFE:

$$ Business\ Equity\ Value = \frac {FCFE\ Next\ Year}{r_e − g} $$

Where,
WACC is the weighted average cost of capital
re is the required return on equity
g is the growth rate of FCFF and FCFE as the case may be

In real life more complex valuation models project cash flows by using more precise period on period growth rates.

Examples

Example 1: FCFF Valuation Model

Free cash flow to firm for Frontier Ceramics is currently $300 million but is expected to grow by 4% each year forever. If the company's cost of capital is 10%, how much is it worth? If market value of debt is $3,000 million and FC has 200 million shares outstanding, find per share value of FC.

Solution

$$ Total\ Business\ Value \\= \frac {$300M × (1 + 4\%)}{10\% − 4\%} \\= $5,200M $$

The model applied here essentially calculates the present value of a growing perpetuity. The relevant FCFF is calculated by projecting current year FCFF at the growth rate for one year.

If market value of debt is $3,000 million, value of equity is $2,200 million [= $5,200M − $3,000M].

Per share intrinsic value for FC is $11 [= $2,200M ÷ $200M].

Example 2: FCFE Valuation Model

PQ has 1 million shares outstanding. Its projected FCFE for next year is $30 million, its required return on equity is 13% and perpetual growth rate of FCFE is 5.5%. Find the intrinsic value of the company's share.

Solution

$$ Business\ Equity\ Value = \frac {$30M}{13\% − 5.5\%} = $400M $$

$$ Intrinsic\ Value\ per\ Share = \frac {$400M}{1M} = $40 $$