Valuation Using Discounted Cash Flow Analysis
Free-cash-flow approaches to estimating intrinsic value
1 Introduction
In our exploration of equity valuation, we have already encountered the Dividend Discount Model (DDM), which values a stock based on the present value of its expected future dividends. While the DDM is elegant in its simplicity, it has a significant limitation: it only works well for companies that pay regular, predictable dividends. Many firms—especially high-growth companies—retain most or all of their earnings to fund expansion, paying little or no dividends. How do we value such companies?
The answer lies in free cash flow valuation. Rather than focusing on what a company actually pays out to shareholders, free cash flow approaches focus on what a company could pay out—the cash generated by operations after accounting for the investments needed to maintain and grow the business. This perspective is powerful because free cash flow represents the true economic value created by a firm, regardless of its dividend policy.
In this lecture, we will examine two complementary approaches to free cash flow valuation. The Free Cash Flow to the Firm (FCFF) approach values the entire enterprise—both debt and equity holders’ claims—and then subtracts debt to arrive at equity value. The Free Cash Flow to Equity (FCFE) approach values equity directly by focusing on cash flows available to shareholders after all obligations to creditors have been met. Both methods, when applied correctly, should yield consistent valuations, but each has its advantages depending on the situation and the data available.
Understanding these methods requires bringing together concepts from corporate finance (capital structure, cost of capital), accounting (financial statement analysis), and the time value of money principles we have been developing throughout this course. By the end of this lecture, you will be able to calculate free cash flows from financial statement data, determine appropriate discount rates, and build complete valuation models for any publicly traded company.
2 The Free Cash Flow to the Firm (FCFF) Approach
2.1 Conceptual Foundation
The FCFF approach begins with a fundamental insight: a firm’s total value equals the present value of the cash flows it generates for all of its capital providers—both debt holders and equity holders. By discounting these cash flows at the weighted average cost of capital (WACC), we obtain an estimate of the total enterprise value. To find the value of equity specifically, we simply subtract the market value of debt from this enterprise value.
This approach is particularly useful when a company’s capital structure (its mix of debt and equity) is expected to remain relatively stable over time. Because FCFF represents cash flows before any payments to debt holders, it is unaffected by the firm’s financing decisions, making it easier to compare companies with different capital structures or to value a company under alternative financing scenarios.
The general valuation formula expresses firm value as the present value of all future FCFFs:
\[\text{Firm Value}_t = \frac{\text{FCFF}_{t+1}}{1+\text{WACC}} + \frac{\text{FCFF}_{t+2}}{(1+\text{WACC})^2} + \frac{\text{FCFF}_{t+3}}{(1+\text{WACC})^3} + \cdots\]
Since we cannot calculate an infinite sum directly, we typically use a two-stage model similar to what we learned with the DDM. We forecast FCFFs explicitly for a finite horizon (say, 5-10 years), then assume that beyond this horizon, FCFFs grow at a constant rate forever. This allows us to calculate a terminal value using the perpetuity growth formula:
\[\text{Terminal Value}_{t+H} = \frac{\text{FCFF}_{t+H}(1+g)}{\text{WACC} - g}\]
where \(H\) is the forecast horizon and \(g\) is the long-term growth rate. With the terminal value in hand, our complete valuation formula becomes:
\[\text{Firm Value}_t = \sum_{i=1}^{H} \frac{\text{FCFF}_{t+i}}{(1+\text{WACC})^i} + \frac{\text{Terminal Value}_{t+H}}{(1+\text{WACC})^H}\]
Alternatively, the terminal value can be estimated using valuation multiples such as EV/EBITDA, which we will discuss in a later lecture on relative valuation.
2.2 Calculating Free Cash Flow to the Firm
FCFF represents the cash flow available to all capital providers after the company has made all necessary investments to sustain and grow its operations. The standard formula is:
\[\text{FCFF} = \text{EBIT}(1 - T_c) + \text{Depreciation} - \text{Capital Expenditures} - \Delta\text{NWC}\]
Let’s break down each component. EBIT (Earnings Before Interest and Taxes) represents the firm’s operating profit before any financing costs. We multiply EBIT by \((1 - T_c)\), where \(T_c\) is the corporate tax rate, to compute the after-tax operating income the firm would have if it were financed entirely with equity. This is sometimes called NOPAT (Net Operating Profit After Taxes).
Depreciation is added back because it is a non-cash expense. When we calculated EBIT, depreciation was subtracted as an expense, but since it does not represent an actual cash outflow, we must add it back to determine true cash generation.
Capital expenditures (CapEx) are subtracted because they represent cash investments in property, plant, and equipment necessary to maintain and expand the business. These are real cash outflows required to generate future FCFFs.
Change in Net Working Capital (\(\Delta\)NWC) captures the cash tied up in day-to-day operations. When a company grows, it typically needs more inventory, extends more credit to customers (accounts receivable), and so on. An increase in NWC represents cash that cannot be distributed to capital providers. When calculating NWC for valuation purposes, analysts commonly exclude cash and interest-bearing debt, defining NWC as:
\[\text{NWC} = \text{Inventory} + \text{Accounts Receivable} - \text{Accounts Payable}\]
This definition focuses on the operating working capital that directly supports the firm’s core business activities.
In practice, we often must estimate the tax rate from financial statements. While the marginal tax rate is theoretically correct, we frequently use the average (effective) tax rate, calculated as tax expense divided by taxable income (pre-tax income), when marginal rate data is unavailable.
2.3 The Weighted Average Cost of Capital
To discount FCFFs to present value, we need the weighted average cost of capital—the blended required return across all sources of financing. The WACC formula is:
\[\text{WACC} = \frac{D}{D+E} \times r_d \times (1 - T_c) + \frac{E}{D+E} \times r_e\]
Here, \(D\) represents the market value of debt, \(E\) represents the market value of equity, \(r_d\) is the cost of debt, \(r_e\) is the cost of equity, and \(T_c\) is the corporate tax rate. The cost of debt is tax-adjusted because interest payments are tax-deductible, creating a tax shield that effectively reduces the cost of borrowing.
For the cost of debt (\(r_d\)), the best approach is to use the yield to maturity on the firm’s existing bonds if the company has publicly traded debt. If not, we can approximate it by dividing interest expense by total debt, though this may reflect historical rather than current borrowing costs.
For the cost of equity (\(r_e\)), we typically use the Capital Asset Pricing Model (CAPM):
\[r_e = r_f + \beta \times \text{Market Risk Premium}\]
where \(r_f\) is the risk-free rate, \(\beta\) measures the stock’s systematic risk, and the market risk premium is the expected return on the market portfolio above the risk-free rate. Some analysts use multifactor models like the Fama-French three-factor model for more refined estimates.
For the market value of equity, we multiply the current stock price by the number of shares outstanding. For debt, market value is theoretically correct but often approximated using book value of long-term debt when market prices are unavailable.
Example 1: FCFF Valuation of MSFT
Suppose in the latest fiscal year, Microsoft (MSFT) had EBIT of $100 billion, depreciation of $10 billion, capital expenditures of $20 billion, and an increase in net working capital of $5 billion. The company has total debt of $70 billion and 2 billion shares outstanding. The tax rate is 30%. You believe FCFFs will grow at 10% per year for the next 5 years, then at 4% per year thereafter. MSFT has a cost of debt of 3% and a CAPM beta of 1.2. The current share price is $200, and the risk-free rate is 0.1%. Assume a market risk premium of 6%. What is the intrinsic value per share?
Step 1: Calculate current FCFF
\[\text{FCFF}_0 = \text{EBIT}(1-T_c) + \text{Dep} - \text{CapEx} - \Delta\text{NWC}\] \[\text{FCFF}_0 = 100(1-0.30) + 10 - 20 - 5 = 70 + 10 - 20 - 5 = \$55 \text{ billion}\]
Step 2: Calculate the cost of equity using CAPM
\[r_e = r_f + \beta \times \text{MRP} = 0.001 + 1.2 \times 0.06 = 0.001 + 0.072 = 0.073 = 7.3\%\]
Step 3: Calculate WACC
First, determine market value of equity: \[E = 2 \text{ billion shares} \times \$200 = \$400 \text{ billion}\]
With \(D = \$70\) billion and \(D + E = \$470\) billion:
\[\text{WACC} = \frac{70}{470} \times 0.03 \times (1-0.30) + \frac{400}{470} \times 0.073\] \[\text{WACC} = 0.1489 \times 0.021 + 0.8511 \times 0.073\] \[\text{WACC} = 0.00313 + 0.0621 = 0.0652 = 6.52\%\]
Step 4: Project FCFFs for the high-growth period
| Year | FCFF (billions) |
|---|---|
| 1 | \(55 \times 1.10 = \$60.50\) |
| 2 | \(60.50 \times 1.10 = \$66.55\) |
| 3 | \(66.55 \times 1.10 = \$73.21\) |
| 4 | \(73.21 \times 1.10 = \$80.53\) |
| 5 | \(80.53 \times 1.10 = \$88.58\) |
Step 5: Calculate terminal value at year 5
\[\text{TV}_5 = \frac{\text{FCFF}_5 \times (1+g)}{\text{WACC} - g} = \frac{88.58 \times 1.04}{0.0652 - 0.04} = \frac{92.12}{0.0252} = \$3,648 \text{ billion}\]
Step 6: Discount all cash flows to present value
| Year | Cash Flow | Discount Factor | Present Value |
|---|---|---|---|
| 1 | \(60.50\) | \(1.0652^1 = 1.0652\) | \(56.8\) |
| 2 | \(66.55\) | \(1.0652^2 = 1.1346\) | \(58.6\) |
| 3 | \(73.21\) | \(1.0652^3 = 1.2086\) | \(60.5\) |
| 4 | \(80.53\) | \(1.0652^4 = 1.2874\) | \(62.5\) |
| 5 | \(88.58\) | \(1.0652^5 = 1.3712\) | \(64.6\) |
| 5 (TV) | \(3,648\) | \(1.3712\) | \(2,659\) |
Total Firm Value \(= \$2,962\) billion
Step 7: Calculate equity value and per-share intrinsic value
\[\text{Equity Value} = \text{Firm Value} - \text{Debt} = 2,962 - 70 = \$2,892 \text{ billion}\]
\[\text{Intrinsic Value per Share} = \frac{2,899.53}{2} = \$1,446\]
3 The Free Cash Flow to Equity (FCFE) Approach
3.1 Conceptual Foundation
While the FCFF approach values the entire firm and then subtracts debt, the FCFE approach values equity directly. FCFE represents the cash flow available to common shareholders after all operating expenses, interest payments, and principal repayments have been made, and after any necessary investments in working capital and fixed assets.
The FCFE approach is particularly useful when a firm’s capital structure is expected to change significantly over time, or when we want to focus specifically on what shareholders can expect to receive. Because FCFE is the cash flow after debt service, we discount it at the cost of equity (not WACC) to obtain the value of equity directly:
\[\text{Equity Value}_t = \frac{\text{FCFE}_{t+1}}{1+r_e} + \frac{\text{FCFE}_{t+2}}{(1+r_e)^2} + \frac{\text{FCFE}_{t+3}}{(1+r_e)^3} + \cdots\]
As with the FCFF approach, we typically assume constant growth after a forecast horizon to calculate a terminal value:
\[\text{Terminal Value}_{t+H} = \frac{\text{FCFE}_{t+H}(1+g)}{r_e - g}\]
This terminal value can alternatively be estimated using equity multiples such as P/E or P/B ratios.
To convert total equity value to per-share intrinsic value, we simply divide by the number of shares outstanding.
3.2 Calculating Free Cash Flow to Equity
FCFE starts with FCFF and adjusts for the cash flows related to debt financing:
\[\text{FCFE} = \text{FCFF} - \text{Interest}(1 - T_c) + \text{Net Debt Issuance}\]
Let’s understand each adjustment. Interest expense represents cash paid to debt holders. We multiply by \((1 - T_c)\) because interest is tax-deductible—the after-tax cost of interest is lower than the pre-tax amount. This after-tax interest must be subtracted from FCFF because it is paid to creditors, not equity holders.
Net debt issuance captures changes in the firm’s borrowing. If the firm issued new debt during the year (i.e., debt increased), this represents cash inflow that is available to equity holders. If the firm repaid debt (debt decreased), this represents cash outflow that reduces what is available to shareholders. We calculate net debt issuance as:
\[\text{Net Debt Issuance} = \text{Debt}_t - \text{Debt}_{t-1}\]
A positive value means debt increased (cash inflow), while a negative value means debt decreased (cash outflow).
The intuition behind this formula is straightforward: we start with cash available to all capital providers (FCFF), subtract what goes to debt holders (after-tax interest), and adjust for any net borrowing or repayment. What remains is the cash flow available exclusively to equity holders.
Example 2: FCFE Valuation of MSFT
Using the same data as Example 1: MSFT had EBIT of $100 billion, depreciation of $10 billion, capital expenditures of $20 billion, and an increase in NWC of $5 billion. The company has current total debt of $70 billion, prior-year debt of $50 billion, and 2 billion shares outstanding. Interest expense was $10 billion and the tax rate is 30%. FCFEs are expected to grow at 10% per year for 5 years, then 4% thereafter. Beta is 1.2, the risk-free rate is 0.1%, and the market risk premium is 6%. What is the intrinsic value per share using the FCFE approach?
Step 1: Calculate FCFF (from Example 1)
\[\text{FCFF}_0 = \$55 \text{ billion}\]
Step 2: Calculate FCFE
Net debt issuance \(= 70 - 50 = \$20\) billion (debt increased, so positive)
\[\text{FCFE}_0 = \text{FCFF} - \text{Interest}(1-T_c) + \text{Net Debt Issuance}\] \[\text{FCFE}_0 = 55 - 10(1-0.30) + 20 = 55 - 7 + 20 = \$68 \text{ billion}\]
Step 3: Cost of equity (from Example 1)
\[r_e = 7.3\%\]
Step 4: Project FCFEs for the high-growth period
| Year | FCFE (billions) |
|---|---|
| 1 | \(68 \times 1.10 = \$74.80\) |
| 2 | \(74.80 \times 1.10 = \$82.28\) |
| 3 | \(82.28 \times 1.10 = \$90.51\) |
| 4 | \(90.51 \times 1.10 = \$99.56\) |
| 5 | \(99.56 \times 1.10 = \$109.52\) |
Step 5: Calculate terminal value at year 5
\[\text{TV}_5 = \frac{\text{FCFE}_5 \times (1+g)}{r_e - g} = \frac{109.52 \times 1.04}{0.073 - 0.04} = \frac{113.90}{0.033} = \$3,451.52 \text{ billion}\]
Step 6: Discount all cash flows to present value
| Year | Cash Flow | Discount Factor | Present Value |
|---|---|---|---|
| 1 | \(74.80\) | \(1.073^1 = 1.0730\) | \(69.71\) |
| 2 | \(82.28\) | \(1.073^2 = 1.1513\) | \(71.47\) |
| 3 | \(90.51\) | \(1.073^3 = 1.2353\) | \(73.27\) |
| 4 | \(99.56\) | \(1.073^4 = 1.3255\) | \(75.11\) |
| 5 | \(109.52\) | \(1.073^5 = 1.4222\) | \(77.00\) |
| 5 (TV) | \(3,451.52\) | \(1.4222\) | \(2,427.04\) |
Total Equity Value \(= 69.71 + 71.47 + 73.27 + 75.11 + 77.00 + 2,427.04 = \$2,793.60\) billion
Step 7: Calculate per-share intrinsic value
\[\text{Intrinsic Value per Share} = \frac{2,793}{2} = \$1,396\]
Note that this differs from the FCFF result ($1,446). In theory, both methods should yield identical values when applied consistently. The discrepancy arises because we used the same growth rates for both FCFF and FCFE, but changes in capital structure affect these cash flows differently. In practice, small differences are common and acceptable.
4 Comparing the Two Approaches
The FCFF and FCFE methods are both legitimate approaches to intrinsic valuation, and each has its strengths. The table below summarizes when each approach is most appropriate:
| Consideration | FCFF Approach | FCFE Approach |
|---|---|---|
| What it values | Enterprise (debt + equity) | Equity directly |
| Discount rate | WACC | Cost of equity (\(r_e\)) |
| Best when | Capital structure is stable | Capital structure is changing |
| Advantages | Independent of financing; easier comparisons | Direct equity valuation; simpler for leveraged firms |
| Key sensitivities | WACC assumptions, debt valuation | Interest and debt issuance forecasts |
In theory, both methods should produce identical equity values when applied with consistent assumptions. In practice, differences arise due to forecasting assumptions about debt levels, interest rates, and growth rates. Analysts often use both methods as a cross-check: if the valuations diverge significantly, it suggests examining the underlying assumptions more carefully.
5 Key Takeaways
Free cash flow valuation extends the principles of the Dividend Discount Model to companies that pay little or no dividends, focusing instead on the cash a firm generates that could potentially be distributed to capital providers. The FCFF approach values the entire enterprise by discounting cash flows available to all capital providers at the weighted average cost of capital, then subtracts debt to arrive at equity value. This method works well when capital structure is relatively stable and provides a clean separation between operating performance and financing decisions. The FCFE approach, in contrast, values equity directly by discounting cash flows available to shareholders after all debt obligations have been met, using the cost of equity as the discount rate. This method is particularly useful when leverage is changing or when the analyst wants to focus specifically on what shareholders can expect to receive.
Both approaches require careful attention to the components of free cash flow: starting with operating earnings, adjusting for non-cash charges like depreciation, and subtracting the cash investments in fixed assets and working capital that are necessary to sustain the business. The choice of discount rate is equally critical—WACC for FCFF and cost of equity for FCFE—and both typically rely on the CAPM to estimate the required return on equity. Terminal value calculations, whether using perpetuity growth or exit multiples, often represent the majority of estimated value and deserve careful scrutiny. When applied consistently, both methods should yield similar valuations, and significant discrepancies signal a need to revisit assumptions about growth, discount rates, or capital structure.
6 Key Formulas Summary
| Concept | Formula | When to Use |
|---|---|---|
| Free Cash Flow to Firm | \(\text{FCFF} = \text{EBIT}(1-T_c) + \text{Dep} - \text{CapEx} - \Delta\text{NWC}\) | To calculate cash available to all capital providers |
| Free Cash Flow to Equity | \(\text{FCFE} = \text{FCFF} - \text{Int}(1-T_c) + \text{Net Debt Issuance}\) | To calculate cash available to shareholders |
| WACC | \(\text{WACC} = \frac{D}{D+E}r_d(1-T_c) + \frac{E}{D+E}r_e\) | To discount FCFF to present value |
| Cost of Equity (CAPM) | \(r_e = r_f + \beta \times \text{MRP}\) | To estimate required return on equity |
| Firm Value (FCFF) | \(\text{FV} = \sum_{i=1}^{H}\frac{\text{FCFF}_i}{(1+\text{WACC})^i} + \frac{\text{TV}_H}{(1+\text{WACC})^H}\) | To value entire enterprise |
| Equity Value (FCFE) | \(\text{EV} = \sum_{i=1}^{H}\frac{\text{FCFE}_i}{(1+r_e)^i} + \frac{\text{TV}_H}{(1+r_e)^H}\) | To value equity directly |
| Terminal Value (FCFF) | \(\text{TV}_H = \frac{\text{FCFF}_H(1+g)}{\text{WACC}-g}\) | To estimate value beyond forecast horizon |
| Terminal Value (FCFE) | \(\text{TV}_H = \frac{\text{FCFE}_H(1+g)}{r_e-g}\) | To estimate equity value beyond forecast horizon |
| Net Working Capital | \(\text{NWC} = \text{Inventory} + \text{AR} - \text{AP}\) | To calculate operating working capital |
7 Practice Problems
Practice Problem 1: FCFF Valuation
TechGrowth Inc. reported the following data for its latest fiscal year: EBIT of $50 billion, depreciation of $8 billion, capital expenditures of $15 billion, and an increase in net working capital of $3 billion. The company has total debt of $40 billion and 1 billion shares outstanding. The tax rate is 25%. You forecast that FCFFs will grow at 12% per year for the next 5 years, then at 3% per year thereafter. TechGrowth has a cost of debt of 4% and a CAPM beta of 1.3. The current share price is $300, and the risk-free rate is 2%. Assume a market risk premium of 5%. Calculate the intrinsic value per share using the FCFF approach.
Step 1: Calculate current FCFF
\[\text{FCFF}_0 = 50(1-0.25) + 8 - 15 - 3 = 37.5 + 8 - 15 - 3 = \$27.5 \text{ billion}\]
Step 2: Calculate cost of equity
\[r_e = 0.02 + 1.3 \times 0.05 = 0.02 + 0.065 = 0.085 = 8.5\%\]
Step 3: Calculate WACC
Market value of equity: \(E = 1 \times 300 = \$300\) billion
\(D + E = 40 + 300 = \$340\) billion
\[\text{WACC} = \frac{40}{340} \times 0.04 \times 0.75 + \frac{300}{340} \times 0.085\] \[\text{WACC} = 0.1176 \times 0.03 + 0.8824 \times 0.085 = 0.00353 + 0.075 = 0.0785 = 7.85\%\]
Step 4: Project FCFFs
| Year | FCFF (billions) |
|---|---|
| 1 | \(27.5 \times 1.12 = \$30.80\) |
| 2 | \(30.80 \times 1.12 = \$34.50\) |
| 3 | \(34.50 \times 1.12 = \$38.64\) |
| 4 | \(38.64 \times 1.12 = \$43.28\) |
| 5 | \(43.28 \times 1.12 = \$48.47\) |
Step 5: Calculate terminal value
\[\text{TV}_5 = \frac{48.47 \times 1.03}{0.0785 - 0.03} = \frac{49.92}{0.0485} = \$1,029.28 \text{ billion}\]
Step 6: Discount cash flows
| Year | Cash Flow | Discount Factor | Present Value |
|---|---|---|---|
| 1 | \(30.80\) | \(1.0785^1 = 1.0785\) | \(28.56\) |
| 2 | \(34.50\) | \(1.0785^2 = 1.1632\) | \(29.66\) |
| 3 | \(38.64\) | \(1.0785^3 = 1.2545\) | \(30.80\) |
| 4 | \(43.28\) | \(1.0785^4 = 1.3530\) | \(31.99\) |
| 5 | \(48.47\) | \(1.0785^5 = 1.4593\) | \(33.21\) |
| 5 (TV) | \(1,029.28\) | \(1.4593\) | \(705.34\) |
Total Firm Value \(= 28.56 + 29.66 + 30.80 + 31.99 + 33.21 + 705.34 = \$859\) billion
Step 7: Calculate equity value per share
\[\text{Equity Value} = 859 - 40 = \$819 \text{ billion}\] \[\text{Intrinsic Value per Share} = \frac{819}{1} = \$819\]
Practice Problem 2: FCFE Valuation
Using the same TechGrowth Inc. data from Practice Problem 1, suppose interest expense was $5 billion and prior-year debt was $30 billion. Calculate the intrinsic value per share using the FCFE approach.
Step 1: FCFF (from Practice Problem 1)
\[\text{FCFF}_0 = \$27.5 \text{ billion}\]
Step 2: Calculate FCFE
Net debt issuance \(= 40 - 30 = \$10\) billion
\[\text{FCFE}_0 = 27.5 - 5(1-0.25) + 10 = 27.5 - 3.75 + 10 = \$33.75 \text{ billion}\]
Step 3: Cost of equity
\[r_e = 8.5\%\]
Step 4: Project FCFEs (12% growth for 5 years)
| Year | FCFE (billions) |
|---|---|
| 1 | \(33.75 \times 1.12 = \$37.80\) |
| 2 | \(37.80 \times 1.12 = \$42.34\) |
| 3 | \(42.34 \times 1.12 = \$47.42\) |
| 4 | \(47.42 \times 1.12 = \$53.11\) |
| 5 | \(53.11 \times 1.12 = \$59.48\) |
Step 5: Calculate terminal value
\[\text{TV}_5 = \frac{59.48 \times 1.03}{0.085 - 0.03} = \frac{61.26}{0.055} = \$1,113.82 \text{ billion}\]
Step 6: Discount cash flows
| Year | Cash Flow | Discount Factor | Present Value |
|---|---|---|---|
| 1 | \(37.80\) | \(1.085^1 = 1.0850\) | \(34.84\) |
| 2 | \(42.34\) | \(1.085^2 = 1.1772\) | \(35.97\) |
| 3 | \(47.42\) | \(1.085^3 = 1.2773\) | \(37.12\) |
| 4 | \(53.11\) | \(1.085^4 = 1.3859\) | \(38.32\) |
| 5 | \(59.48\) | \(1.085^5 = 1.5037\) | \(39.56\) |
| 5 (TV) | \(1,113.82\) | \(1.5037\) | \(740.76\) |
Total Equity Value \(= 34.84 + 35.97 + 37.12 + 38.32 + 39.56 + 740.76 = \$926.58\) billion
Step 7: Per-share value
\[\text{Intrinsic Value per Share} = \frac{926.57}{1} = \$926.57\]
The FCFE approach yields a higher value than FCFF ($926.57 vs. $819), reflecting the different treatment of debt financing in the two models.
8 Ask an LLM
Here are three questions you might ask an AI assistant to deepen your understanding of these concepts:
- What happens to the FCFF and FCFE valuations when a company’s debt-to-equity ratio changes significantly over time? How should I modify my model to account for changing capital structure?
- Can you walk me through how to estimate the long-term growth rate (g) for terminal value calculations? What are reasonable bounds, and how does overestimating g affect valuation?
- Why might FCFF and FCFE approaches give different valuations in practice, and what should I check if the difference is large?
- How would I adjust the FCFF/FCFE valuation framework to value a company with negative free cash flows (like many growth-stage tech companies)?
- What are the main criticisms of DCF-based valuation methods, and when might relative valuation (multiples) be more appropriate?