Chapter

5 Free cash flow valuation

approaches

Instructor: Pham Ha
5.1 Definitions
• We can value companies that do not pay dividends using the residual income
model.

• Note: We assume positive earnings when we use the residual income model.

• But there are companies that do not pay dividends and have negative
earnings.

• Do negative earnings imply zero value?

• We calculate earnings based on accounting rules and tax codes.

• It is possible that a company has:

• negative earnings,
• positive cash flows,

• and therefore, a positive value.

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5.1 Definitions and other characteristics
• Depreciation is key to understanding how a company can have negative
earnings and positive cash flows.

• Depreciation reduces earnings because it is counted as an expense (more

expenses = lower taxes paid).

• Most stock analysts use a simple formula to calculate Free Cash Flow, FCF:

FCF = EBIT(1 − Tax Rate) + Depreciation

− Capital Spending − Change in Net Working Capital

• Looking at the FCF formula, you can see how Earnings, i.e., EBIT < 0 but
FCF > 0

• It is also possible, i.e., via a big capital expenditure, for EBIT > 0 and FCF < 0
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5.1 Free Cash Flow Valuation Approaches (in
detail)
• Free Cash Flow for Firm (FCFF)
• 𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑡𝑐 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 −
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑁𝑊𝐶
• EBIT = Earnings before interest and taxes
• 𝑡𝑐 = Corporate tax rate
• NWC = Net working capital

• Free Cash Flow to Equity Holders (FCFE)

• 𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹𝐹 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 × 1 − 𝑡𝑐 +
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡

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5.1 Free Cash Flow Valuation Approaches
• Estimating Terminal Value using Constant
Growth Model
𝑇 1+𝐹𝐶𝐹𝐹𝑡 𝑃𝑇
• 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = σ𝑡=1 +
(1+𝑊𝐴𝐶𝐶)𝑡 (1+𝑊𝐴𝐶𝐶)𝑇
𝐹𝐶𝐹𝐹𝑇+1
• 𝑃𝑇 =
𝑊𝐴𝐶𝐶−𝑔

• WACC = Weighted average cost of capital

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5.1 FCF Valuation Approaches: FCFF Example
• Suppose FCFF = $1 mil for years 1-4 and then is
expected to grow at a rate of 3%. Assume WACC = 15%
T
FCFF PT
FirmValue =  +
t =1 (1 + WACC ) (1 + WACC )T
t

$1, 000, 000  1.03

4
=
$1, 000, 000
+ .15 − .03
t =1 (1 + .15)t (1 + .15) 4
= $ 7, 762, 527
• If 500,000 shares are outstanding, what is the predicted
price of this stock if the firm has $5,000,000 of debt?
$7, 762, 527-$5,000,000
P0 = = $5.53
500, 000

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5.1 Free Cash Flow Valuation Approaches
• Market Value of Equity
𝑇 𝐹𝐶𝐹𝐸𝑡 𝑃𝑇
• 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = σ𝑡=1 +
(1+𝑘𝐸 )𝑡 (1+𝑘𝐸 )𝑇
𝐹𝐶𝐹𝐸𝑇+1
• 𝑃𝑇 =
𝑘𝐸 −𝑔

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5.1 FCF Valuation Approaches: FCFE Example
• Suppose FCFE = $900,000 for years 1-4 and then is
expected to grow at a rate of 3%. Assume ke = 18%
T
FCFE PT
Market Value of Equity =  +
t =1 (1 + k e ) t
(1 + k e ) t

$900, 000  1.03

4
=
$900, 000
+ .18 − .03
t =1 (1 + .18) t
(1 + .18) 4

= $ 2, 500,851
• If there are 500,000 shares outstanding, what is the
predicted price of this stock? Why can debt be ignored?
$ 2, 500,851
P0 = = $5.00
500, 000

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Spreadsheet 5.1: FCF

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5.1 Free Cash Flow Valuation Approaches
• Comparing Valuation Models
• Model values differ in practice
• Differences stem from simplifying assumptions

• Problems with DCF Models

• DCF estimates are always somewhat imprecise
• Investors employ hierarchy of valuation
• Real estate, plant, equipment
• Economic profit on assets in place
• Growth opportunities
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5.2 Examples
• Two companies have the same constant revenue and expenses for the next
three years. Also, assume no debt (no interest expense), no taxes, no
CAPEX, and no change in Working Capital. So, without depreciation, each
year:

• Assume depreciation chosen by each company is:

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5.2 Examples

• Let’s compare Cash Flow = Net Income + Depreciation (with our

assumptions):

• Net income differences have nothing to do with the profitability of the

companies.

• Cash flows are the same; depreciation differs.

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5.3 DDMs Versus FCF
• The DDMs calculate a value of the equity only.
• DDMs use dividends, a cash flow only to equity holders.
• DDMs use the CAPM to estimate required return.
• DDMs use an equity beta to account for risk.

• Using the FCF model, we calculate a value for the

firm.
• Free cash flow can be paid to debt holders and to stockholders.
• We can still calculate the value of equity using FCF:
• Calculate the value of the entire firm.
• Subtract out the value of debt.

• We need a beta for assets, not the equity, to account for risk.

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5.4 Asset Betas
• Asset betas measure the risk of the company’s industry.

• Firms in an industry should have about the same asset betas.

• Their equity betas can be quite different.

• Investors can increase portfolio risk by borrowing money.

• A business can increase risk by using debt.

• So, to value the company, we must “convert” reported equity betas into asset betas by
adjusting for leverage.
• Analysts widely use the following conversion formula:

Debt
BEquity = BAsset  [1 + (1 − t )]
Equity
What happens when a firm has no debt? tax rate.

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5.5 The FCF Approach, Example in practice
• Inputs
• An estimate of FCF:

• Net Income

• Depreciation

• Capital Expenditures

• The growth rate of FCF

• The proper discount rate

• Tax rate

• Debt/Equity ratio

• Equity beta

• Calculate value using a modified “DDM” formula

• “DDM” because we are using FCF, not dividends.

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Valuing Landon Air: A New Airline
• An estimate of FCF:
By Using CAPM with Asset Beta.
• EBIT: $45 million
Assume:
• Interest Expense: 6.45 million No dividends
• Depreciation: $10 million Risk-free rate = 4%
• No change in Net Working Capital Market risk premium = 7%
• Capital Expenditures: $3 million
The proper discount rate:
• Growth rate of FCF: 3%
k = 4.00 + (7 × 0.912) = 10.38%
• Tax rate: 21%
𝐹𝐶𝐹 = $45 × 1 − .21 + 10 − 3 − 0 = $42.55
• Debt/Equity ratio: .40
• Equity Beta: 1.2 Put FCF into the Basic DDM formula:

$42.55 ×(1+.03)
• Asset Beta:
Landon Air Value = = $593.62
.1038 − .03

1.2 = BAsset × [1+.4 × (1 − .21)]

If Landon Air has $100 million in debt, the total
1.2 = BAsset × 1.32
equity value is $493.62 million
BAsset = .912

Value per share = $4,936,200 / number of shares

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 Thank you

Never forget CAPM- it will be

with you for a long time