Chapter 12

Valuation:
Cash-Flow-Based
Approaches

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Valuing the Firm

Economic theory teaches us that the value of an
investment is:

Projected Future Payoffs t

V0
(1 Discount Rate)t
t 1
n

Expected future payoffs can be measured in

terms of:
Dividends
Cash Flows
Earnings
Chapter: 12

Approaches to firm valuation

Chapter: 12

Cash-Flow-Based Valuation
Focus is on the cash that flows into the

firm.
Measures the cash flows that are free
to be distributed to shareholders.
Cash flows generated by the firm create
dividend-paying capacity.

Chapter: 12

Cash-Flow-Based Valuation (Contd.)

Amount of cash flowing into firm differs

from dividends paid in a particular period.

But over the lifetime of the firm, cash
flows into and cash flows out of the firm
will be equal.

Chapter: 12

Rationale for Using Free-Cash-Flows

Cash is the ultimate source of value.

The free cash flows approach measures

value based on the cash flows that the
firm generates that can be distributed to
investors.
It is a measurable common denominator
for comparing the future benefits of
alternative investment instruments.
Chapter: 12

Cost of Common Equity Capital

CAPM Model:
E[REj ] E[R F ] j {E[RM ]E[RF ]}
Where :
E expectatio n
REj Required return on common equity in firm j
RF Risk - free rate of return
j Market beta for firm j
RM Required return on marketwide portfolio
Chapter: 12

Weighted Average Cost of Capital

RA [wD RD ( 1tax rate)] [wP RP ] [wE RE ]
Where :
wD wP wE 1
R is cost of each type of capital
w is proportion of each type of capital
Tax rate is rate applicable to debt costs

Chapter: 12

Measuring Free Cash Flows

Under U.S. GAAP and IFRS, Cash flow

statement categorize the activities as

operating, investing and financing.
Some rearrangements are necessary to
compute free cash flows.

Chapter: 12

Measuring Free Cash Flows (Contd.)

Cash flow from operations from the

projected statement of cash flows is the

most direct starting point because it
requires the fewest adjustments.
However, some analysts compute free
cash flows using alternative starting points.

Chapter: 12

10

Measuring Free Cash Flows

Free Cash Flows for All Debt and Equity

Stakeholders:
Operating Activities:

Cash Flow from Operations

+/- Net Interest after Tax
+/- Changes in Cash Requirements for Liquidity

= Free Cash Flows from Operations for All Debt and Equity

Investing Activities:
+/- Net Capital Expenditures

= Free Cash Flows for All Debt and Equity Stakeholders

Chapter: 12

11

Measuring Free Cash Flows

Free Cash Flows for Common Equity Shareholders:
Operating Activities:
Cash Flow from Operations
+/- Changes in Cash Requirements for Liquidity

= Free Cash Flows from Operations for Equity

Investing Activities:
+/- Net Capital Expenditures

Financing Activities:
+/- Debt Cash Flows
+/- Financial Asset Cash Flows
+/- Preferred Stock Cash Flows

= Free Cash Flows for Common Equity Stakeholders

Chapter: 12

12

Cash-Flows-Based Valuation Models

To value common equity measure:
Discount rate RE .
Expected future free cash flows FCFEq for

periods 1 through T over forecast horizon.

Continuing free cash flows, FCFEq(T+1), and
long-run growth rate, g.

Chapter: 12

13

Free-Cash-Flows-Based Valuation
Models
For common equity shareholders:
FCFEt
T
V0

[FCFE
]

[
1
/(R
g)]

[
1
/(
1

R
)
]
T 1
E
E
t
t 1 ( 1 RE )
T

Where,
V0
Present value of the common equity of a firm
FCFE Free cash flows for common equity shareholde rs
RE
Required rate of return on equity capital
g
Growth rate
Chapter: 12

14

Free-Cash-Flows-Based Valuation
Models
For all debt and equity capital stakeholders:
FCFAt
T
VNOA0

[FCFA
]

[
1
/(R
g)]

[
1
/(
1

R
)
]
T 1
A
A
t
t 1 ( 1 RA )
T

Where,
VNOA0 Present value of net operating assets of a firm
FCFA Free cash flows for all debt and equity capital
stakeholde rs
RA
Expected future weighted average cost of capital
g
Growth rate
Chapter: 12

15

Continuing Value
Represented by last term of equation:

[FCFAT 1 ] [ 1/(RA g)] [ 1/( 1 RA ) ]

T

Use expected long-term growth rate, g, to

project all items on Year T+1 income

statement and balance sheet.
RA must be greater than g for this formula
to work.
Chapter: 12

16

What now?
Once valuation model is applied, then
Conduct sensitivity analysis:
Vary cost of equity capital rate (RE)
Vary long-run growth rate (g)
Discount rate assumptions
Vary these parameters and assumptions

individually and jointly.

Chapter: 12

17

Evaluation of the Free-Cash-FlowsValuation method

Advantages:
Focuses on free cash flows, believed to
have more economic meaning than
earnings.
Results from projections of future
operating, investing, and financing
decisions of a firm made by the analyst.

Chapter: 12

18

Evaluation of the Free-Cash-FlowsValuation method

Advantages: (Contd.)
Focuses directly on net cash inflows
available to be distributed to capital
providers. This perspective is especially
pertinent to acquisition decisions.
Widely used in practice.

Chapter: 12

19

Evaluation of the Free-Cash-FlowsValuation method

Disadvantages:
Can be time-consuming making it costly.
Continuing value tends to dominate the
total value but is sensitive to assumptions
growth rates and discount rates.
Free cash flow computations must be
internally consistent with long-run
assumptions regarding growth and payout.
And is affected by estimation errors.
Chapter: 12

20