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Lecture 4
Part A
Stock valuation (2)
Bodie, Kane and Marcus 11/12E McGraw Hill: Chapter 18
Semester 1, 2023
17-03-2023
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What is free cash flow?
• Cash flows into the company as it sells its products or provide services
• Cash flows out as it pays its cash operating expenses (e.g.. salaries and taxes, admin costs)
• Then the firm takes the leftover cash and makes short-term net investments in working capital
(e.g. inventory and receivables) and long-term net investments in property, plant and
equipment (PP&E).
• Remaining cash is free cash flow to the firm (FCFF) and available to pay out to the firm’s
investors
- Bondholders
- Shareholders
• The cash that is left after the firm has met all its obligations to other investors is free cash
flow to equity (FCFE).
Free cash flow model
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 Firm value = FCFF discounted at the WACC
 Equity value = FCFE discounted at the required return on equity
 Equity value = firm value – market value of debt
Why use free cash flow model?
• Many firms pay no, or low, cash dividends.
• Dividends are paid at the discretion of the board of directors, hence may be poorly aligned with
the firm’s long-run profitability.
• Free cash flows may be more related to long-run profitability of the firm as compared to
dividends.
Free cash flow model
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Calculate FCFF from net income
FCFF = NI + [Interest*(1 – tax rate)] + NCC – FCInv – WCInv
NCC: non cash charge
- Added back to net income because they represent expenses that reduced reported net
income but didn’t actually result in an outflow of cash.
- Depreciation and amortisation
FCInv: Fixed capital investment
- Investments in fixed capital do not appear on the income statement, they do represent cash
leaving from the firm.
- FCInv = capital expenditure – proceeds from sales of long-term assets
WCInv: working capital investment
- Investment in net working capital.
Free cash flow model
[Presentation Title] [Date] 4
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 Calculate FCFF from EBIT and EBITDA
 FCFF = EBIT(1-tax rate) + Dep – FCInv – WCInv
 FCFF = EBITDA(1-tax rate) + Dep*tax rate – FCInv – WCInv
 Calculate FCFE directly from FCFF
 FCFE = FCFF – [Interest*(1 – tax rate)] + net borrowing
 Net borrowing = new debt issues – debt repayments
 Free cash flow valuation model
 Single stage constant growth model
 Two, three or multi-stage model
Free cash flow model
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Free cash flow model
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where market value of equity and debt is applied
• Firm value is the present value of expected free cash flow to the firm (FCFF), discounted
at the weighted average cost of capital (WACC).
• Replacing FCFF and WACC using FCFE and required return on equity, respectively gives
the equity value.
• Equity value is firm value less the market value of debt.
• Under consistent assumptions about growth and capital structure, DDM and FCFF provide
exactly the same valuation.
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• Firm value assuming constant growth in the terminal state
Free cash flow to the firm model (2)
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Example:
Zoe Ltd had a net profit margin of 25% on revenues of $30 million this year. Fixed capital
investment was $3million. Depreciation was also $3 million. Working capital investment is 7.5%
of total sales. Net income, fixed capital investment, depreciation, interest expense, and sales
are expected to increase at 10% per year for the next three years, after which, the growth will be
stable at 4% per year. Tax rate is 40% and the company has 1 million shares outstanding. The
company’s long term debt has market value of $30million. Interest rate is 10%. What is the firm
value and the firm’s equity value. Use FCFF model and assume WACC is 18% during the high-
growth stage and 13% during the stable stage.
Free cash flow
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Residual income
• The net income of a firm less a charge that measures stockholders’ opportunity cost of capital.
• Recognises the cost of equity capital in the measurement of income.
• Explicitly deducts all capital costs, unlike accounting net income which only deducts cost of
debt.
Et = expected EPS for year t
ke = required return on equity
Bt-1 = book value of equity in year t –1
Residual income model
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 Equity value is the book value of equity plus the present value of expected residual income.
 Residual income is the excess earnings above what would be earned if the book value of
equity earned a return just equal to the cost of equity capital.
 Book value of equity is typically well below market value of equity, so it is usual to expect
positive residual income.
Residual income model
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Example
• Consolidated Product has a required rate of return of 14%. The current book value is $6.5.
Earnings forecasts for 2013, 2014 and 2015 are $1.1, $1 and $0.95, respectively. Dividends
in 2013 and 2014 are forecasted to be $0.5 and $0.6, respectively. The dividend in 2015 is a
liquidating dividend, which means that the company will pay out its entire book value in
dividends and cease doing business at the end of 2015. Calculate value of Consolidated
Product’s stock at the beginning of 2013 using the residual income model.
Residual income model
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DDM and FCF vs Residual income model
- DDM and FCF models measure value by discounting a stream of expected cash flows.
- The residual income model starts with a book value and adds to this the present value of the
expected stream of residual income.
- Theoretically, if the underlying assumptions used to make necessary forecasts are the same,
intrinsic value for all models should be identical.
Strength of residual income model
- Terminal value does not dominate the intrinsic value estimate
- Applicable to firms that do not pay dividends or that do not have positive expected free cash
flows in the short run
- Focus on economic profitability rather than just on accounting profitability
Weaknesses
- Rely on accounting data that can manipulated by management
- Clean surplus relation ( Bt = Bt-1 +Et – Dt) assumed to hold.
Residual income model
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Price-earnings:
• Compute share price relative to expected earnings per share for a set of comparable firms.
• Apply the median or mean price-earnings ratio for the comparable firm set to the forecast
earnings for the firm of interest.
Price-book value of equity:
• Similar valuation technique to the price-earnings ratio.
• Stocks with low price-book values have historically outperformed stocks with high price-book
ratios.
Limitations of book value
• Book values are based on historical cost, not actual market values.
• It is possible, but uncommon, for market value to be less than book value.
Multiples-based valuation: Equity
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• Consider the constant growth dividend discount model shown below. Dividing both sides of
the equation by earnings per share shows that the price-earnings ratios is a function of three
variables – reinvestment rate, risk and growth.
• Therefore, when comparing valuations derived under DCF versus multiples-based
valuations, differences have nothing to do with valuation techniques themselves. They simply
result from different assumptions about embedded options, risk, growth or reinvestment.
There is no instance in which one technique is “better” or “worse” than another. The only
question is whether you want to incorporate the market’s assumptions into your analysis, or
derive assumptions from some other source.
Valuation: The impact of risk and growth
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• If the assumptions in the various methods are consistent, then the valuation derived from
those methods should be identical
Reconcile various valuation methods
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• Textbook Chapter 18.3 – 18.5
Readings
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Lecture 4
Part B
Assignment guidelines
Capital IQ, Class/blackboard materials
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Thank you