The value of a firms stock is calculated by forecasting free cash flow to equity (FCFE) or free cash flow to the firm (FCFF) and discounting these cash flows back to the present at the appropriate required rate of return. FCFE or FCFF are the appropriate modes to use when: (1) the firm does not pay dividends at all or pays out fewer dividends than dictated by its cash flow, (2) free cash flow tracks profitability, or (3) the analyst takes a corporate control perspective
FCF to Equity(FCFE) Models Valuation: 중앙대학교 경영학부 박창헌 교수 Free Cash Flow Valuation The value of a firm's stock is calculated by forecasting free cash flow to equity (FCFE) or free cash flow to the firm (FCFF) and discounting these cash flows back to the present at the appropriate required rate of return FCFE or FCFF are the appropriate modes to use when: (1) the firm does not pay dividends at all or pays out fewer dividends than dictated by its cash flow, (2) free cash flow tracks profitability, or (3) the analyst takes a corporate control perspective FCFF and FCFE Free Cash Flow to the Firm (FCFF) Free Cash Flow to Equity (FCFE) FCFF Approach to Valuation FCFE Approach to Valuation Common Mistakes in FCFE and FCFF Valuation Ownership Perspective in FCF and DDM Models Free Cash Flow vs Dividend in Valuation Analysts often prefer to use free cash flow rather than dividendbased valuation for the following reasons: Example: Three-stage FCFE model 44 Example: Three-stage FCFE model 45 Example: Three-stage FCFE model 46 DDM Valuation and FCFE Valuation When the Values from DDM and FCFE Models Are Similar? There are two conditions under which the value from using the FCFE in discounted cash flow valuation will be the same as the value obtained from using the dividend discount model The first is the obvious one, where the dividends are equal to the FCFE The second condition is more subtle, where the FCFE is greater than dividends, but the excess cash (FCFE minus dividends) is invested in projects with net present value of zero (For instance, investing in financial assets that are fairly priced should yield a net present value of zero.) Source: Aswath Damodaran (p 372) 47 DDM Valuation and FCFE Valuation When the Values from DDM and FCFE Models Are Different? When the FCFE is greater than the dividend and the excess cash either earns below-market interest rates or is invested in negative net present value projects; V(FCFE) > V(DDM) When the payment of smaller dividends than can be afforded to be paid out by a firm may lead to a lower debt ratio and a higher cost of capital, causing a loss in value; V(FCFE) > V(DDM) Continued on next slide Source: Aswath Damodaran (pp 372-373) 48 DDM Valuation and FCFE Valuation When DDM valuation and FCFE valuation are different? When, in the cases where dividends are greater than FCFE, the firm has to issue either new stock or new debt to pay these dividends leading to negative consequences for value: substantial issuance costs, overlevered and exposed to distress/default and leading to a loss in value, paying too much in dividends leading to capital rationing constraints where good projects are rejected When firms pay out much less in dividends than they have available in FCFE, the expected growth rate and terminal value will be higher in the DDM, but the year-to-year cash flows will be higher in the FCFE model Source: Aswath Damodaran (pp 372-373) 49 Differeces between DDM and FCFE Models Source: Aswath Damodaran (p 373) 50 Valuing Coca-Cola with a Three-Stage FCFE Model Source: Aswath Damodaran (pp 374-376) Valuing Coca-Cola with a Three-Stage FCFE Model Valuing Coca-Cola with a Three-Stage FCFE Model Valuing Coca-Cola with a Three-Stage FCFE Model Valuing Coca-Cola with a Three-Stage FCFE Model Conclusion (tip) Equity Valuation versus Firm Valuation Firm Valuation: Value the entire business Equity valuation: Value just the equity claim in the business Source: Aswath Damodaran 57 This work is protected by copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted The work and materials from it should never be made available to students except by instructors using the accompanying texts published by Kaplan, Wiley and McGraw-Hill in their classes All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials ! 58 [...]... on FCFF 11 Calculating FCFF from Net Income (e.g., depreciation expenses) (a.k.a., capex) (changes in noncash working capital) 12 Calculating FCFF from EBIT 13 Calculating FCFF from CFO 14 Calculating FCFE from FCFF 15 Calculating FCFE from NI or CFO 16 Free Cash Flow with Preferred Stock 17 FCFE when there are Preferred Dividends paid + Source: Aswath Damodaran (p 353) 18 Forecasting FCFE and FCFF... 19 Forecasting FCFE and FCFF (2) Source: Aswath Damodaran 20 Forecasting FCFE and FCFF (2) Source: Aswath Damodaran 21 Net Income a Proxy for FCFE? 22 Estimating Growth in FCFE Continued on next slide 23 Estimating Growth in FCFE 24 Approaches for Calculating the Terminal Value 25 Example: Estimating terminal value with a P/E 26 Undervalued, Fairly Valued, or Overvalued? 27 DDM and FCFE Models When... free cash flow to equity is designed to correct for this limitation Source: Aswath Damodaran (p 355) 28 Single-Stage FCFE Model The single-stage FCFE model assumes that (1) FCFE grows at a constant rate (g) forever, and (2) the growth rate is less than the required return on equity 29 Single-Stage FCFE Model The single-stage FCFE Model is best suited for firms growing at a rate comparable to or lower... vs FCFE – Global Comparison In 2010, the global median of dividends as a percent of FCFE was about 60%, with most companies paying out less in dividends than they had available in FCFE Source: Aswath Damodaran (p 355) 10 How Financing Decisions Affect Future FCFE Dividends, share repurchases, and share issues have no effect on FCFE (and FCFF); Changes in leverage have only a minor effect on FCFE... single-stage FCFE model is often used in international valuation, especially for companies in countries with high inflationary expectations when estimation of nominal growth rates and required returns is difficult In those cases, real (i.e., inflation-adjusted) values are estimated for the inputs to the single-stage FCFE model: FCFE, the growth rate, and the required return 30 Example (1): Single-stage FCFE... dividends that exceed FCFE have to finance these dividend payments either out of existing cash balances or by making new stock issues The implications for valuation are simple If we use the dividend discount model and do not allow for the buildup of cash that occurs when firms pay out less than they can afford, we will underestimate the value of equity in firms If we use the model to value firms that... model: FCFE, the growth rate, and the required return 30 Example (1): Single-stage FCFE model 31 Example (2): Single-stage FCFE model Source: Aswath Damodaran (p 360) 32 Example (2): Single-stage FCFE model 33 Leverage, FCFE, and Equity Value Source: Aswath Damodaran (p 361) 34 Two-Stage FCFE Model Source: Aswath Damodaran (p 362) 35