FCF to Equity(FCFE) Models

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

1

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

2

FCFF and FCFE

3

Free Cash Flow to the Firm (FCFF)

4

Free Cash Flow to Equity (FCFE)

5

FCFF Approach to Valuation

6

FCFE Approach to Valuation

7

Common Mistakes in FCFE and FCFF Valuation

8

Ownership Perspective in FCF and DDM Models

9

Free Cash Flow vs Dividend in Valuation

Analysts often prefer to use free cash flow rather than based valuation for the following reasons:

dividend-10

Dividends 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)

11

How Financing Decisions Affect Future FCFE

on FCFE (and FCFF);

no effect on FCFF

12

Calculating FCFF from Net Income

(changes in noncash working capital) (e.g., depreciation expenses)

(a.k.a., capex)

13

Calculating FCFF from EBIT

14

Calculating FCFF from CFO

15

16

17

Free Cash Flow with Preferred Stock

18

FCFE when there are Preferred Dividends paid

Source: Aswath Damodaran (p 353)

+

19

Forecasting FCFE and FCFF (1)

Source: Aswath Damodaran

20

Forecasting FCFE and FCFF (2)

Source: Aswath Damodaran

21

Forecasting FCFE and FCFF (2)

Source: Aswath Damodaran

22

Net Income a Proxy for FCFE?

23

Estimating Growth in FCFE

Continued on next slide

24

Estimating Growth in FCFE

25

Approaches for Calculating the Terminal Value

26

Example: Estimating terminal value with a P/E

27

Undervalued, Fairly Valued, or Overvalued?

28

DDM and FCFE Models

 When a firm is paying out less in dividends than it has available in free

cash flows, it is generating surplus cash For those firms, this cash surplus

appears as an increase in the cash balance Firms that pay 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 pay out more dividends than they

have available, we will overvalue the firms

 The valuation using free cash flow to equity is designed to correct for this limitation

Source: Aswath Damodaran (p 355)

29

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

30

Single-Stage FCFE Model

at a rate comparable to or lower than the nominal growth in the economy

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

31

Example (1): Single-stage FCFE model

32

Example (2): Single-stage FCFE model

Source: Aswath Damodaran (p 360)

33

Example (2): Single-stage FCFE model

34

Leverage, FCFE, and Equity Value

Source: Aswath Damodaran (p 361)

35

Two-Stage FCFE Model

Source: Aswath Damodaran (p 362)

36

Example: Two-stage FCFE model

37

Example: Two-stage FCFE model

38

Example: Two-stage FCFE model

39

Example: Two-stage FCFE model

40

The E-Model: A Three-Stage FCFE Model

Source: Aswath Damodaran (p 366)

41

The E-Model: A Three-Stage FCFE Model

Source: Aswath Damodaran (p 368)

42

Three-Stage FCFE Model

different than the last two examples because we are given

growth in total FCFE in each of three stages, rather than the

growth rates in the components

 Growth in the first and third stage is constant, while growth in the second stage is declining

 There is one tricky feature to this problem - the required return

in each of the three growth stages is different

43

Example: Three-stage FCFE model

44

Example: Three-stage FCFE model

45

Example: Three-stage FCFE model

46

Example: Three-stage FCFE model

47

Source: Aswath Damodaran (p 372)

DDM Valuation and FCFE Valuation

When the Values from DDM and FCFE Models Are Similar?

FCFE in discounted cash flow valuation will be the same as the value obtained from using the dividend discount model

the FCFE

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.)

48

DDM Valuation and FCFE Valuation

Source: Aswath Damodaran (pp 372-373)

cash either earns below-market interest rates or is invested in

negative net present value projects; V(FCFE) > V(DDM)

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)

When the Values from DDM and FCFE Models Are Different?

Continued on next slide

49

DDM Valuation and FCFE Valuation

When DDM valuation and FCFE valuation are different?

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

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)

50

Differeces between DDM and FCFE Models

Source: Aswath Damodaran (p 373)

Valuing Coca-Cola with a Three-Stage FCFE Model

Source: Aswath Damodaran (pp 374-376)

Valuing Coca-Cola with a Three-Stage FCFE Model

Conclusion

(tip) Equity Valuation versus Firm Valuation

Equity valuation: Value just the equity

claim in the business

Firm Valuation: Value the entire business

Source: Aswath Damodaran 57

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