Chapter 12
Valuation:
Cash-Flow-Based
Approaches
Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and
South-Western are trademarks used herein under license.
Valuing the Firm
Economic theory teaches us that the value of an
investment is:
ProjectedFuture Payoffst
V0  
t
(1

Discount
Rate)
t 1
n
Expected future payoffs can be measured in
terms of:
 Dividends
 Cash Flows
 Earnings
Chapter: 12
2
Approaches to firm valuation
Chapter: 12
3
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
4
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
5
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
6
Cost of Common Equity Capital
CAPM Model:
E[REj ]  E[R F ]  ß j  {E[RM ]–E[RF ]}
Where :
E  expectation
REj  Required return on common equity in firm j
RF  Risk - free rate of return
ß j  Market beta for firm j
RM  Required return on marketwide portfolio
Chapter: 12
7
Weighted Average Cost of Capital
RA  [wD  RD  ( 1–tax 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
8
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
9
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 shareholders
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
stakeholders
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