© CFA Institute. For candidate use only. Not for distribution.

Summary 59

● if free cash flows align with profitability within a reasonable forecast period
with which the analyst is comfortable; or
● if the investor takes a control perspective.
■ The FCFF valuation approach estimates the value of the firm as the present
value of future FCFF discounted at the weighted average cost of capital:
∞ FCFFt
Firm value = ∑ .
t =1 (1 + WACC)t
The value of equity is the value of the firm minus the value of the firm’s debt:
Equity value = Firm value – Market value of debt.

Dividing the total value of equity by the number of outstanding shares gives the
value per share.
The WACC formula is
MV ( Debt )
WACC = rd (1 − Tax rate)
MV ( Debt ) + MV ( Equity)
MV(Equity)
+ r.
MV (Debt ) + MV (Equity)

■ The value of the firm if FCFF is growing at a constant rate is

FCFF1 FCFF0 (1 + g )
Firm value = = .
WACC − g WACC − g
■ With the FCFE valuation approach, the value of equity can be found by dis-
counting FCFE at the required rate of return on equity, r:
∞ FCFEt
Equity value = ∑ .
t =1 (1 + r )t
Dividing the total value of equity by the number of outstanding shares gives the
value per share.
■ The value of equity if FCFE is growing at a constant rate is
FCFE1 FCFE 0 (1 + g )
Equity value = = .
r−g r−g
■ FCFF and FCFE are frequently calculated by starting with net income:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv.
FCFE = NI + NCC – FCInv – WCInv + Net borrowing.

■ FCFF and FCFE are related to each other as follows:

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

■ FCFF and FCFE can be calculated by starting from cash flow from operations:
FCFF = CFO + Int(1 – Tax rate) – FCInv.
FCFE = CFO – FCInv + Net borrowing.

■ FCFF can also be calculated from EBIT or EBITDA:

FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv.
 © CFA Institute. For candidate use only. Not for distribution.
60 Reading 24 ■ Free Cash Flow Valuation

FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.

FCFE can then be found by using FCFE = FCFF – Int(1 – Tax rate) + Net
borrowing.
■ Finding CFO, FCFF, and FCFE may require careful interpretation of corporate
financial statements. In some cases, the necessary information may not be
transparent.
■ Earnings components such as net income, EBIT, EBITDA, and CFO should
not be used as cash flow measures to value a firm. These earnings components
either double-count or ignore parts of the cash flow stream.
■ FCFF or FCFE valuation expressions can be easily adapted to accommodate
complicated capital structures, such as those that include preferred stock.
■ A general expression for the two-stage FCFF valuation model is
n FCFFt FCFFn +1 1
Firm value = ∑ t
+
( WACC − g ) (1 + WACC)n
.
t =1 (1 + WACC)
■ A general expression for the two-stage FCFE valuation model is
n FCFEt  FCFE n +1   1 
Equity value = ∑ t
+  .
t =1 (1 + r )  r − g   (1 + r )n 

■ One common two-stage model assumes a constant growth rate in each stage,
and a second common model assumes declining growth in Stage 1 followed by a
long-run sustainable growth rate in Stage 2.
■ To forecast FCFF and FCFE, analysts build a variety of models of varying com-
plexity. A common approach is to forecast sales, with profitability, investments,
and financing derived from changes in sales.
■ Three-stage models are often considered to be good approximations for cash
flow streams that, in reality, fluctuate from year to year.
■ Non-operating assets, such as excess cash and marketable securities, noncur-
rent investment securities, and nonperforming assets, are usually segregated
from the company’s operating assets. They are valued separately and then added
to the value of the company’s operating assets to find total firm value.

REFERENCES
Bahnson, P., P. B. Miller, and B. P. Budge. 1996. “Nonarticulation Huefner, R. J., J. E. Ketz, and J. A. Largay. 1989. “Foreign Currency
in Cash Flow Statements and Implications for Education, Translation and the Cash Flow Statement.” Accounting
Research and Practice.” Accounting Horizons 10 (4): 1–15. Horizons 3 (2): 66–75.
Casey, Ryan J., Feng Gao, Michael T. Kirschenheiter, Siyi Li, and Luehrman, T. A. 1997. “Using APV (Adjusted Present Value): A
Shailendra Pandit. 2016. “Do Compustat Financial Statement Better Tool for Valuing Operations.” Harvard Business Review
Data Articulate?” Journal of Financial Reporting 1 (1): 37–59. 75 (3): 145–46, 148, 150–54.
Gordon, Elizabeth A., Elaine Henry, Bjorn N. Jorgensen, Pinto, Jerald E., Thomas R. Robinson, and John D. Stowe. 2019.
and Cheryl L. Linthicum. 2017. “Flexibility in Cash-Flow “Equity Valuation: A Survey of Professional Practice.” Review
Classification under IFRS: Determinants and Consequences.” of Financial Economics 37 (2): 219–33.
Review of Accounting Studies 22 (2): 839–72. Shi, Linna, and Huai Zhang. 2011. “On Alternative Measures of
Hribar, P., and D. W. Collins. 2002. “Errors in Estimating Accruals.” Accounting Horizons 25 (4): 811–36.
Accruals: Implications for Empirical Research.” Journal of Wilkins, M. S., and M. L. Loudder. 2000. “Articulation in Cash
Accounting Research 40 (1): 105–34. Flow Statements: A Resource for Financial Accounting
Courses.” Journal of Accounting Education 18:115–26.