Securities Analysis

Semester 2, 2024/2025
Lecture 8: SIMPLE VALUATION: DISCOUNTED
CASH FLOWS
LEARNING OUTCOMES
1. Explore Equity Valuation Models
2. Compare FCFF and FCFE approaches to valuation
3. Explain the conditions to use FCF valuation
4. Revise one-stage and two-stage DCF models
5. Describe Fama-French Model

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EQUITY VALUATION MODELS
Present value models (discounted cash flow models)

• estimate the intrinsic value of a security as the present value of

the future benefits expected to be received from the security
• benefits are often defined
• in terms of cash expected to be distributed to shareholders (dividend
discount models)
• in terms of cash flows available to shareholders after meeting capital
expenditure and working capital needs (free cash flow to equity models)

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EQUITY VALUATION MODELS
Multiplier models (market multiple models)

• Share price multiples estimates intrinsic value of a common share

from a price multiple for some fundamental variable:
• revenues, earnings, cash flows, or book value
• Enterprise value (EV) multiples have the form (EV)/(Value of a
fundamental variable):
• EBITDA or total revenue

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EQUITY VALUATION MODELS
Asset-based valuation models

• estimate intrinsic value of a common share from the estimated

value of the assets of a corporation minus the estimated value of
its liabilities and preferred shares
• the value of a business is equal to the sum of the value of the
business’s assets

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FCFF vs FCFE
• FCFF – free cash flow available to all investors of a firm
• FCFF = CFO + (IE * (1 − TR)) − CAPEX

• FCFE – free cash flow available to common equity shareholders

of a firm
• FCFE = CFO − CAPEX + Net Debt Issued

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DCF MODELS
• Free cash flow to the firm (FCFF) is
the cash flow generated by the firm’s
operations that is in excess of the
capital investment required to sustain
the firm’s current productive capacity
• Free cash flow to equity (FCFE) is the
cash available to stockholders after
funding capital requirements and
expenses associated with debt
financing

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FCFF vs FCFE
• FCFF – excludes the impact of leverage, hence referred to as
unlevered cash flow

• FCFE – includes the impact of leverage as it subtracts interest

payments and principal repayments to debt holders to arrive at
the cash flow, hence referred to as levered cash flow
​

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 FCFF vs FCFE
• FCFF • FCFE

• to calculate the enterprise • to calculate the equity

value value
• WACC • cost of equity
• preferred by the • preferred by analysts as it
management of highly provides a more accurate
leveraged companies picture
​

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DCF VALUATION
Discounted Cash Flow Model

Financials 2020E 2021F 2022F 2023F 2024F 2025F Supporting Schedules

Net Income available to common shareholders 182,835 181,573 210,753 230,355 251,683 271,403 Tax rate 24.26%
Plus: Interest Expense x (1 - Tax rate) 4,494 8,409 9,760 10,668 11,656 12,569 Perpetual Growth Rate 1.5%
Plus: Non-cash expenses 58,392 79,790 92,613 101,227 110,599 119,265 Share Price 6,273
Less: Investment in Fixed Capital 59,263 71,562 83,063 90,789 99,194 106,966 Shares Outstanding 259,356,608
Less: Investment in Working Capital 15,460 9,747 31,113 34,457 37,925 40,940 Market Value of Debt 113,281
Unlevered FCF 170,998 188,462 198,950 217,005 236,818 255,330 Cash and Cash Equivalents 114,073
WACC 13%
Discount Period - 1 2 3 4 5 Expected Return
Discount Factor 1.00 0.88 0.78 0.69 0.61 0.54 Target Price Upside / Downside 25%
Discounted FCFF 170,998 166,315 154,939 149,140 143,631 136,660

Enterprise Value Intrinsic Value Market Value

Cumulative Present Value of FCFF 921,682 Enterprise Value 2,095,576 Market Capitalization 1,626,944
Terminal Value Plus: Cash 114,073 Less: Cash 114,073
Perpetual Growth 1.5% Less: Debt 113,281 Plus: Debt 113,281
WACC 13% Less: Minority Interest 25,331 Plus: Minority Interest 25,331
Terminal Value 2,193,256 Less: Preferred Securities - Plus: Preferred Securities -
Discount Factor 54% Implied Equity Value 2,071,037 EV 1,651,483
Present Value of Terminal Value 1,173,893
% of Enterprise Value 56% Shares Outstanding 259,356,608 Shares Outstanding 259,356,608
Enterprise Value 2,095,576 Implied Equity Value / Share 7,985 Equity Value / Share 6,368

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DCF MODELS
• helps to determine the value of an investment based on its future cash flows
• the present value of expected future cash flows is arrived at by using a
projected discount rate
• typically uses the weighted average cost of capital (WACC) for the discount
rate because it accounts for the rate of return expected by shareholders
• a disadvantage of DCF is its reliance on estimations of future cash flows,
which could prove inaccurate

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DCF MODELS

• ​DCF = CF1 / (1+r)1 + CF2 / (1+r)2 + CFn / (1+r)n

• where:
• CF1 – the cash flow for year one
• CF2 – the cash flow for year two
• CFn – the cash flow for additional years
• r – the discount rate
•​

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DCF MODELS
Analysts often prefer to use free cash flow rather than dividend-
based valuation for the following reasons:
• Many firms pay no, or low, cash dividends
• Dividends are paid at the discretion of the board of directors. It may,
consequently, be poorly aligned with the firm’s long-run profitability
• If a company is viewed as an acquisition target, free cash flow is a more
appropriate measure because the new owners will have discretion over its
distribution (control perspective)
• Free cash flows may be more related to long-run profitability of the firm as
compared to dividends

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DCF MODELS
The value of the firm is the present value of the expected future
FCFF discounted at the WACC:

𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = ∑(𝐹𝐶𝐹𝐹𝑛) / (1 + 𝑊𝐴𝐶𝐶)𝑛

WACC is the required return on the firm’s assets

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DCF MODELS
The value of the firm’s equity is the present value of the expected
future FCFE discounted at the required return on equity:

𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = ∑(𝐹𝐶𝐹𝐸𝑛) / (1 + 𝑟𝑒)𝑛

𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 − 𝑀𝑉 𝑜𝑓 𝐷𝑒𝑏𝑡

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DCF MODELS
• The differences between FCFF and FCFE account for differences in capital
structure and consequently reflect the perspectives of different capital
suppliers. FCFE is easier and more straightforward to use in cases where
the company’s capital structure is not particularly volatile.

• On the other hand, if a company has negative FCFE and significant debt
outstanding, FCFF is generally the best choice. We can always estimate
equity value indirectly by discounting FCFF to find firm value and then
subtracting out the market value of debt to arrive at equity value.

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DCF MODELS
• The single-stage FCFF model is useful for stable firms in mature
industries:
• FCFF grows at a constant rate (g) forever
• the growth rate is less than the weighted average cost of capital (WACC)

• the Gordon growth model with FCFF replacing dividends and

WACC replacing required return on equity

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑖𝑟𝑚 = (𝐹𝐶𝐹𝐹1) / (𝑊𝐴𝐶𝐶 − 𝑔) = (𝐹𝐶𝐹𝐹0(1+𝑔)) /

(𝑊𝐴𝐶𝐶 − 𝑔)

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DCF MODELS
• The single-stage FCFE model is analogous to the single-stage
FCFF model, with FCFE instead of FCFF and required return on
equity instead of WACC:

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = (𝐹𝐶𝐹𝐸1) / (𝑟𝑒 − 𝑔) = (𝐹𝐶𝐹𝐸0(1+𝑔)) / (𝑟𝑒 − 𝑔)

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DCF MODELS
• Two-stage model assumes one growth rate for short-term and
another constant growth rate forever:

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FAMA-FRENCH MODEL
• In 1993, researchers Eugene Fama and Kenneth French
addressed perceived weaknesses of the CAPM in a model with
three factors, known as the Fama-French model (FFM):

• RMRF, standing for RM – RF, the return on a market value-

weighted equity index in excess of the one-month T-bill rate – this
is one way the equity risk premium can be represented and is the
factor shared with the CAPM

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FAMA-FRENCH MODEL
• SMB (small minus big), a size (market capitalization) factor. SMB
is the average return on three small-cap portfolios minus the
average return on three large-cap portfolios. Thus, SMB
represents a small-cap return premium

• HML (high minus low), the average return on two high book-to-
market portfolios minus the average return on two low book-to-
market portfolios. HML represents a value return premium

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FAMA-FRENCH MODEL
• The FFM estimate of the required return is as follows:

r = RF + βmkt * RMRF + βsize * SMB + βvalue * HML

• small market-cap companies may be subject to risk factors such as less

ready access to private and public credit markets and competitive
disadvantages
• high book-to-market may represent shares with depressed prices because of
exposure to financial distress

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TODAY YOU HAVE LEARNT
1. Equity Valuation Models
2. FCFF and FCFE approaches to valuation
3. The conditions to use FCF valuation
4. One-stage and two-stage DCF models
5. Fama-French Model

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