Chapter 7: FCF Valuation Model

Chapter 7: Free Cash Flow Valuation Model

Computing Horizon Value

• Value of firm at the end of the forecasting period of FCF that occurs after the forecast period 

• (HV) represents the value of a firm at the end of the explicit forecast period — that is, after the company’s free cash flows (FCFs) are expected to grow at a stable, constant rate.

  • It reflects the present value of all future cash flows that occur after the forecast period, assuming constant growth

  • The horizon value helps estimate the total value of the business by combining

    • The present value of forecasted cash flows (during the forecast period)

    • The present value of cash flows beyond the forecast period (captured by the horizon value)

Intrinsic value of the firm

• Intrinsic value of firm= V(ops) + V(non-operating assets) 

  • V(ops)= PV of FCF

• Entity value represents the total value of a company, which comes from two main components:

• Entity value = value of company

• Operating assets

• Non-operating assets

  • Marketable securities

  • Cash above level necessary for operations

  • Investments in other businesses

  • Operating assets – Assets directly involved in generating revenue through the company's core business operations.

  • Non-operating assets – Assets that are not necessary for daily business operations but still hold value.

Intrinsic value of equity

• The intrinsic value of equity- value of debt - value of preferred stock 

• represents the true or fundamental value of a company’s equity based on the value of its operations and assets, after accounting for its financial obligations

• If the intrinsic value of equity exceeds the market value of the company's shares → The stock is undervalued and may be a good investment.

• If the intrinsic value of equity is less than the market value → The stock is overvalued and may be risky.

Intrinsic stock price

• Intrinsic stock price= intrinsic value of equity/ # of shares outstanding 

• The Intrinsic Stock Price represents a company's stock's estimated true or fair value based on its underlying fundamentals rather than its current market price.

• The intrinsic stock price helps determine whether a stock is overvalued or undervalued compared to its market price.

• If the intrinsic stock price exceeds the current market price, → The stock is undervalued and could be a buying opportunity.

If the intrinsic stock price is lower than the current market price, → The stock is overvalued and may be overpriced.