Sustainable Growth Rate: Concept
We have studied the various discounted cash flow valuation models in this module. These different models need to be applied in different situations. We have studied these situations as well. However, regardless of which model is being applied, one thing remains constant. In the end, the growth rate of the company plateaus down at a […]
Interest Rates and Their Effect on Small Businesses
Predicting future interest rate movements is not only important for traders who invest in financial markets. Instead, it is also important for regular business people. It is important for small businesses because the increase and decrease in demand is related to interest rates which the central bank sets. The problem is that most central banks […]
Lifecycle of Public Private Partnership (PPP) Projects
In the previous articles, we have undertaken careful consideration of how public-private partnership (PPP) projects work. A lot of details have been provided about the execution stage of PPP projects. However, little is known about how these huge infrastructure projects come into being in the first place. In this article, we will have a closer […]
Prospectus in Investment Banking – Part 1
The job of an investment banker includes enabling the flow of information between the company and its investors. When a company is going public for the first time, investors do not have any information about the company. As such, they do not have a strong basis for making a well-informed decision. Hence, it is the […]
Single Period Dividend Discount Model
To understand the dividend discount model, we need to start from the basics. The simplest way to understand the dividend discount model and its application is to first start with a single period and then later extend it on to more complex cases. Hence, the term single period dividend discount model. The objective of application […]
We now have a fair understanding of what the concepts of free cash flow to the firm is. We also know how to calculate this metric under various circumstances. It is now time to use this metric to arrive at the final valuation for a given firm which is the objective of the whole exercise.
The FCFF metric can be used in various ways to derive the valuation for a firm. One of the most basic ways is called the single stage FCFF model.
In this article we will have a look at this model. It is very basic and is usually not used by analysts. However, it helps in forming a strong base on which the concepts related to slightly complicated models can be built. So let’s begin.
The best way to introduce this model will be to highlight its similarities with the Gordon Growth model. FCFF valuation is almost analogous to the Gordon model except that it uses other components as inputs to the calculation.
Like the Gordon model, the single stage FCFF model calculates the value of the firm in two parts. The first part is called the horizon period. This is the period for which the analyst explicitly forecasts the value of the firm by explicitly forecasting the growth rates. Obviously this can only be done for a short period of time let’s say 5 to 7 years.
However, the firm has a perpetual life and its value can only be calculated by using a perpetuity. This is accomplished by using a terminal value. Once again, the assumptions of the Gordon growth rate model are followed. The long term growth rate that the firm is expected to achieve is always less than the long term discount rate which is being used. Only if this assumption is used, can a finite value be reached.
There are some differences between the single stage FCFF model and the Gordon growth model. These differences stem from the different inputs that are used by the models:
There are certain assumptions implicit in this model.
This model is therefore only useful for very mature companies who have extremely stable cash flows. Since these companies are few and far off, the usage of the single stage FCFF model in the real world is very limited
Formula
Lastly, the formula for calculating the value of the firm using the single stage FCFF model is as follows:
Terminal Value of the Firm = FCFF (1) / WACC – g
Where
FCFF (1) is the cash flow that accrues to the firm in the first year post the horizon period
WACC is the weighted average cost of capital
G is the long term growth rate
WACC itself is calculated as follows:
WACC = (w (E) * r (E) ) + (w (D) * r (D) *(1-tax rate) )
The intention behind conducting this analysis is to ensure that the future valuation of the company is known. Also, we are using the cash flows which will accrue in the future to arrive at the valuation. Hence, it only makes sense that the discount rate being used also depicts the future.
In many cases, the present capital structure as well as the target capital structure for the future may be mentioned in the question paper. Students are expected to use the target capital structure for calculation of the WACC.
This may sound counter-intuitive as present capital structure is a fact and the future capital structure is only a target which may or may not be used by the firm. However, it would still be advisable that the future target structure is used since even the cash flows being discounted are only an assumption!
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
