Free Cash Flow, Terminal Value, and Discount Rates and Methods
We have built a dynamic model and discussed important sections in detail, but we have yet to consolidate our work to derive a corporate value. This chapter lays out the theory and technical implementation of deriving a corporate value. Overall, we will take an intrinsic, cash flow-based approach to determining the value. This is similar to the valuation of many financial instruments, where cash flow is projected and then discounted back to the present day to determine the present value. This discounted cash flow (DCF) methodology can be applied when discussing securities pricing, project valuation, and nearly any other investment opportunity valuation.
The challenge of using a DCF methodology for corporations is determining what constitutes cash flow, what the company is worth beyond the forecast period, and what discount rate(s) to use to determine the present value. Relevant cash flow calculations can be confusing because there are many sources and uses of funds. Also, perspective matters. Cash available for a debt holder is most likely different from that of an equity holder. The number of periods of cash flow we count in a forecast is also of major concern. Many company owners would suggest that their company is worth more than just the cash flows that can be spun out of the firm during the forecast period. They would suggest that there is a terminal value to a firm, since after the forecast period the ...