Equity Markets, Valuation, and Analysis

CHAPTER 11Free Cash Flow Valuation

Tom Barkley

Professor of Finance Practice, Syracuse University

INTRODUCTION

Discounted cash flow (DCF) analysis is probably the most commonly used approach to equity analysis. This type of analysis estimates the value of a company's equity on an absolute basis, rather than providing a valuation relative to other firms in the same industry. The versatility of the DCF method allows for explicit assumptions about various line items from the financial statements to be built into the model, whether these items are expressed as growth rates or specific monetary values. Although the DCF approach is useful in valuing entire companies, whether public or private, analysts also use it for specific projects that a corporation or government sector entity might undertake. These analysts then employ capital budgeting tools, such as net present value (NPV) and internal rate of return (IRR), to decide whether to undertake the project.

Gordon (1959) introduces the constant growth dividend discount model (DDM) as a valuation technique based on future cash dividend payments or share repurchases made by a company. Chapter 10 describes these techniques. A challenge of using these techniques is that they are limited in scope to those firms that make regular distributions to shareholders. To be used to value non-dividend-paying firms or those with an irregular dividend pattern, analysts must make assumptions about (1) when the firm is likely to pay dividends, (2) ...