FCF APPROACH

The basic idea behind any valuation approach is to estimate the intrinsic value of a company. The first step is to split the company into operating and financial activities. So, the value of the company’s equity is the present value (PV) of expected FCFs minus the financial obligations, including any passive financial assets. Passive financial assets are those assets that are unnecessary to operate the business, which makes them conceptually similar to financial obligations:

image

where

Value = intrinsic value of equity

FCFs = cash generated by the business, net of capital expenditures

Net financial obligations = financial obligations (debt) obligations minus financial assets

In this approach, the PV is determined by a discount factor set equal to the company’s weighted-average cost of capital (WACC), which in turn, is a function of the company’s cost of equity and after-tax borrowing cost. The cost of equity is typically inferred from the capital asset pricing model or arbitrage pricing theory, which estimate beta, the risk premium, and the risk-free rate. Also, the PV of FCFs usually has two components: the PV of annual FCFs for some specified time horizon, say 7 years or 10 years, plus the PV of the company’s “continuing” or “terminal” value as of the end of the time horizon.

Practical issues of implementation arise with this approach; establishing the length of the horizon, ...

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