Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

INCOME APPROACHES

Under the category of income approaches, I will discuss free cash flow to the firm (FCFF), free cash flow to equity (FCFE), and dividend discount model (DDM) approaches.

FCFF Approaches

In the FCFF approaches, the analyst values the free cash flows that the firm is expected to generate. This is the free cash flows from the left-hand side of the finance balance sheet (shown in Figure 13.1), which includes a measure of net working capital (current assets less non-interest-bearing current liabilities), PP&E (property, plant, and equipment), intangible assets, and going-concern value. The FCFF is independent of the financing used by the firm.

The most common FCFF approach involves using the weighted-average cost of capital (WACC) to discount the FCFF, or the WACC method. Specifically, the total value of the firm, VF, is computed as the present value of the FCFF discounted by the firm’s WACC:

where t equals the period when the cash flow is received.

In estimating FCFF, the analyst begins with net revenue and makes several adjustments, as shown in Figure 13.2. Analysts typically forecast the future FCFF by forecasting each of the individual components and then performing the calculation shown in Figure 13.2. The resulting FCFF values are discounted back to the present using the WACC, which is estimated with the following formula:

FIGURE 13.2 FCFF: WACC Method

where ...