Valuation: The Market Approach

Chapter 11

Summary and Concluding Remarks

To tie this all together, and to conclude on the relationship between the DCF approach and the market approach, we will outline the link between these two approaches in a purely mathematical perspective. To do this, we apply the EV/FCFF multiple.

Suppose we have a British service company, Service Plc, with an expected free cash flow to firm (FCFF) next year of £10 million. Suppose further that we have calculated its proper cost of capital (i.e. its WACC) at 15 percent. Annual expected FCFF growth as from next year and in perpetuity is assumed at 2 percent.

As the expected growth of Service Plc is assumed to be constant, we need not compose an explicit forecast up until a “normalized” point of time, as was required with Engineering Corp. Recall that we created an explicit forecast for Engineering Corp as it was expected to have a cash flow growth significantly above that deemed sustainable, over the coming three years. Owing to the expected short-term “super growth” of Engineering Corp, we were forced to calculate its DCF value using a two-stage model in which we first estimated the net present value of the explicit forecast period and then estimated the net present value of all cash flows following that (i.e. the residual value). As we are in a position of sustainable growth with Service Plc from the start, we need not create an explicit forecast period as we had to with Engineering Corp. We can thus calculate the (total) enterprise value ...