101 Concepts for the Level I Exam

Essential Concept 53: Estimating Company Value using Cash Flow Models

Single-stage (constant-growth) FCFF and FCFE models:

$\mathrm{Firm\ value=\ }\frac{\mathrm{FCF}{\mathrm{F}}_{\mathrm{1}}}{\mathrm{WACC\ -\ g}}$

$\mathrm{Equity\ value=\ }\frac{\mathrm{FCF}{\mathrm{E}}_{\mathrm{1}}}{\mathrm{r\ -\ g}}$

Multi-stage FCFF and FCFE models

There are several versions of the multi-stage model. In one version, we estimate the free cash flows up to a certain number of years and assume that the free cash flows will grow at a constant rate from there on. The formulas for this version are:

$\mathrm{Firm\ value=\ }\sum\limits_{t=1}^{n}{\frac{\mathrm{FCF}{\mathrm{F}}_{\mathrm{t}}}{{\left(\mathrm{1+WACC}\right)}^{\mathrm{t}}}}\mathrm{\ +\ }\frac{\mathrm{FCF}{\mathrm{F}}_{\mathrm{n+1}}}{\mathrm{WACC-g}}\mathrm{\ *\ }\frac{\mathrm{1}}{{\left(\mathrm{1+WACC}\right)}^{\mathrm{n}}}$

$\mathrm{Equity\ value=\ }\sum\limits_{t=1}^{n}{\frac{\mathrm{FCF}{\mathrm{E}}_{\mathrm{t}}}{{\left(\mathrm{1}\mathrm{+r}\right)}^{\mathrm{t}}}\mathrm{\ +\ }\frac{\mathrm{FCF}{\mathrm{E}}_{\mathrm{n+1}}}{\mathrm{r-g\ }}\mathrm{\ *\ }\frac{\mathrm{1}}{{\left(\mathrm{1+r}\right)}^{\mathrm{n}}}}$

Another version assumes declining growth in Stage 1 followed by a long-run sustainable growth rate in Stage 2. We can use the H-model formula (discussed in DDM) for this version.

Three-stage growth models are appropriate for companies that have three distinct stages of growth – growth phase, transition phase and mature phase.