Explain how to use the free cash flow valuation model to find the price per share of common

equity.

 Free cash flow

Discounted cash flow (DCF) valuation views the intrinsic value of a security as the present value
of its expected future cash flows. When applied to dividends, the DCF model is the discounted
dividend approach or dividend discount model (DDM). Our coverage extends DCF analysis to
value a company and its equity securities by valuing free cash flow to the firm (FCFF) and free
cash flow to equity (FCFE). Whereas dividends are the cash flows actually paid to stockholders,
free cash flows are the cash flows available for distribution to shareholders.

The value of a firm is determined by the size, timing, and risk of its free cash flows (FCF). One
use of FCF is to pay dividends. One way to estimate the intrinsic value of stock is to discount the
cash flows to stockholders (dividends, Dt) at the rate of return required by stockholders (rs). The
result is the intrinsic value to stockholders
In free cash flow valuation, intrinsic value of a company equals the present value of its free cash
flow, the net cash flow left over for distribution to stockholders and debt-holders in each period.
FCF is the cash flow available for distribution to all of the firm’s investors, bondholders as well
as stockholders. Also, the WACC is the average rate of return required
by all of the firm’s investors, not just shareholders.

There are two approaches to valuation using free cash flow. The first involves discounting
projected free cash flow to firm (FCFF) at the weighted average cost of the capital (WACC) to
find a company's total value (i.e. sum of its equity and debt). The second involves discounting
the free cash flow to equity (FCFE) at the cost of equity to find the value of the company's
shareholders equity.