FINANCIAL MANAGEMENT

(FIN401)

Lecture 4:
Stock Valuation Models

Stock Valuation Models

(Cont.)

By: Sana Tauseef & Midhat Kidwai

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Free cash flows are useful as the definition of return
when…

• the company is non dividend paying

• the company is dividend paying but
dividends exceed or fall short of free cash

Stock Valuation Models

flows to equity
• the company’s free cash flows align with
the company’s profitability
• the investor takes a control perspective
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There are two variants of Free Cash
Flows…
• Free Cash Flow-Firm (FCFF)  cash
flow to all suppliers of capital (Lenders as
well as equity suppliers)

Stock Valuation Models

• Free Cash Flow-Equity (FCFE) 
cash flow to common shareholders only

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Understanding the Free Cash Flow
to the Firm…
• Free cash flow means the cash which is left after deducting
necessary operating expenses and capital expenditures.
• It is different from operating cash flow (computed on the
cash flow statement) because some of the OCF is not free

Stock Valuation Models

and must be used for reinvestments.
• It is different from the net cash flow (net of operating,
investing and financing CF computed on CF statement)
because net cash flow is the cash left after taking into
account all operating, investing and financing transactions.

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What is FCFF???
• The cash flow available to the company’s suppliers of
capital after all operating expenses have been paid and
necessary investments (working capital and fixed capital)
have been made.
• The cash which is available for distribution to all securities

Stock Valuation Models

holders of the company.

• It is that part of cash flow generated by company’s

operations that can be withdrawn by bondholders and
stockholders without economically impairing the company.
• FCFF can be computed using EBIT, NI or OCF.
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Computing FCFF using EBIT…

EBIT × (1-tax rate)

Plus: Net noncash charges (Dep & Amort)
Less: Investment in working capital

Stock Valuation Models

Less: Investment in fixed capital

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Computing FCFF using Net
Income…
Net income
Plus: Interest expense x (1 – Tax rate)@@
Plus: Net noncash charges (Dep & Amort)

Stock Valuation Models

Less: Investment in working capital
Less: Investment in fixed capital

@@
Reason for adding after tax interest is explained on next page.
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Computing FCFF using OCF…

Operating Cash Flow

*Plus: Interest expense x (1 – Tax rate)
Less: Investment in fixed capital

Stock Valuation Models

* The adjustment is not needed for companies using
IFRS and recording the interest expense under
financing activities.
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What is FCFE???
• The cash flow available to the company’s common
equity holders after all operating expenses have been
paid, necessary investments (working and fixed
capital) have been made and the payments to capital
suppliers other than common equity holders have

Stock Valuation Models

been made.

• After netting FCFF for all cash transactions of firm with

its debt holders and preferred equity holders, we are
left with FCFE.

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Computing FCFE using FCFF…

Free Cash Flow to Firm

Less: Interest expense x (1 – Tax rate)
Less: Preferred Dividends

Stock Valuation Models

Add: Net borrowings (additional
borrowings minus repayments)

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Computing the fair value of stock
using FCFF…
• PV* of FCFF = Value of firm’s operating assets
• Value of operating assets + cash/marketable
securities = Firm Value
• Firm Value – Market Value of debt and market value

Stock Valuation Models

of preferred equity = Value of common equity
• Value of common equity divided by number of
common shares = Fair value of common share

* Discounting at WACC 18
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Computing the fair value of stock
using FCFE…
• PV* of FCFE = Value of firm’s common equity

• Value of common equity divided by number of common

Stock Valuation Models

shares = Fair value of common share

* Discounting at KCE and not at WACC

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 Case 1: Constant Growth in Free
Cash Flows…

Using FCFF:
FCFF1 FCFF0 (1  g)
Firm' s operating assets value  

Stock Valuation Models

WACC - g WACC - g

Using FCFE:
FCFE1 FCFE0 (1  g)
Equity value  
kCE - g kCE - g

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Proust Company has FCFF of $1.7 million and FCFE of
$1.3 million for the year just ended. Proust’s WACC is
11% and its required return for equity is 13%. FCFF is
expected to grow forever at 7% and FCFE is expected to
grow forever at 7.5%. Proust has $2 million in cash,
500,000 shares outstanding and a debt outstanding of
$25 million.

Stock Valuation Models

A. What is the value of Proust’s common share using
the FCFF valuation approach?
B. What is the value of Proust’s common share using
the FCFE valuation approach?

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What is EBITDA?
•EBITDA stands for:
Earnings Before Interest,

Stock Valuation Models

Taxes, Depreciation &
Amortization

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Finding FCFF & FCFE from EBIT
& EBITDA

Stock Valuation Models

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Adjusting EBIT & EBITDA to find
FCFF & FCFE

Class assignment
USE PITTS CORPORATION FINANCIAL

Stock Valuation Models

STATEMENTS (HAND OUT) TO
CALCULATE FCFF AND FCFE STARTING
FROM:
a) EBIT
b) EBITDA 34
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Case 2: Variable Growth in Free
Cash Flows…
• Assume that FCFs will grow at different rates
in the foreseeable future and then will grow at
a constant rate thereafter.

Stock Valuation Models

• Since FCF is based on different components, a
better approach is to estimate each of them
(sales forecast, profit margins, working capital
and fixed capital investment, debt ratio).
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Two Stage Free Cash Flow Models

Stock Valuation Models

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Proust Company has FCFF of $1.7 billion for the year
just ended. Proust’s WACC is 11% and its required
return for equity is 13%. FCFF is expected to grow at
7% for next two years, at 6% for year 3 and 5% for
year 4, after which it will grow at 4% for each year
thereafter. Proust has $2 billion in cash, 50,000,000

Stock Valuation Models

shares outstanding and a debt outstanding of $20
billion.
What is the value of Proust’s common share using
the FCFF valuation approach?

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Cases in which FCFF preferred over
FCFE…
• A levered company with changing capital structure

• A levered company with negative FCFE

Stock Valuation Models

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Residual Income is useful as the definition
of return when…

• the company is not paying dividends

• the company’s expected free cash

Stock Valuation Models

flows are negative within the analyst’s
comfortable forecast horizon

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What is Residual Income???
• It is the earnings for a period in excess of investors’
required return on beginning-of-period investment.
• It measures the value added for common equity holders
in excess of opportunity costs.

Stock Valuation Models

• Due to the degree of distortion and the quality of
accounting disclosure, the application of residual income
model is error-prone.

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Axis Manufacturing Company (AMC) has total assets of €2,000,000 financed
50% with debt and 50% with equity capital. The cost of debt capital is 7%
pre-tax (4.9% after tax) and the cost of equity capital is 9%. If EBIT is
€200,000, net income for AMC can be determined as follows:
EBIT €200,000
Less: Interest Expense 70,000
Pre-Tax Income €130,000
Income Tax Expense 39,000
Net Income € 91,000

Stock Valuation Models

Equity Charge/cost of equity:
Equity Capital (Beg of the year) х Cost of Equity Capital in %
Cost of Equity = €1,000,000 х 9% = € 90,000
Net Income € 91,000
Equity Charge 90,000
Residual Income €1,000
 
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In the Residual Income Model (RIM) of
valuation, the intrinsic value of the firm has
two components…

Fair value = Current book value per share

+

Stock Valuation Models

PV* of expected future residual incomes

* Discounting at KCE
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A company will earn $1.00 per share forever, and the
company also pays out all of this as dividends, $1.00 per
share. The equity capital invested (book value) is $6.00 per
share. Because the earnings and dividends will offset each
other, the future book value of the stock will always stay at
$6.00. The required rate of return on equity (or the percent
cost of equity) is 10%.

Stock Valuation Models

a. Calculate the value of this stock using the dividend
discount model.
b. What will be the residual income each year? Calculate
the value of the stock using a residual income valuation
model.
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References
• Equity, CFA-II Program Curriculum. Reading 43.

Stock Valuation Models

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