FCFE Model Valuation

Session 9
 Measuring Cash flows
• Cash flow to Equity Holders:
– Free Cash Flow to Equity (FCFE) = Net Income -( CAPEX –Depreciation)
– change in Non cash working Capital + Net Debt Issues – Preferred
Dividend
Cash flows to Firm:
– Free Cash flows to firm (FCFF):EBIT (1-tax) –( CAPEX –Depreciation) –
change in Non cash working Capital
• Note: Net Debt Issues = New Debt Issues- Principal Repaid
• Non-Cash Working Capital = Debtors +Inventory-Creditors
• Change in Non Cash Working Capital = NWC2-NWC1
 FCFCE Models
• Constant Growth FCFE Model
• Two Stage FCFE Model
• Three Stage FCFE Model
 Constant Growth FCFE Model
•

• It is similar to Gordon Growth Model for DDM.

• Best Suited Firms:
a) growing at rate comparable to or less than nominal
growth rate in economy.
b) Firms that pay dividends higher or lower than FCFE.
 Illustration
• Using stable growth model, find if BIFM Ltd. is
undervalued or overvalued:
Current Year Per Share Value
Net Income 110
Depreciation 23.07
Capex 190.24
Change in NWC 6.20
Net Debt Issues 118.51
DPS 55
EPS 110
Beta 1.10
Rf 6%
Risk Premium 10%
RoE 7.5%
Current Market Price (CMP) Rs. 400
 Solution
• FCFE: 55.14
• g= .0375
• Ke = 17%
• FCFE1 = 57.208
• Price: 57.208/.1325 = 431.75, Undervalued
 Two Stage FCFE Model
• Value = PV of FCFE + PV of Terminal Price
=

where,
FCFEt = Free cash flow to equity in year t
Pn = Price at the end of extraordinary growth period i.e.
FCFEn+1/ (ke,st – gn)
Ke = cost of equity in high growth (hg) and stable growth (st)
periods.
 Illustration
• AXA Ltd. is going to remain in high growth period for next 3 years with the
following information:
Details 2017 2018 2019
NI 163.43 362.86 450.67
Depreciation 34.36 69.54 75.24
Capex 398.11 432.55 450.25
Change in non 10.41 93.08 95.16
cash W.C.
Net Debt 228.43 128.87 70.37
Issues

Assume ke=9.5% constant throughout and growth to be 3% for stable phase. Determine
whether it is overvalued or undervalued at the current price of Rs.600.
 Solution
• High Growth Phase:
Year FCFE PV
2017 17.7 17.7/1.095=16.16
2018 35.67 29.75
2019 50.87 38.34
Total 84.66

Stable Growth Phase:

FCFE2020: 50.87*(1.03)= 52.40
TV: 52.40/0.065 = 806.154
PV of TV: 806.154/(1.095)3 = 613.96
Intrinsic Value = 84.66 + 613.96 = 700.08
 Three Stage FCFE Model
• Value = Initial Phase of high Growth + Transitionary
Phase+ Stable Growth Rate
 Firm Valuation
• Free Cash Flow to Firm (FCFF):
EBIT (1-t) + Depreciation – Capex -∆ W.C.

Expected growth in operating Income:

Reinvestment Rate * Return on Capital
 ..continued
• Growth in Operating Income: Reinvestment Rate * Return on
Capital
where,
Equity Reinvested in business : Capex – Dep. + change in Non
cash WC
Reinvestment Rate: Equity Reinvested in business/ EBIT(1-t)
Return on capital: EBIT (1-t)/ Capital Invested
 Stable Growth Firm

where,
FCFF1= Expected FCFF next Year
WACC = Weighted Average Cost of Capital
Gn = Growth Rate in FCFF forever
 Illustration
• AXA Ltd. is going to remain in high growth period for next 3 years with the
following information:
Details 2017 2018 2019
NI 163.43 362.86 450.67
Depreciation 34.36 69.54 75.24
Capex 398.11 432.55 450.25
Change in non 10.41 93.08 95.16
cash W.C.
Net Debt 228.43 128.87 70.37
Issues

Assume ke=9.5% constant throughout and growth to be 3% for stable phase.

Determine whether it is overvalued or undervalued at the current price of Rs.600.
 Solution
• High Growth Phase:
Year FCFE PV
2017 17.7 17.7/1.095=16.16
2018 35.67 29.75
2019 50.87 38.34
Total 84.66

Stable Growth Phase:

FCFE2020: 50.87*(1.03)= 52.40
TV: 52.40/0.065 = 806.154
PV of TV: 806.154/(1.095)3 = 613.96
Intrinsic Value = 84.66 + 613.96 = 700.08
 Two Stage Model

where,
WACC = cost of capital (hg: high growth , st : stable growth)
 Two Stage Model Illustration
• Gerdau Steel is a Brazilian steel company with current year’s after tax operating
income of R$. 8005 mn. During the year company charged depreciation of R$.
1896, capital expenditure incurred was 6818mn and non cash working capital
increase of R$ 1083mn. Gerdau’s marginal tax rate is 34%. The market value of
equity and debt is R$17,449mn and R$15979mn.
• The reinvestment rate used by company is 60% and return on capital of 16%. The
company is expected to remain in high growth for 5 years.
• To estimate cost of equity Treasury Bond Rate is 3%, the equity risk premium used
for matured market was 6% and additional country risk premium is 4.75% for Brazil
and levered beta is 1.94.
• The pretax cost of debt of Gerdau is 9%.

• In stable growth it is assumed that the company will grow at 3% a year. The debt
ratio would be 50% and cost of pre tax debt would be 8%. Find out value of firm.
 Solution
• FCFF0= 8005+1896 – 6818-1083= 2000
• g (hg) = .60*.16 = .096
• High Growth cost of Capital:
– Ke: 3+ 1.94(10.75) = 23.85
– Cost of Debt: 9 (1-.34) = 5.95
– WACC : 17449/33428(23.85) + 15979/33428*(5.95)
= 12.45+ 2.84=15.29
FCFF Values PV PV FCFF
Factor
FCFF1 2192 1/1.152 1901.12
9=0.867
3
FCFF2 2402 0.7523 1807.02
FCFF3 2633 0.6526 1718.30
FCFF4 2886 0.5660 1633.48
FCFF5 3163 0.4909 1552.72
Total 8612.64
 Contd…
• Stable Growth Phase:
– Ke: 3+ 1.94(10.75) = 23.85
– Kd = 8(1-.34)= 5.28
– WACC = .50*23.85 + .50*5.28 = 14.56
– g= 3%
– FCFF6 = 3163*(1.03) = 3258
– TV = 3258/.1456-.03 =28183
– PVTV = 28183/(1.1529)5 = 13837
Value of Firm = 13837+8612 = 22448
 Problems with FCFF Models
• There a 3 problems associated with the Model:
1. FCFE is a much more intuitive model than FCFF.
2. Focus on pre debt cash flows can sometimes be dangerous.
Eg: Assume a firm has a FCFF of Rs. 100 lakhs but its large
debt makes its FCFE equal to Rs. -50 lakhs. This firm will have
to raise Rs. 50 lakhs in new equity to survive or all cashflows
beyond this will be in jeopardy. FCFE would have alerted
about this situation.
 Summarizing the Inputs
• One has to decide:
– The current cash flows on the investment, either
to equity investors (Dividends or FCFE) or to the
firm (FCFF)
– The current cost of equity or cos of capital
– the expected growth rate in earnings, based upon
historical growth, analyst forecast or fundamentals
 Which cashflow should I discount?
• Use Equity Valuation:
– For firms which have stable leverages, whether high or low and
– If equity (stock) is being valued
• Use Firm Valuation:
– For firms having leverage which is too high or low and expect to
change the leverage over time, it is better because debt payments and
issuances have not to be factored while calculating FCFF.
– For firms for which you have partial information about leverage ( eg
interest information is missing)
– When you are interested in valuing firm
 Given cashflow to equity should I discount
dividend or FCFE
• Use the DDM:
– For firms which pay dividend (and repurchase stock) which are close to
the FCFE (over an extended period).
– For firms where FCFE are difficult to estimate (example banks and
financial services)
• Use FCFE :
– For firms which pay dividends which are significantly higher or lower
than FCFE. As a rule of thumb, if dividends are less than 80% of FCFE
or greater than 110% of FCFE over a 5 year period, use FCFE model
– For firms where dividends are not available ( Private Companies, IPOs)
 Which discount Rate should I use?
• Cost of Equity Versus Cost of Capital
– If discounting cash flows to equity use cost of equity
– If discounting cashflow to firm use WACC
• What currency should the discount rate be in?
– Match the currency in which you estimate the risk free rate to the
currency of your cash flows
• Should I use real or nominal cash flows?
– If discounting real cash flows use real cost of capital
– if nominal cash flows use nominal cost of capital
– In inflation is low <10-15% stick to nominal cash flows since taxes are
based on nominal cash flows
– If it is higher than 10-15% switch to real cash flows
 Which Growth Rate Should be Used?
• If your firm is
– Large and growing at a close to or less than growth rate of economy or
– Constrained by regulation from growing at a faster rate than economy or
– Has the characteristics of stable growth firm
then Use a Stable Growth Model
• If your firm
• Is large and growing at a moderate rate (15% or so) or
• Has a single product and barriers to entry with finite life (patents)
Use a Two Stage Model
• If your firm:
• Is small and growing at a very high growth rate (>15%) or
• Has significant barriers to entry into business
• Has firm characteristics very different from the norm
Use a 3 stage or n stage model