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How do you use free cash flow valuation to find the value of a stock? (Please...

How do you use free cash flow valuation to find the value of a stock? (Please include formula and example.)

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Expert Solution

The free cash flow valuation model is based on the same premise as the dividend discount model. The value of a share of common stock is the present value of all future cash flows it is expected to provide over an infinite time horizon. In the free cash flow valuation model, instead of valuing the firms expected dividends, we value the firms expected free cash flows.

Vc = FCF1 (1+Ka)1 + FCF2 (1+Ka)2  + FCF3 (1+Ka)3  + ------+

where Vc is the market value of the entire enterprise.

The common stock value is found as

Vs = Vc - Vd - Vp

where Vd is the maket value of the firms debt and Vp is the market value of the firms preferred stock.

Suppose the firms free cash flows is $ 1000 in year 1 and 2. The firm's debt value if $ 300 and firms preferred stock value if $ 250. The firm's cost of capital if 7%. The firm has 100 shares of common stock outstanding.

Vc = $ 1000 (1+0.07)1 + $ 1000 (1+0.07)2

Vc = $ 1,808.02

Vs =  $ 1,808.02 - $ 300 - $ 250

Vs = $ 1,258.02

Value of stock = $ 1,258.02 100

Value of stock = $ 12.58

jeff jeffy answered 2 years ago
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