Set out ways of working out terminal value in a valuation model with several stages
The idea
The terminal value captures the cash flows after the explicit forecast. One approach assumes stable growth from then on and applies the constant-growth model: terminal value of FCFF at year n equals FCFF(n+1) ÷ (WACC − g), and likewise FCFE(n+1) ÷ (r − g) for equity. The long-run growth rate should be sustainable, usually no higher than nominal growth in the economy, and investment in the stable stage should be consistent with that growth. The other approach applies a multiple, such as a P/E or EV/EBITDA, to a forecast at the horizon. Multiples rest on market data but may import current mispricing. The mistake to avoid is putting FCFF(n) rather than FCFF(n+1) in the numerator.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Contrast valuing a business by the free cash flow available to equity (FCFE) with valuing it by its free cash flow to the whole firm (FCFF)
- Explain whose point of view as owner the FCFE approach takes
- Explain which adjustments turn EBIT (pre-interest, pre-tax earnings), EBITDA, net income and operating cash flow (CFO) into FCFF and FCFE
- Work out FCFF and FCFE
- Set out ways of projecting FCFF and FCFE
- Explain how dividends, buybacks, new share issues and shifts in leverage can change future FCFF and FCFE
- Contrast the FCFE model with dividend discount models
- Assess using EBITDA and net income as stand-ins for cash flow when valuing a firm
- Explain how sensitivity analysis is used in FCFF and FCFE valuation
- Explain FCFF and FCFE models with one stable-growth stage, two stages and three stages, and argue which suits a given firm's characteristics
- Estimate what a firm is worth with the free cash flow model or models that fit it
- Judge from a free cash flow valuation whether a stock is priced too high, too low or fairly