Judge from a free cash flow valuation whether a stock is priced too high, too low or fairly
The idea
Once a free cash flow model yields an intrinsic value per share, the analyst compares it with the market price. Value above price suggests the share is undervalued; value below price suggests it is overvalued. With FCFF, the model gives the value of the whole firm, so debt must be subtracted before dividing by shares; comparing firm value per share with the share price overstates the case for buying. The analyst should also test whether the verdict survives reasonable changes in the discount rate and terminal growth rate, and whether the forecast reinvestment is consistent with the forecast growth. The trap is declaring a share undervalued on a gap smaller than the change produced by a plausible shift in the key assumptions.
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
- Set out ways of working out terminal value in a valuation model with several stages