Hi everyone. Our coverage of Advanced Valuation Models focuses on three models. The dividend discount model, the discounted cash flow model, also referred to as a discounted free cash flow model and the residual income model. Today we will go through the mechanics of using the discounted free cash flow model. The discounted free cash flow model focuses on a company's ability to generate cash from its operations and its investments. Now note that a company uses both equity and debt to finance its operations and investments. That is, a company uses cash from shareholders and lenders to fund its activities. So the dividend free cash flow model estimates the enterprise value of the company based on the cash that is generated from its activities. And investments, net of any cash that is re-invested in the business. The model then discounts the value of the company's net debt to arrive at the intrinsic value of equity. Now let's formally define free cash flow as a concept. A company's free cash flow is essentially the cash in flows from its operations and investments minus the cash used to invest in new operating assets, example, property plant and equipment. So the first step in applying a discounted free cash flow model is to start with a company statement of cash flows and generate forecasts of its operating cash flows and the cash used for investments. This will allow you to generate forecasts of the company's free cash flows over a forecast horizon. Let's walk through the steps in greater detail to apply the model. First, as mentioned, we must forecast the company's free cash flow over a reasonable horizon, say, three to five years. We will also need to forecast a terminal or final year free cash flow that is expected to extend into perpetuity. We will use this terminal free cash flow to calculate a continuing value with an estimated growth rate. Next, we will discount both the stream of forecasted free cash flows and the continuing value to present value, using the weighted average cost of capital as our discount rate. We use the weighted average cost of capital since the company's operating and invest in operations are funded by a mix of debt and equity. We will sum these two discounted amounts to arrive at enterprise value. For our last two steps, we will subtract the company's net debt to arrive at the estimated value of equity. We will then take this estimated equity value and divide it by the total number of common shares outstanding to arrive at the company's estimated price per share. We will now formalize these steps into the following model. Here, the intrinsic value of equity or equity value at present time is equal to the intrinsic value of the estimated free cash flows minus the company's net debt. We use the netbook value of the company's non operating liabilities and any preferred shares to estimate the value of net debt. Also, as noted, we use the weighted average cost of capital to discount the individual free cash flows over our forecast horizon, as well as a terminal continuing value. Let's now look at a detailed example for the Coca Cola Company. The amounts here are denoted in millions of dollars. My forecast horizon is 5 years from the year 2000 to 2004. I will forecast a set of free cash flows over this time horizon by forecasting the company's cash flow from operations for each year, along with an estimate of the cash used to invest in operating assets. Note that the final year forecast at the end of the forecast horizon that is in year 2004 is 5,311 million. Note also that the estimated weighted average cost of capital is 9% annually and the terminal growth rate is 5%. Once I have the forecasted free cash flows, the next step is to convert each amount to present value by multiplying the amount by the discount rate at a weighted average cost of capital at 9%. We can use present value tables to arrive at the discount rates or compute the rates as 1.09 to the power n. I will then sum all my present value amounts to arrive at a total amount of 14,367 million. My next step is to compute the continuing value for the terminal free cash flow and convert this to present value. Recall that my terminal forecasted amount in 2004 is 5,311 million and that the estimated terminal growth rate is 5%. So I will compute the continuing value as 5,311 million times 1 plus the 5% growth rate divided by the discount rate of 9%, minus the growth rate of 5%. This gives me a continuing value of 139,414 million. I will further divide this value by the discount rate in 2004 of 1.5386 to arrive at a present value of 90,611 million. Next, I will sum the total present value of the estimated free cash flows to the present value of the continuing value to arrive at a total enterprise value of 104,978 million. From this amount, I will subtract out the book value of net debt to calculate an estimated value of equity of 100,543 million. I will convert the equity value to a per share amount by dividing the amount by the total number of shares outstanding. This final step gives me an estimated value of equity per share of $40.67. That is, my estimated price per share for the Coca Cola Company at the beginning of 2000 would have been $40.67. Now the calculations I just did worked great for the Coca Cola Company. Their forecasted free cash flows were positive and quite strong over or forecast horizon. Now the big question is, what do we do when a company has negative free cash flows? This was exactly the situation for Wal-Mart Stores Inc, now known as simply Wal-Mart, back in the late 1980s and into the 1990s. During that time, the company was in a heavy investment phase, and the cash they invested into the business exceeded the cash they generated from their operations. This resulted in negative free cash flows for several years in the early to mid 1990s. At that time, if we were to use a discounted free cash flow model to generate an equity value for Wal-Mart, then the estimated valuation would be meaningless. You would actually get a negative share price, which does not make sense as a price of a share cannot go below zero. So this indicates that I would need to use an alternative valuation model. Such as the dividend discount model or the residual income model, to come up with a meaningful valuation estimate for Wal-Mart. These alternative models will likely show that negative free cash flows is not a bad thing in the short run if the company is investing in long term growth. These heavy investments in long term growth will likely translate into higher dividend payouts in the future as well as higher residual income amounts. Now the Wal-Mart example just shows one drawback of the discounted free cash flow model. There are several advantages to using this model, along with some disadvantages. Let's start with the advantages. First, free cash flows represent real cash, and the concept is easy for investors to grasp. These cash flows are also not affected by a cruel accounting rules. Second, the model is a straight application of familiar net present value techniques. There are no complicated calculations beyond what we have learned in computing the present value of a future stream of payments, plus the present value of a continuing valuation amount into perpetuity. Despite these advantages, critics argue that free cash flows do not fully depict the value a company creates in the short run. This is because income that is gained and accounted for as deferred income is not accounted for in a cash flow statement. Also, free cash flows do not properly match value that is created with value that is given up. For example, the cash flow statement does not match income earned with the expenses incurred to gain that income. Others also argue that free cash flows do not recognize increases in value that do not involve cash flows. For example, free cash flows do not include increases in the value of certain assets that are held at fair or market value. Lastly, free cash flow is sometimes viewed as a liquidation concept, as firms can artificially increase their free cash flows by cutting back on much needed investments. Two other disadvantages relate to the forecast horizon and the alignment with common forecasts. Like the dividend discount model, the discounted free cash flow model requires forecasts over long periods, and terminal values are difficult to estimate reliably. Also, most analysts forecast earnings not free cash flows. And to convert earnings forecasts into free cash flows, we would need to forecast the crew rules, which are generally more difficult to estimate. So to wrap up, the discounted free cash flow model works well when the company's investment pattern produces a constant stream of free cash flows or a stream that grows at a constant rate. The model also works well when the free cash flow pattern is positive over the forecast horizon.
