Free Cash Flow
The Free Cash Flow method is the most widely accepted valuation method, particularly for evaluating an on-going concern. The method is based on measuring the business opportunities in the future and its projected cash flows. Both are crucial to the investors and shareholders.
The Formula
Where:
FC = Free Cash Flow in Year i
n = The Forecast Period in Years
r= Discount Rate
RV= Residual Value in Year n
ADJ = Adjustments: Surplus assets less Debts
Operating Steps
Step 1
Enter the Discount Rate. This rate is based on the free risk interest rate in the market (e.g. government bonds) with a Market Risk Premium which grow as much as the risk which is involved in the business, or as much as the uncertainty in the business, its products and markets.
If you are not familiar with selecting the right discount rate, it is recommended to use 12-15% rate for a low risk business and 25-40% for a high-risk business.
Professionals use the Weighted Average Cost of Capital (WACC) calculated by the following formula:
Where:
T= Marginal Tax Rate
CD= Cost of Debt (The average interest rate on the company's debt)
CE= Risk Free Interest + (Beta * Market Risk Premium)
Beta= Risk factor of the business compared to the average risk in its industry. A Beta that is lower than 1 means that the business is less risky than similar businesses in its industry and vice versa.
Step 2
Enter the Price/Earnings factor. The factor should be selected according to the average Price/Earnings factor of public companies that belong to the same industry that your business belongs to. This data can be accessed every day from the financial section in almost every daily newspaper.
Step 3
Enter the amount of Surplus Assets (assets that the business can sell without hurting its current operations) and the amount of Debt Value (short and long term debts that the business owes).
Step 4
View the Company Value in three residual value methods. These methods are explained below.
Φ Note the company value is calculated based on the accumulated discounted cash flow during the plan period, added with the discounted residual value and the surplus assets, less the debt value.
Residual Value Methods
The three main methods to measure the residual value, which is calculated as part of the Free Cash Flow method, are as follows:
1. The Perpetuity Method
The perpetuity method assumes that the company's future cash flow will continue forever. The residual value of the business is calculated according to the following formula:
Where:
r= Discount Rate
n = The last year of the analysis period
Φ Notes
- Some analysts suggest using the operating profit instead of the free cash flow in the formula.
- Some analysts use a different (higher) perpetuity discount rate as opposed to the free cash flow discount rate, assuming that the uncertainty grows in future period that is far from the plan period.
- Some analysts include growth rate in the formula assuming that the business will continue to grow. They do it by multiplying the free cash flow of the last year by the growth factor, and reducing the growth rate from the discount rate.
- The software does not support the above methods and they are described for your information.
2. The Liquidation Method
This method assumes that the most conservative way to calculate residual value is to assume that the firm will be liquidated at the end of the forecasting period. Therefore the residual value should be calculated as the net liquidation value - the assets value (including cash, account receivable, inventory, plant and equipment) less liabilities value (including accounts payable, short and long term liabilities). This value that is calculated for the end of the forecasting period is discounted for the beginning of the period before adding it to the discounted cash flow, in order to calculate the company value.
3. The Price Earnings Method
This method assumes that the best way to determine a company's residual value is to calculate its market price using the relevant Price Earning factor.
The Formula
Where :
Comparative P/E= P/E of any similar public company or industry average
r = The discount rate
n = The selected year
The residual value calculated by this formula is discounted to the beginning of the plan period and is added to the discounted cash flow.
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