Video Transcript: Free Cash Flow Valuation

Hello, welcome. We're going to discuss free cash flow valuation and how to  value firms based off their free cash flow, and how to value a firm stock based  off their free cash flow. Now, free cash flow is the cash flow available to all  suppliers of capital. So anything that we have left over that we can pay down  using debt, or pay down our debt, or anything else the free cash flow will do it.  So the free cash flow is the operating cash flow, minus the net fixed asset  investment, minus the net current asset investment, right? So our net fixed asset investment will be okay. What is fixed? Right? Debt payments. Right, notes  payable long term debt. Right? Our financing on our plant, property and  equipment, right? Net current asset investment. What else is there? So we  have, potentially purchases of stock, right? So our net current asset investment,  or our inventory or working capital, so our free cash flow will be our operating  cash flow, our total operating cash flow from sales, investment opportunities and financing opportunities, subtracting out the net fixed asset investment and  subtracting out the net current asset investment. So we're going to look at  valuing the firm. So we want to take our free cash flow project it out, how many  years, right? So you can see the sigma, or the E is standard for summation,  we're going to add the values up, so you're going to have free cash flow one  plus free cash flow two, plus free cash flow three, as you'll see in the example  that we are about to portray. So equity value, valuing the price of the stock, the  free cash flow, the T stands for time period. So free cash flow, one, free cash  flow, two, for cash flow, three divided by one plus the rate of return required  raised to the time, or if it's period one, period two, period three, etc, then we'll  subtract out the value of the debt, and then we'll subtract out the value of the  preferred stock. So this is the constant growth free cash flow valuation model.  So we are going to compute the firm value, and we are going to compute the  equity value. So first, we'll begin with the firm value. Notice we have free cash  flow one, free cash flow one for period one, so we have the rate of return that's  required, subtracting out the projected growth rate of the free cash flows. So you can see it can be otherwise written as free cash flow, one equals the free cash  flow from the period prior times one plus the growth rate of our free cash flow.  Equity value, as we just discussed, same thing, free cash flow one divided by  the rate required of return and growth of our projected free cash flow. That rate  minus the value of the debt minus the value of the preferred stock. So let's run  through a free cash flow example. These are the metrics that we're going to use  to define this equation, work it out and solve the problem for firm value and  equity value. So let's look at this. Step one. We want to calculate the present  value of the free cash flow occurring from the end of 2018 to infinity, measured  at the end of 2017 so we're going to project out in perpetuity, the value of the  firm, right, using the metrics from 2013, 14, 15, 16, and 17. So we're going to  use those metrics to project out our future cash flow growth and our rate of  return. So we'll see right let's go to our equation. So we've got the value of free 

cash flow, 2017, To perpetuity, right? So this equals, what is our free let's look at  it. What is our free cash flow for 2018 Well, remember, we defined the free cash  flow one, which for 2018 we're solving for is free cash flow zero, which is the  period prior, which would be that we need to find the free cash flow of 2017 and  multiply that times one plus the growth rate of the free cash flow. So what do we  have here? What was the free cash flow in 2017 right? So the free cash flow of  2017 if you'll see on column two at the bottom, it is 600,000 Okay, 600,000 we're going to divide that by the rate, right? So let's see what the rate is. The rate will  be 3% now you'll see in the column or in the Row 2013 and it says other data  says growth rate of free cash flow beyond 2017 to infinity is 3% so they're going  to project out that 2018 through infinity is going to be 3% So now we've got the  growth rate here, right? So we've got .03 that's 3% and then now we have the  rate of return, 9% if you look at the weight, weighted average cost of capital, 9%  is our return that we need that is required, our cost of capital, our average cost  of capital, that is a blend of equity and debt financing. How much does it cost  us? Our average cost of capital is 9% so say our return, our debt interest rate is  12% and our return to our shareholders on equity is 6% and on average, that  gives us a weighted average cost of capital of 9% depending on how we're  distributing our equity financing and our debt financing. But for this example, the  cost of capital is 9% so in order for this project to move forward, forward, we  cannot make anything less than 9% that way will be at least break even, and we won't be losing money. So for this example, will use our average cost of capital  as our required return rate. That's .09 so we'll always signify percentages as a  decimal, right? So two place decimal, 9% 3% okay, .1 one would be 10% so as  we calculate this, you can see that the value at the end of 2017 equals  10,300,000 Now step two, we want to add the present value of The free cash  flow from 2018 to infinity to 2017 free cash flow value to get the total cash flow  in 2017 so as we're projecting this out, we see that total cash flow for 2017 we're going to add back in the 600,000 the free Cash Flow of 2017 we're going to add  that into our firm value, right? We're trying to find the value of the firm. So the  value of the firm at the end of 2017 we projected was 10.3 million. Now the total  free cash flow, right, the total value after we add in the 600 we'll have  10,900,000 so Now Step Three to finding the value of our firm. So we need to  find the sum of the present values of the future free cash flows, or the free cash  flows for 2013 through 2017 to determine the value of the entire company. So  now what we're going to do is we're going to find the present value so we can go back and we can find the free cash flows for the periods, 2013, 14, 15, 16, 17,  and column two. So those were our free cash flows at the end of those periods.  2013, 14, 15, 16, 17. So now we are going to project out the present value of  each of those periods, add them together, and that is going to give us the value  of our entire company. So we're going to go back through and so to find the  present value. So let's go here, say present value equals free cash flow and 

whatever period it is, period 1, 2, 3, 4, 5, so we'll just represent that with a T  representing time right, divided by one plus the rate of return, or our weighted  average cost of capital. So now we're going to go through we're going to project  out the present values of these future cash flows to find our value of the firm. So let's look back at cash flow 1 2013, the free cash flow 400,000 so you'll see  400,000 so the value of our company equals 400,000 divided by one plus .09,  raised to one. Why do we raise it to one every time that it's a period a different  period, we're going to raise it by that period. So, for example, 450,000 was our  free cash flow in 2014 we're going to divide that one plus the growth rate, or the, I'm sorry, the required return, or the weighted average cost of capital. Then we'll  raise it to two, because it's period two, so we'll raise that to two. Now we're  going to add this so for period 3 is 520,000 divided by one plus the growth rate  three running out of board space. So we'll go here plus 560,000 for period four  divided by one plus ladies, average cost of capital will give us four plus so now  for five, you'll see that they that we are going to use 10,900,000 as our total free  cash flow, because we're projecting that out for 2017 as the total free cash flow,  and we'll need that number to make sure we can project out 2018 accurately,  right? So this will be our our calculation for the entire value of the firm. So we'll  go, 10,900,000 divided by one plus the weighted average cost of capital raised  to the fifth, right. So now, as we'll solve we'll go so we equal so So, so let's run  through this real quick, 400,000 so we're going to add one plus .09 and raise  that to the first power. So this, this number won't change. One plus .09 raised to  the first this cash flow will be 36,972, that's the cash flow that is the present  value of this 400,000 that will need to add up to give us our value of our firm, to  give us the total value of the firm. So now the next for period two. For period  two, our cash flow will our the present value of cash, free cash flow from period  two is 378,756, and we'll Add the present value of period, 3 401535, plus,  396718, plus 7084252, we add all of these to. Together, add all of these present  values together to find the value of the company. The value of the company.  After all present values have been calculated and added together, 8,628,234  this is the value of our firm based off of the free cash flows that we have  acquired over the period 2013-2017 so now we're just using those free cash  flows, finding their present value, adding them together, and now we're getting  the total value of the firm today, because they're all those cash flows are taken  to a present value status. So this is the present value of those future cash flows, right? So now our present value of the firm, 8,628,000 sorry, 628,000 to 2  628,002 34, firm value. Now let's calculate the equity value, our price per share.  I'm going to erase this so Okay, now let's discuss finding the equity value of our  firm so we can see that we to calculate the value of our common stock. We are  going to so the value of our stock, the value of our stock, equals the value of our company, minus the value of the debt, minus the value of preferred stock. So we will take our firm value the 8,628,234 that's our VC. That's our company value. 

So we've got 8,628, 234, now we'll subtract out. Now we'll subtract out the value of our debt. So you can see the market value of our debt is 3.1 million under the  other data column and the 1, 2, 3, third row down 3.1 million. So we got minus  3.1 million, minus 800,000 for the market value of our preferred shares. It is the  fourth row down in column three market value of preferred shares minus  800,000 so now our value for our stock is 4,728,234 10, 728,234 to get that  number, we just did the simple math. 8,628,234 minus 3.1 million minus 800,000 so now we're going to take this is our this is our base price, right? This is the  value of our total common stock, right? This is the owner's equity, if you will,  divided by seeds. So we've took out our value from our right here, minus the  debt, minus the equity, right? So that gave us our owner's equity here, right? So  now we're going to divide this because we have 300,000 shares in the market.  This is our firm value total. This is our owner's equity. We have 300,000 shares  available in the market to be sold and bought. So now our we want to calculate  our price per share. So that's why we're dividing this number by this number.  This is our total value. This is the total number of shares available. So we want  to find out. The price per one share. So this is our price. These are our number  of shares, the price per share, 15.76 now financial managers, portfolio  managers, market investors, they'll go through this valuation process to figure  out if the market value is greater or lower than this value, and make investment  decisions based upon the value they find on free cash flow valuation, right? So  the 15.76 if the stock price in the market is trading at 12.50, as an investor, I  would probably say, hey, let's buy that. I think that that stock price is  undervalued based on the analysis of their free cash flows and the constant  growth model. So but if the market price based on free cash flows, let's say is  17.50 don't buy that stock, move on to another investment because it's  overvalued.