PARt 2: VALUAtIoN, RISk ANd REtURN5-3 tHE FREE CASH FLoW APPRoACH to
oRdINARY SHARE VALUAtIoN
One way to deal with the valuation challenges presented by a company that does not pay dividends is
to value the free cash flow generated by the company. This approach makes sense because, after all,
if you buy a company, you obtain rights to all of its free cash flow. The advantage of this procedure is
that it requires no assumptions about when the company distributes cash dividends to shareholders. In
practice, most analysts estimate the value of a share using several different methods to see how widely
the alternative estimates vary. Therefore, the free cash flow approach is widely used, even for shares
that do pay dividends. When using the free cash flow approach, we begin by asking, what is the total
operating cash flow generated by a company? Next, we subtract from the company’s operating cash flow
the amount needed to fund new investments in both fixed assets and working capital. The difference is
total free cash flow (FCF). We introduced the equation for free cash flow in Chapter 2, but here it is again:FCF = OCF – ∆FA – DWC
Free cash flow represents the amount of cash that a company could distribute to investors after
meeting all its other obligations. Note that we used the word investors in the previous sentence. Total free
cash flow is the amount that the company could distribute to all types of investors, including bondholders,
preferred shareholders and ordinary shareholders. Once we have estimates of the FCFs that a company
will generate over time, we can discount them at an appropriate rate to obtain an estimate of the total
enterprise value.free cash flow (FCF)
The net amount of cash flow
remaining after the company
has met all operating needs,
including capital expenditure
and working capital needs.
It represents the cash
amount that a company
could distribute to investors
after meeting all its other
obligations
finance in practiceSHOULD I BUY A 25% INTEREST IN SAWFT PTY LTD?A friend offers you the opportunity to buy into his
two-year-old software business, Sawft Pty Ltd. Your
friend will give you a 25% interest in the company for
$50,000. Some of the company’s key financial data
are summarised below.Free cash flow (prior year) $27,800
Expected annual growth in free cash flow:
Next 3 years 12%
Year 4 to ∞ 5%
Your required return 20%You need to determine: (1) the value of the
business; and (2) whether a 25% interest in the
business is worth $50,000. Use the variable growthmodel to estimate the value of the business, starting
with estimates of the free cash flows (FCFs) at the
end of each of the next four years:Year 1 FCF = $27,800 × 1.12 = $31,136
Year 2 FCF = $31,136 × 1.12 = $34,872
Year 3 FCF = $34,872 × 1.12 = $39,057
Year 4 FCF = $39,057 × 1.0 = $41,010Next, we calculate the present value (PV 0 ) of the
FCFs for the first three years:
PV $31,136 1. 20 $34,872 1. 20 $39, 057 1. 20
$25, 947 $24,217 $22,602
$72,7660