94 Part One Value
bre44380_ch04_076-104.indd 94 09/30/15 12:46 PM
DCF models work just as well for entire businesses as for shares of common stock. It
doesn’t matter whether you forecast dividends per share or the total free cash flow of a
business. Value today always equals future cash flow discounted at the opportunity cost of
capital.Valuing the Concatenator Business
Rumor has it that Establishment Industries is interested in buying your company’s concatena-
tor manufacturing operation. Your company is willing to sell if it can get the full value of this
rapidly growing business. The problem is to figure out what its true present value is.
Table 4.7 gives a forecast of free cash flow (FCF) for the concatenator business. Free cash
flow is the amount of cash that a firm can pay out to investors after paying for all investments
necessary for growth. As we will see, free cash flow can be negative for rapidly growing
businesses.
Table 4.7 is similar to Table 4.4, which forecasted earnings and dividends per share for
Growth-Tech, based on assumptions about Growth-Tech’s equity per share, return on equity,
and the growth of its business. For the concatenator business, we also have assumptions about
assets, profitability—in this case, after-tax operating earnings relative to assets—and growth.
Growth starts out at a rapid 12% per year, then falls in two steps to a moderate 6% rate for the
long run. The growth rate determines the net additional investment required to expand assets,
and the profitability rate determines the earnings thrown off by the business.
Free cash flow, the fourth line in Table 4.7, is equal to the firm’s earnings less any new
investment expenditures. Free cash flow is zero in years 1 to 3, even though the parent com-
pany is investing over $3 million during this period.
Are the early zeros for free cash flow a bad sign? No: Free cash flow is zero because the
business is growing rapidly, not because it is unprofitable. Rapid growth is good news, not
bad, because the business is earning 12%, 2 percentage points over the 10% cost of capital.
If the business could grow at 20%, Establishment Industries and its stockholders would be
happier still, although growth at 20% would mean still higher investment and negative free
cash flow.1 2 3 4 5 6 7 8 9 10
Asset value, start of year 10.00 11.20 12.54 14.05 15.31 16.69 18.19 19.29 20.44 21.67
Earnings 1.20 1.34 1.51 1.69 1.84 2.00 2.18 2.31 2.45 2.60
Investment 1.20 1.34 1.51 1.26 1.38 1.50 1.09 1.16 1.23 1.30
Free cash flow (FCF) 0.00 0.00 0.00 0.42 0.46 0.50 1.09 1.16 1.23 1.30
Asset value, end of year 11.20 12.54 14.05 15.31 16.69 18.19 19.29 20.44 21.67 22.97
Return on assets (ROA) 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12
Asset growth rate 0.12 0.12 0.12 0.09 0.09 0.09 0.06 0.06 0.06 0.06
Earnings growth rate, from previous year 0.12 0.12 0.12 0.09 0.09 0.09 0.06 0.06 0.06❱ TABLE 4.7 Forecasts of free cash flow in $ millions for the concatenator division, with input assumptions
in boldface type. Free cash flow is zero for periods 1 to 3 because investment absorbs all of net income. Free
cash flow turns positive when growth slows down after period 3. Inputs required for the table’s calculations are in
bold type.
Notes:- Starting asset value is $10 million. Assets grow at 12% to start, then at 9%, and finally at 6% in perpetuity. Profitability is assumed constant at 12%.
- Free cash flow equals earnings minus net investment. Net investment equals total capital outlays minus depreciation. We assume that investment for replacement
of existing assets is covered by depreciation and that net investment is devoted to growth. Earnings are also net of depreciation.