CHAPTER 7 Stock Valuation 331- The approach demonstrated here is consistent with that found in Alfred Rappaport, Creating Shareholder Value
(New York: The Free Press, 1998). A somewhat similar approach to value can be found in G. Bennett Stewart III,
The Quest for Value(New York: HarperCollins, 1999).
TABLE 7.4 Dewhurst Inc.’s Data for Free Cash Flow
Valuation ModelFree cash flow
Year (t)(FCFt)a Other data2004 $400,000 Growth rate of FCF, beyond 2008 to infinity, gFCF3%
2005 450,000 Weighted average cost of capital, ka9%
2006 520,000 Market value of all debt, VD$3,100,000
2007 560,000 Market value of preferred stock, VP$800,000
2008 600,000 Number of shares of common stock outstanding300,000
aDeveloped using Equations 3.2 and 3.3 (page 106).Note the similarity between Equations 7.7 and 7.2, the general stock valuation
equation.
Because the value of the entire company, VC,is the market value of the entire
enterprise (that is, of all assets), to find common stock value, VS, we must sub-
tract the market value of all of the firm’s debt, VD,and the market value of pre-
ferred stock, VP,from VC.
VSVCVDVP (7.8)
Because it is difficult to forecast a firm’s free cash flow, specific annual cash
flows are typically forecast for only about 5 years, beyond which a constant
growth rate is assumed. Here we assume that the first 5 years of free cash flows
are explicitly forecast and that a constant rate of free cash flow growth occurs
beyond the end of year 5 to infinity.^9 This model is methodologically similar to
the variable-growth model presented earlier. Its application is best demonstrated
with an example.EXAMPLE Dewhurst Inc. wishes to determine the value of its stock by using the free cash
flow valuation model. In order to apply the model, the firm’s CFO developed the
data given in Table 7.4. Application of the model can be performed in four steps.
Step 1 Calculate the present value of the free cash flow occurring from the end
of 2009 to infinity, measured at the beginning of 2009 (that is, at the end
of 2008). Because a constant rate of growth in FCF is forecast beyond
2008, we can use the constant-growth dividend valuation model (Equa-
tion 7.5) to calculate the value of the free cash flows from the end of
2009 to infinity.
Value of FCF 2009 ∞$
1
0
,
3
0
0
,
0
0
0
$618,000
0.06$600,000 (10.03)
0.090.03FCF 2009
kagFCF