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After going through the Business Valuation lecture, It felt like Free Cash flow to Firm and Value of Firm are the same thing. It felt like Free Cash Flow to Firm is actually the Value of the Firm. But apparently it is not the case. I found a term ‘share price as a multiple of free cash flow’ in a question in BPP kit. 8 meant that Current Equity Value was 8 times the free cash flow. In an ungeared company, Free Cash Flow was multiplied with growth formula to get Current Equity Value. Can you please explain what is the difference between the two. Thanks.
The value of equity is the PV of the free cash flows to equity (after interest payment) discounted at the cost of equity. The value of the firm is the PV of the free cash flows of the firm discounted at the WACC.
If the company has no gearing, then the free cash flows of the firm will equal the free cash flows to equity, and the growth formula calculates the PV of any growing perpetuity.
As far as PE valuations are concerned (which is that you are referring to by share price as a multiple of free cash flow), then (as you should remember from Paper FM) this is an alternative valuation model but one that is only relevant in the exam if the question mentions it. In theory values are always arrived at by discounting the future expected flows, but in real life PE valuations are common because of the problem of estimating the future expected cash flows.
In Q 25 of BPP Kit, aka Selrone, Growth Formula is applied to Free Cash Flows of an ungeared Company to calculate Current Equity Value. If Equity Value and Free Cash Flow are same thing, then why is Growth being applied to one, to find another? Free Cash Flow is 7M and after applying Growth to it, Current Equity Value becomes 60.1M. How are these two different from each other?
Equity value is not the same as free cash flows.
The market value of equity is the present value of the free cash flows to equity (just as it was in Paper FM (was F9) ).
If they are not the same thing ( Equity Value and FCF), then what is the relationship between them and How to calculate one from the other? Most importantly, If I am to buy a company, the consideration I will pay will be equal to the ‘FCF’ or the ‘Equity Value’?
In FM I believed that consideration should be equal to Equity Value.
In AFM I was told that consideration should be equal to FCF.
So I assumed them to be the same thing.But I explained the relation in my previous reply.
The value of equity is the present value of the free cash flows to equity discounted at the cost of equity.
Ok, So I conclude from all this that FCF discounted to PV equals Value of Equity. And when we apply Growth formula to discounted FCF, what we get is the non-discounted FCF. Please correct me if I am wrong.
Also, If am am to buy a company today, will I be looking at discounted FCF or non-discounted FCF. In my opinion it should be discounted FCF but the suggested answers multiplies it by ‘share price as a multiple of free cash flow’ and the answer becomes 8 times more. This is what keeps bothering me.The value of equity is the PV of the free cash flows to equity discounted at the cost of equity.
When the free cash flows are growing in perpetuity, then the growth formula calculates the PV (as it does for any growing perpetuity). The first sentence of your post makes no sense whatsoever.
As I wrote in my first reply, in theory the market value is the PV of the free cash flows. However you should remember from Paper FM (was F9) that in practice there are other methods of valuation – PE valuations and asset-based valuations.
For Selorne we already know its current share price because it is given in the question. The question tells us that the price is 8 times its free cash flow (i.e. a PE ratio of 8), so we can calculate the current free cash flow.
For Chawon we are not told anything about its PE ratio but we are told its free cash flow, growth rate, and return on equity, so we can calculate its market value using the growth model.The question also says that after the acquisition the PE ratio will remain at 8 and so we can then apply that to the total free cash flows.
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