computer science ebooks free download pdf return for the entire business given the risks to investors of investing in the business. You are welcome to learn a range of topics free cash flow valuation model example accounting, economics, finance and more.">

# free cash flow valuation model example

The technical definition of WACC is the required rate of return for the entire business given the risks to investors of investing in the business. These definitions refer to two sides of the same coin. The WACC simply does this for all investors in a company, weighted by their relative size.

But how do we determine what that required return should be? Put simply, it is a function of the alternative investment opportunities available to all of the investors in the company, and the riskiness of making that investment in the company relative to those available alternative returns. Here is an example that illustrates the calculation of WACC for our hypothetical company, using the average adjusted levered beta for a sample of hypothetical, comparable companies:.

Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:. The sum can then be used as a net present value figure. If the cash flow stream is assumed to continue indefinitely, the finite forecast is usually combined with the assumption of constant cash flow growth beyond the discrete projection period. The total value of such cash flow stream is the sum of the finite discounted cash flow forecast and the Terminal value finance.

The act of discounting future cash flows answers "how much money would have to be invested currently, at a given rate of return, to yield the forecast cash flow, at its future date? For the latter, various models have been developed, where the premium is typically calculated as a function of the asset's performance with reference to some macroeconomic variable - for example, the CAPM compares the asset's historical returns to the " overall market's "; see Capital asset pricing model Asset-specific required return and Asset pricing General Equilibrium Asset Pricing.

An alternate, although less common approach, is to apply a "fundamental valuation" method, such as the " T-model ", which instead relies on accounting information. Other methods of discounting, such as hyperbolic discounting , are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry.

By Tiffany C. Free Cash Flow Definition Free cash flow is a company's operational cash flows less the cash it needs to fund capital expenditures and net working capital needed to maintain current growth. Cash Flow to Firm Free cash flow can flow to equity or to the firm in general.

Manage your Professional Learning credits. If you use the site without changing settings, you are agreeing to our use of cookies. Learn more in our Privacy Policy. Privacy Settings. Operating Free Cash Flow. Calculating the Growth Rate. No Growth. Constant Growth.

Multiple Growth Periods. The Bottom Line. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. It is thus the most theoretically correct valuation method available: the value of a firm ultimately derives from the inherent value of its future cash flows to its stakeholders. DCF is probably the most broadly used valuation technique, simply because of its theoretical underpinnings and its ability to be used in almost all scenarios.

However, DCF is fraught with potential perils. If even one key assumption is off significantly, it can lead to a wildly different valuation. This is quite possible, given that DCF involves predicting future events forecasting , and even the best forecasters will generally be off by some amount.

Therefore, DCF should generally only be done alongside other valuation techniques, lest a questionable assumption or two lead to a result that is substantially different from what market forces are indicating. Before looking in more detail at the different cash flow discounting-based valuation methods, we must first define the different types of cash flow that can be used in a valuation 2.

Figure 4. Table 6. The Equity Cash Flow. The required return to equity can be estimated using any of the following methods: 1. PQ has 1 million shares outstanding. Find the intrinsic value of the company's share. This lesson is part 2 of 11 in the course Equity Analysis Part 3.