Chapter Four: DCF “Top Down” Valuation Approach:
(Enterprise Value & Equity Value as the Present Value of the Free Cash Flows)
Introduction
In the previous section (chapter two), we valued the EV by using the book approach (the left-hand side of the
firm’s enterprise value balance sheet at carrying amount) and market approach (the right-hand side of the
firm’s enterprise value balance sheet at market amount). In this section we concentrate again on the left-hand
side of the enterprise value balance sheet.
The discounted cash flow (DCF) approach is a valuation technique that values the enterprise value and/or
equity value as the present value of the firm’s future anticipated free cash flows (FCFs) discounted at the
weighted average cost of capital (WACC). This is done through direct valuation of corporate future anticipated
(FCFs) free cash flows from the firm’s consolidated statement of cash flows (CSCF) and from the projection of
firm pro-forma financial statements. The difference between the two DCF approaches is in the derivation of
the future FCFs.
Definition of Free Cash Flows (FCFs)
The FCFs can best be thought of as the cash flows produced by the firm’s productive assets—its working
capital, fixed assets, goodwill, etc. “Free cash flow” is another name for cash flow from assets. Free cash
flow, there is no such thing as “free” cash (we wish!). Instead, the name refers to cash that the firm is free to
distribute to creditors (pay of debt plus interest) and stockholders (dividend) because it is not needed for
working capital or fixed asset investments. When used as the discount rate for a firm’s anticipated free cash
flows (FCFs), the WACC gives the enterprise value of the firm. FCF is discussed at this point it suffices to say
that the FCF is the cash flow generated by the firm’s core business activities.
Some Notes on the Valuation Procedure
The discounted cash flow (DCF) method focuses on two central concepts:
• The firm’s free cash flows (FCFs) are defined as the cash created by the firm’s operating activities (the real
assets not the financial assets). •The firm’s weighted average cost of capital (WACC) is the risk-adjusted
discount rate appropriate to the risk of the FCFs.
The Firm’s Free Cash Flows (FCFs) to Compute Enterprise (Firm) Value & Its Equity Value
The firm’s enterprise value (EV) is the present value of the all future FCFs discounted at the WACC, to project
with finite number of free cash flows.
a. Computing the Terminal Value
Most financial analysts consider terminal value presumptuous to project an infinite number of free cash flows;
therefore, the projected cash-flow stream is often cut off at some arbitrary date, and a terminal value is
substituted for the cash flows beyond this date. The terminal value of a company estimates the value of the
business after the last estimated year. Then the enterprise value of the firm is the discounted value (PV) of the
firm’s projected FCFs plus its terminal value:
(FCF1) (FCF2) (FCF5) Year_5 Terminal Value
EV = 1
+ 2
+ ⋯+ 5
+
(1 + WACC) (1 + WACC) (1 + WACC) (1 + WACC)5
In this formula, the Year-5 Terminal Value is a proxy for the present value of all FCFs from year 6 onward.
Instead of projecting the FCFs from year 6 onward, we use the most common terminal value model, assuming
that year-5 free cash flows grow at a long-term growth rate LTg (5%). We have assumed that—after the year-5
projection horizon—the cash flows will grow at constant long-term growth rate of 5%. This gives the terminal
value as (I.e., using perpetuity method; it is the most common terminal value model):
This formula is only valid if the long-term FCF growth is less than the WACC, which means /LTg/ < WACC.
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b. Mid-Year Discounting
The above EV formulation assumes that all cash flows occur at the end year. In fact, most corporate cash
flows occur throughout the year; for valuation (discounting cash flow) purposes, we approximate this fact by
assuming that on average the year- t cash flow occurs in the middle of the year. We simply take the PV of
the firm’s projected FCFs plus its terminal value and multiply it by (1 + WACC)0.5
(FCF1) (FCF2) (FCF5) Year_5 Terminal value
EV = + + ⋯+ + ∗ (1 + WACC)0.5
(1 + WACC)1 (1 + WACC)2 (1 + WACC)5 (1 + WACC)5
Using the definition of free cash flows from the FCF Definition:
We can now use these free cash flows to compute the enterprise value (EV) and equity value of the firm.
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(176) (187) (201) (215) (228) (1,596)
EV (Year_End discounting) = + + + + + = 𝟏, 𝟐𝟑𝟎
(1.2)1 (1.2)2 (1.2)3 (1.2)4 (1.2)5 (1.2)5
(176) (187) (201) (215) (228) (1596)
EV (Mid_Year discounting) = + + + + + ∗ (1.2)0.5 = 𝟏, 𝟑𝟒𝟕
(1.2)1 (1.2)2 (1.2)3 (1.2)4 (1.2)5 (1.2)5
𝐎𝐫 𝐬𝐢𝐦𝐩𝐥𝐲
EV (Mid_Year discounting) is equal with EV (Year_End discounting) multiply by (1 + WACC)0.5
Thus, EV (Mid_Year discounting) = 1,230 ∗ (1.2)0.5 = 𝟏, 𝟑𝟒𝟕
228 ∗ (1.05)
Terminal value at end of year_5 = = 𝟏, 𝟓𝟗𝟔
15%
Summary
In this chapter we have introduced the remaining two primary enterprise-value valuation methods:
One approach to discounting the firm’s free cash flows (FCFs) bases the estimates of future FCFs on the
firm’s consolidated statement of cash flows. A second approach to discounting the firm’s free cash flows
constructs the FCFs from a model of the firm’s projected future accounting statements (pro-forma
accounting statements). These FCFs are then discounted at the appropriate weighted average cost of capital
(WACC). Thus, enterprise value can be said a discount (present) value.
Thus, to get to an unlevered cash flow amount, we want to remove all cash flows related to the capital
structure. So, we eliminate dividend payouts, non-controlling interests, share issuances, share buybacks,
debt raises, and debt pay-downs; the entire financing activities section is removed. Further, we want a
measure of cash that approaches everyday activity, so non-recurring and extraordinary items such as
acquisitions and divestitures will be removed.
Equity value is the fair value of all equity claims.
Enterprise value (EV) represents the fair value of all equity and non-equity financial claims attributable to
all capital providers (i.e., equity & debt holders).
Free cash flow to the equity (FCFE), are the cash flows available to all equity capital providers. In other
word are cash flows from assets, after debt payments and after making reinvestment that are needed for
future growth.
Free cash flow to the firm (FCFF), are the cash flows available to all capital providers (equity and debt
holders). In other word are cash flows from assets, before any debt payments but after making reinvestment
that are needed for future growth.
