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#FREE CASH FLOW FORMULA CFA LEVEL 2 FREE#

For example, a longer period of high growth will lead to a higher valuation, and analysts may be tempted to assume an unrealistically long period of extraordinary growth.

There is the difficulty of defining the duration of the extraordinary growth period.

These two-stage models share the same limitations with respect to the growth assumptions: V 2002 = -$1.05/1.16 1 + 0.70/1.16 2 + ($2.38 + $41.58)/1.16 3īoth the two-stage DDM and FCFE models allow for two distinct phases of growth, an initial finite period where the growth is abnormal, followed by a stable growth period that is expected to last forever.

#FREE CASH FLOW FORMULA CFA LEVEL 2 FREE#

To find the equity value, we discount terminal equity value and expected free cash flows to equity before the terminal period, using the cost of equity as the discount rate:Įquity value = Σ (FCFE t / (1 + r) t) + FCFE n+1/

Similarly to the DDM model, an alternative way to estimate the terminal value of equity is to find a product of a price multiple and expected sales, earnings or cash flow.

To find the total present value of a firm, we discount FCFF before the terminal period and the terminal firm value, using WACC as the discount rate:įirm value = Σ (FCFF t / (1 + WACC) t) + FCFF n+1 / Terminal Firm Value = FCFF n+1 / (WACC - g) Analysts may use growth rates of sales, earnings, or some other fundamentals and then forecast growth rates of free cash flows.Īt the beginning of the stable-growth stage (for example, at the beginning of period n), the terminal firm value can be calculated using the single-stage model: It is worth noting, that the growth rates do not necessarily describe dynamics of free cash flows. The growth trends described by the two-stage model can occur if a company is losing its competitive advantage or the entire industry is entering the mature stage. Another case when the two-stage models are appropriate is when the growth is stable but is expected to drop discontinuously to another stable rate at some point in the future. These models are employed when a company's growth is expected to decelerate in the future and stabilize at some rate g. International setting or volatile inflation rates: use real rates.This rate may not be the same as the rate in the previous model.Įquity value = FCFE 0 (1 + g)/(r - g) = FCFF 1/(r - g) This model is employed when free cash flow to equity is expected to grow at a stable rate indefinitely extending in the future. This model is employed when free cash flow to the firm is expected to grow at a stable rate indefinitely extending in the future.įirm value = FCFF 0 (1 + g) / (WACC - g) = FCFF 1/(WACC - g)Įquity value = Firm value - Market value of debt