Quick Question: Lets say the PV of all FCFF is 500,000.
Cash 50,000
long term debt 200,000
Notes payable 50,000
Other current liablities(payables) 20,000
So Firm value would be 550,000 (PV of FCFF plus 50k cash)???
What about FCFE= 500,000 minus 250k(longterm debt¬es) plus 50k cash or would I deduct payables as well (which mean deducting all liabilities and adding cash). I’m sure it’s somewhere in the books!
When you are applying valuation models (GGM, FCFF, FCFE, RI, EVA, etc), you typically do not consider the balance sheet monetary asset or liabilities components. Most times than not, the net monetary asset/liability value on the balance sheet dwarfs the value calculated from these valuation models, thus it will not impact the arrived figure by a much. Unless for cases when going concern is not applicable, a valuation on the basis of liquidation by emphasising on the balance sheet asset will be more appropriate.
Very interesting question!
Assume you set up a company with $1.1 billion cash, so equity is $1.1 billion. You use 4100 million to start operatio (buying equipment,hiring, etc.) So, your balance sheet shows an equity of $1.1 billion. No debt. Clearly, if you value this company today it is worth $1.1 billion, right?
Let us say that sales of $1000 (in dollars, not million or billions) are expected at the end of the first year. No COGS, no interst, no depreciation. So, expected FCFF1=$1000. Assume growth is 5% forever, and WACC=10%. Then :
Value of firm = $1000*(1.05)/(0.10-0.05) = $21,000.
How can that be? The firm is worth at least $1.1 billion. I know I’m missing something, but what is it?
Well. When you use FFCE or FFCF or Dividend. You’re measuring future benefits provided by the firm. Since you’re not going to liquidize the firm, what’s on your firm’s balance sheet doesn’t matter. It’s all about the cash/dividend your going to get in the future.
Notice how there are no proponent for any share buyback or dividend in the free cashflow model. It’s because if you give it to the investors or if it stay in the firm it’s the same since you own the firm (ur using fcfe and fcff because you have ownership).
For your example your answer the answer is right… no futher adjustment needed. You’re never going to get anything back (since you’re not liquidating), so whatever you earn is what you’ll get (I assume you need those cash/equity for the firm to produce that).
Best thing to do is to use Residual income, since most of the value is locked in the book. However I think the book value will be similar to FCFE because your ROE is like .00005, but your R is going to be like 10%, so residual income is negative, meaning book value would be reduce, so the value might be similar to FCFE.
I still don’t get it!
When you calculate the value of a stock using Gordon, for example. The next dividend * growth divided by Re minus growth rate gets you the value of the stock…i.e., you can buy the whole comany by paying that price. We can do dividend valuation on the above…if dividend was $1000, again the value of the stock would be $21,000! How can I buy a company woth $1.1 billion for $21k? no brain power left to think further…
define what you mean by firm value?
if you mean FCFE (tha’ts the value of the equity). or do you mean EV = MV of equity + Debt - Cash.
What value do you get when you use a dividend discount mode, like Gordon’s? It’s the value or price you would pay for the thing… FCFF is no different.
Well if you look at it this way. You know the firm is going to do bad in the future. ROE < r. Why would you pay top dollar for it. It’s kinda like RIMM right now. The liquidation value maybe worth more than the stock, but it’s not like anyone is paying top dollar for it(btw liquidation is lower than stock value, but I have check their bs in a while). So if it’s going to continue to be in existence it’s gonna continue to lose the shareholders money, since the shareholders aren’t even earning their require rate of return.
Yes thinking in terms of ROE might be it, but I have to defer this till after D-day… this maes sense in RI valuation, but with GGM and FCFF it is not clear.
By the way, there are hundreds of companies whose liquidation value (i.e., BV) is much higher than stock price…that would be a solid reason to buy the stock immediately *if* it weren’t for the fact that BV is not a measure to be trusted. If it were known by all participants that the book value is accurate, market-value wise, there is no way for the market price to be lower then BV.
This just means that you have paid TOO MUCH for machinery, etc., destroying value from the first moment. You have used equity to buy goods that are too expensive, given their capacity of generating cash flows.