Question

Explain how free cash flow is used to estimate the value of a firm or individual stock.

Answer 1

Answer :- Free cash flows of firm over the number of years in future are discounted with the cost of capital to arrive at the valuation of firm. Mathematically, Value of firm is calculated using the free cash flows in the following manner:-

Value of firm = Expected free cash flows in future / (Cost of capital - Growth in free cash flows).

(Cost of capital is Weighted average cost of capital here in the above equation).

Similarly, Value of individual stock can also be calculated using the free cash flows (in dividend form on stock) in the following manner :-

Value of stock (Price of stock) = Expected dividend at the year end / (Required return - Growth in dividends).

(In the above equation, Required return in denominator portion is the Rate of return available to stockholder / Cost of equity stock capital from company point of view)