Fundamental Valuation: Implementation
1. Fundamental Valuation
We now recap the two fundamental valuation techniques we learned.2. Fundamental Valuation techniques
The Free Cash Flow to Equity or FCFE Model and the Dividend Discount Model or DDM.3. Free Cash Flow to Equity Model Recap
The value of the firm's equity is equal to the present value of expected free cash flows to equity discounted at the cost of equity. Implementing this calculation using the FCFE model requires two parts. First, is during the explicit T-year projection period. There, we discount the FCFE for each year at the cost of equity. Second, we calculate the Terminal Value by using the perpetuity with growth formula. We take the FCFE in Year T and grow it one period forward. Then, we divide the FCFE in Year T + 1 by the difference between the cost of equity and the perpetuity growth rate. This gives us the Terminal Value at Year T - again, the way the perpetuity with growth formula works, we use a Year T + 1 FCFE in the numerator but the resulting value is a Year T value. Therefore, we only need to discount the Terminal Value by T years to get to its present value. Adding the values during the projection period and the terminal value yields the value of the firm's equity.4. Dividend Discount Model Recap
The value of a firm's equity can also be estimated as the present value of dividend payments discounted at the cost of equity. Let's recap what we've learned when using the DDM. If you expect a constant dividend stream, the value of the firm's equity is equal to the dividend payment divided by the cost of equity. This is the perpetuity with no growth formula. If you expect that dividend stream to grow at a constant rate g, then the value of the firm's equity is equal to the dividend divided by the difference between the cost of equity and the growth rate. This is the perpetuity with growth formula that we have seen when we calculated the terminal value. We also discussed how if there are no dividends for the first T years but you expect the dividends to start paying in Year T + 1, then we can value the firm's equity as the sum of two components. The first T years has a value of $0 because there are no dividend payments. The period following Year T can be valued like the terminal value. We use the perpetuity with growth formula for the dividend stream beginning Year T + 1 and discount the resulting value by T periods.5. Let's practice!
In the following exercise, you will be able to practice what you've learned about fundamental valuation.Create Your Free Account
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