Variations in Cash Flow Models

We are now aware of how to use the basic single stage models for both free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). It is now time to look into more advanced models which involve two or more stages for which cash flows will be predicted.

Now, we need to understand that there is no finite number of models for calculating the value of the firm using these metrics. We could have an infinite number of models, if we just tweak the assumptions pertaining to free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) a little bit.

Listing down all the models which are used will overwhelm any students. Instead we must look at what causes the variations in these models. We will do so in this article.

How Many Stages to Assume?

The first question we need to answer is how many stages of cash flow projections we need to assume at arrive at a fair valuation.

Let’s first define what a stage means and why it is important. A stage of cash flow is a group of years wherein the cash flow of the firm will behave in a similar manner.

For instance, if a firm will experience a 7% growth in its free cash flows for the next 5 years, then for calculation ease we can combine these 5 years into 1 stage and use a single formula to derive a valuation for all these five years.

The common variations used are two stage, three stage and even spreadsheet modeling wherein every year is considered separately and the concept of stages does not apply at all.

How to Decide the Number of Stages?

The number of stages that are used by the analyst in valuation are connected to the characteristic of the firm being valued.

  • In case the firm being valued is a relatively new firm, then there are expected to be a lot of fluctuations in the free cash flow that accrue to the firm. In the first few years, the firm may experience a negative cash flow.

    In the forthcoming years, the firm may experience positive cash flows growing at a high rate and then the growth rate may fall down before finally the free cash flows stabilize. In this case, a three stage model may be relevant

  • In case of relatively mature firm, there may be no negative cash flows. The growth rate of the cash flows may be expected to change because of the business cycles. Hence, in this case a two stage growth model may be more relevant

  • In some cases, analysts may have access to specific information which may allow them to model in detail the cash flows that the firm will receive over a period of years. In such cases, spreadsheet modeling will provide a much more accurate estimate.

Hence, based on the characteristics of the firm, the relevant model may be decided.

Which Metric to Use?

The next question which arises is that which metric of free cash flow should be used. Would free cash flow to the firm provide a more accurate forecast? Or would free cash flow to equity be more relevant? This is a fairly simple question to answer.

If we are only considering the point of view of equity shareholders, then we must use free cash flow to equity. In other cases, free cash flow to the firm may be used. So every model will have two variations like two stage model using free cash flow to the firm and two stage model using free cash flow to equity.

How to Estimate Free Cash Flow?

The next question pertains to how to calculate the growth rates for the cash flow metric choses. When we were using dividends, we had no option but to make assumptions regarding what the growth rate of dividends will be.

When it comes to free cash flows, we have two options:

  1. For instance, we could just simply make assumptions about the growth rates of these cash flows in the forthcoming years. For instance, we may assume that the free cash flow to the firm will grow at 7% for the next 5 years. This will obviously provide a very rough and inaccurate value of the firm.

  2. Secondly, free cash flows are open to more analysis. We could calculate what the movements in the individual components of the cash flows would be and derive the cash flows as a result.

    For instance, we could use changes in net borrowing and working capital investment as input and derive free cash flow to equity as output. This model is more accurate. However, it also necessitates that the analyst must have access to information about how the company plans to change its cash flows in future periods.

    For a short period of time, let’s say 5 years, this information is obtainable. Beyond that, it is pure speculation since not even the company would be in a position to make an accurate forecast for such a long time horizon.

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Equity Valuation