Wednesday, February 12

Company Valuation - Free Cash Flow (FCFF) Method


One of the methods of valuing a company based on Discounted Cash Flow Method is as follows:

Value of the Company = Free Cash Flow for the Firm (FCFF) for next year / (Cost of Capital - Growth Rate)

where:

FCFF = EBIT next year x (1 - Tax Rate) x (1 - Reinvestment Rate)

Cost of Capital is the Weighted Average Cost of Capital (WACC)
i.e. Weight of Debt (Wd) x Cost of Debt (Kd) + Weight of Equity (We) x Cost of Equity (Ke)

Reinvestment Rate represents the amount required to be invested in the company every year to keep the company looking good and working well, even if the company does not grow in size.
Reinvestment Rate is calculated as Expected Growth rate (g) / Cost of Capital (Kc)

Note this is a simplistic method of calculation and is just one of the many ways of calculating value of a company. The method assumes that the company is growing at a constant growth rate which may not be a fair assumption to make, especially in case of start-ups or companies undergoing change in their life cycle stage.

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