ACCA Strategic Professional · Advanced Financial Management

Valuation and the Use of Free Cash Flows in AFM

Free cash flow valuation estimates a company's value as the present value of its future free cash flows. You forecast FCFF, discount it at the WACC to get firm value, then deduct debt to reach equity value. Or you discount FCFE at the cost of equity. Then you test the result against other methods and its limits.

What this chapter covers

This chapter is about putting a value on a company or a business unit. The core method is discounted cash flow. You work out the cash the business generates after tax and reinvestment, forecast it, and discount it back to today. The chapter covers two versions: free cash flow to the firm, which is discounted at the WACC, and free cash flow to equity, which is discounted at the cost of equity.

You also need to forecast the inputs. That means estimating growth rates, building a forecast period and a terminal value, and deciding what to do about reinvestment and risk. Then you compare the result with other methods, such as P/E, earnings yield, asset-based values and dividend valuation. Finally you judge how far the answer can be trusted and what adjustments are needed.

This chapter links to much of the rest of AFM. The cost of capital and WACC you use come from the cost of capital work. The same valuation skills sit under acquisitions and mergers, restructuring, and project appraisal. Section A case studies often ask for a valuation and then a recommendation, so you need the numbers and the judgement together.

Valuation turns up repeatedly in AFM because it ties together cost of capital, forecasting, risk and corporate decisions. It can appear as a calculation inside a Section A case study or as a full Section B question. Calculation marks are easy to lose through small errors in cash flow definitions, discounting and terminal value. Many marks are also for professional skills: explaining the results, comparing methods, and saying how reliable the figure is to a board or client. If you can calculate cleanly and then comment well, you protect both technical and professional skills marks.

Valuation and the use of free cash flows: topics in the order to study them

1Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)Everything else depends on knowing exactly which cash flow you are discounting and who it belongs to.
2Discounted Cash Flow Valuation of CompaniesOnce you can build the cash flows, you learn to discount them, add terminal value and move from firm value to equity value.
3Estimating Growth Rates and Forecast Cash FlowsGrowth and forecasts drive the valuation, and the terminal value is very sensitive to them, so study them after the basic method is secure.
4Other Valuation Methods and Comparison with Free Cash FlowWith a DCF value in hand, you can compare it against market and asset-based methods and explain why the numbers differ.
5Valuation Using Free Cash Flows: Limitations and AdjustmentsThis comes last because you need the full method before you can criticise it and adjust for real-world problems.

How to prepare Valuation and the use of free cash flows

Treat this chapter as a method you can repeat, plus a set of comments you can attach to any answer. Practise on written questions, not just on formulas.

Learn the definitions of FCFF and FCFE and write each build-up from memory until it is automatic. Note what each one is discounted at.
Do short DCF calculations with a finite forecast and a terminal value. Check each step: discount factors, timing, terminal value and the bridge from firm value to equity value.
Practise forecasting from a scenario. Pull growth, margin, tax, capital expenditure and working capital assumptions out of the text and state them clearly before you calculate.
Work the other valuation methods on the same company, so you can compare values side by side and explain the differences in a few sentences.
For every valuation you finish, write three or four sentences on limitations: sensitivity to growth and discount rate, forecast uncertainty, and any adjustment you would make.
Finish with timed Section A style questions. Allow time for the calculation, then for a clear recommendation written for the client or board.

Common mistakes in Valuation and the use of free cash flows

Discounting FCFF at the cost of equity, or FCFE at the WACC.
Fix: Write the pairing at the top of the answer: FCFF with WACC, FCFE with cost of equity, and check it before discounting.
Forgetting to deduct debt after valuing the firm using FCFF.
Fix: Label the result as firm value and add a line for the bridge to equity value every time.
Using a terminal value with unrealistic growth, or discounting it for the wrong number of years.
Fix: Check that growth is sensible, use the correct year's cash flow in the formula, and discount the terminal value from the end of the forecast period.
Ignoring reinvestment and working capital when forecasting.
Fix: Build each forecast from operating profit through tax, depreciation, capital expenditure and working capital changes, so you reach cash.
Presenting a single number with no judgement.
Fix: Reserve time to explain the assumptions, compare methods, state limitations and make a clear recommendation.
Comparing valuation methods without saying why they differ.
Fix: For each method, say what it captures, such as future cash, market sentiment or asset backing, and use that to explain the gap.

Last-day revision: Valuation and the use of free cash flows

FCFF is the cash available to all capital providers after tax and reinvestment; discount it at the WACC.
FCFE is the cash available to equity holders after debt servicing and reinvestment; discount it at the cost of equity.
Firm value from FCFF less the value of debt gives equity value.
Discounting FCFE gives equity value directly, with no debt deduction.
Terminal value is often a large share of total value, so check it carefully.
A constant growth terminal value uses the next year's cash flow divided by (discount rate − growth).
Long-run growth should be realistic and should not exceed the growth of the economy in which the firm operates.
Reinvestment is needed to support growth, so do not assume high growth with no capital expenditure.
The discount rate must match the cash flow: WACC for FCFF, cost of equity for FCFE.
P/E and other multiples are quick but depend on a comparable company and market conditions.
Asset-based values may ignore future earning power and intangible assets.
Always state the main assumptions and say how sensitive the value is to them.

Valuation and the use of free cash flows practice questions

Valuation and the use of free cash flows in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Valuation and the use of free cash flows: frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash flow available to all providers of capital, both debt and equity. FCFE is what remains for shareholders after debt interest and net borrowing movements are dealt with. FCFF is discounted at the WACC and FCFE at the cost of equity.

Why is terminal value so important in a DCF valuation?

The forecast period is usually short compared with the life of the business, so terminal value stands for all later cash flows. It often makes up a large part of the total value. Small changes in growth or the discount rate can move it a lot.

Should I use DCF or P/E in the exam?

Use the method the requirement asks for. If the question is open, a DCF is often the main method and other methods act as cross-checks. Explain the strengths and weaknesses of each so your recommendation is balanced.

How do I get professional skills marks in a valuation question?

State your assumptions clearly, analyse why the results differ, and show commercial awareness of what drives value. Then give a clear, well-structured recommendation aimed at the reader, such as a board or client.