In a previous section of Stephen Horan, Robert R. Johnson and Thomas Robinson's "Strategic Value Investing: Practical Techniques of Leading Value Investors," we were given an overview of free cash flow models.

Specifically, the free cash flow to the firm (FCFF) model and the free cash flow to equity (FCFE) model. In the next section, we are offered a more comprehensive look at the FCFF model. The authors wrote, "The FCFF valuation model estimates the value of the firm (debt and equity) as the present value of future FCFF estimates discounted at a rate known as the weighted average cost of capital (WACC)."

That's a lot of information in one sentence, so let's unpack it:

- This is a valuation model (or process) used to estimate the value of a company; some would refer to this on a per-share basis as a stock's intrinsic value.
- Because we are dealing with an FCFF model, both debt and equity are part of it.
- The output will be a stock's present value, which is to say the sum of all future cash flow estimates.
- Those cash flows are discounted to current dollars, using a rate called the weighted average cost of capital.

This is the formula:

Does this formula look like the one for the dividend growth model? It should. According to the authors, the two valuation models are nearly identical. This model uses free cash flow estimates rather than estimated dividends, and it uses the WACC as a discount factor, rather a company's estimated riskiness.

Given that we're likely going to determine if we want to buy a stock, our principal interest is in the market value of the equity, not the market value of the company with debt included. To get to the equity value, simply subtract the value of the debt from the value of the company.

**Weighted average cost of capital**

So far, there has been no discussion about determining the weighted average cost of capital. Basically, this is the overall average rate of return to the suppliers of capital, whether through debt or equity (it can also include preferred shares, if necessary).

There is also a formula for calculating WACC, which is the cost of debt and equity, weighted by the amount of debt and equity, respectively. Here is the formula:

In this formula, the after-tax cost of debt equals the before-tax cost of debt multiplied by one minus the tax rate.

The cost of equity can be computed by using the capital asset pricing model, the build-up method or less common calculations.

**Forecasting free cash flow to the firm**

To begin, the authors warned analysts should have a good understanding of the company and its financial statements, and that future cash flows should not be a simple extrapolation of historical amounts.

They use a model that goes through a series of steps:

- Forecast revenue.
- Forecast operating income.
- Forecast operating cash flow.
- Forecast free cash flow to the firm.

By using this model, investors gain the flexibility to vary the inputs based on their opinions about future situations, including the level of profit margins, tax rates and capital expenditures going up or down.

*Read more here:*

- Strategic Value Investing: Free Cash Flow Models
- Strategic Value Investing:The Discount Rate
- Strategic Value Investing: Estimates of Cash Flows

**Stock valuation with FCFF**

The free cash flow to the firm model can be used to estimate the value of a company by assuming a constant future growth rate into perpetuity:

This formula uses the average weighted cost of capital minus the future growth rate. The next step is to subtract the value of debt from the value of the company to get to the equity value of the firm.

To illustrate, the authors did a valuation of Walmart (NYSE:WMT); they used:

- The forecast FCFF for 2014 of $13.458 billion.
- An estimated WACC of 7%.
- A perpetual growth rate of 3% after next year (2015).

Thus:

At the time, Walmart had an outstanding debt of some $54 billion, which can be subtracted from $336 billion to arrive at the value of the company's equity: $282 billion.

Dividing that number by the 3.34 billion shares available, the value works out to $84.43 per share. At the time, Walmart shares were trading for about $76 per share, roughly 10% below the FCFF or intrinsic value. Therefore, the stock was available with a modest margin of safety, but probably not enough for most value investors.

**Multistage FCFF**

The Walmart example shows the FCFF model using a constant growth rate. A multistage model would allow an investor to estimate free cash flow at two or more stages, something that might be useful for a company currently experiencing high growth rates--for the time being.

The authors explained, "In a multistage FCFF model, you explicitly forecast FCFF for a number of years and then assume the constant growth formula to determine the terminal value--the value in the last year of the forecast."

They added that this is analogous to the multistage dividend growth model and that investors usually forecast five years ahead, but any number of years will work (keeping in mind that our confidence should decline as we go farther out into the future).

**Conclusion**

Getting under the hood of the "free cash flow to the firm" model allows us to see the working parts that affect the outcomes of our valuation efforts.

In this model, the key issue is the weighted average cost of capital, the equivalent of the dividend growth rate in the dividend discount model. The authors also provided a four-step process that allows us to precisely prune down our inputs rather than extrapolate historical data.

They also provided a guide to valuing stocks with the FCFF model, including a case study that illustrated how the pieces came together to produce an intrinsic value for Walmart shares.

Finally, they pointed out that investors can also use a multistage model to handle companies experiencing a growth phase that is not expected to last too many years into the future.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.

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