Building blocks
Continuing from the last section, we analysed both relative and absolute valuation approaches. Three primary components are the basis of absolute valuations
The cash flow
The timing of the cash flow
The rate at which the cash flow gets discounted
Let us explore the larger idea of cash flow within this chapter. Building on from the previous chapter and the following ones, we will focus on comprehending the theoretical side of valuation. Ultimately, upon grasping this concept sufficiently, we can construct a valuation model and incorporate it into our existing structure.
The term ‘Free Cashflow’ is used here to refer to the cash generated from a company’s operations. This gives it freedom to use the money as it sees fit. To answer the question of who it belongs to, you must consider the two sources of funding a company usually has: debt and equity.
The debt and equity holders together finance the assets of the company. Hence, the following equation represents a company –
Debt Holders + Equity holders = Assets of the company
The debt and equity holders are the primary financiers of company assets. The resulting cash flow from these assets is shared between them, proportionately. To get a better sense of the company’s value, we factor in cash flow timing and discount rate when assessing the worth of said cash flow.
Here it is important to remember that all of the available cash belongs to the firm. This money, termed ‘Free Cash Flow to the Firm’ (FCFF), will be further divided between debt and equity expenses. The portion allocated to equity is known as ‘Free Cash Flow to Equity’ (FCFE).
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