Let’s Learn Stock Valuation With Various Methods

2. Stock Valuation with Free Cash Flow Growth Method

In addition to using dividends, the calculation of a company’s stock valuation can also use The Free Cash Flows (FCF) Method.

This approach can be used as an alternative to comparing valuations with other methods (valuation methods with dividends that we have discussed, or valuations with market ratio approaches).

The Free Cash Flow Valuation Model is especially suitable for stock valuations of a company that does not yet have dividend history data, or for a start-up or company that is just about to enter the capital market (IPO).

The main principle is the same as the dividend approach, that the value of a stock is basically the present value of all future cash flows of the company until an infinite time.  

What is Free Cash Flow (FCF)?

Free Cash Flow (FCF) is the value of the cash flow of a Company available to investors – [who provides debt to the company (creditor), and equity (owner)] – after the company meets all its operational obligations, including capital expenditure (Capex) and working capital.

Free Cash Flow (FCF) can be calculated from the Company’s Financial Statements.

There are several approaches (formulas) in calculating FCF, I present two of them as follows:

If EBIT data is not available in the Income Statement, you can also use Net Profit After Taxes (NOPAT), as follows:

Both formulas will give the same calculation results.

More details about Free Cash Flow along with examples of calculations, can be read in my article below:

Understanding 4 Types of Company Financial Statements  

Meaning of Free Cash Flow (FCF)

Free cash flow (FCF) indicates the health level of a company and its ability to grow.

A positive FCF with a significant face value means the Company has more money that can be invested to grow the business. 

A positive FCF with a historically stable trend indicates the company’s potential for future profit increases.

Negative FCF does not necessarily mean bad, we have to look at the historical data of the Company’s FCF in some period to draw better conclusions.

If negative FCF occurs for only one or two years, it could be a sign that the company is making a large investment (financed not only from cash flow from operating activities, but also from long-term debt and/or equity). The results of these investments have the potential to generate growth that can only be seen in the following year.

Likewise, an oversized FCF may indicate the company is not investing enough to grow its business, which would result in losing opportunities to achieve better growth in the future.  

Free Cash Flow Valuation Model

The Free Cash Flow Valuation Model estimates a company’s overall value by calculating the present value of the free cash flows that the company can generate in the future.  

As a discounted factor in calculating present value is used weighted average cost of capital (WACC) of the company.

Here is the basic formula of the company’s valuation using this method:

Since a V_C is the overall value of a company (in other words the market value of all its assets), in order to obtain common stock value (V_S), we need to subtract the overall value of this company by the market value of all the company’s debt (V_D) and also the market value of its preferred stock (V_P).

Here is the formula to get the valuation of common stock shares:

Because it is difficult to estimate the value of a company’s free cash flow in the long term, it is usually forecast for a certain period of time only (e.g. 5 years), then for the following year it is used the assumption that the company’s free cash flow will grow at a constant rate.

This approach model is similar to the variable growth model that we discussed before it.

Ok, to be clear, let’s look at the following example case:

Still with Fulan, our stock investor, and imaginer company “danieel.id Bersaudara“

Fulan again considered buying shares of “danieel.id Bersaudara“, this time he wanted to use a different approach, namely with The Free Cash Flows Model.

Note: To simplify writing, all the numbers in this case example are in million rupiah (x 1,000,000)

From the company’s financial statements and historical free cash flow data, Fulan made a forecast of free cash flow “danieel.id Bersaudara” for the next 5 years (2021 – 2025) as follows:

Furthermore Fulan assumes, the company’s free cash flow will grow 4% (g_FCF) every year (starting in 2025 onwards).

Other data available are as follows:

• • • Weighted average cost of capital (WACC) “danieel.id Bersaudara” is 10.34%
    • Market value of all the company’s debt (V_D): Rp 2,250,000
    • Market value of preferred stock (V_P) “danieel.id Bersaudara“: Rp 300,000
    • Number of common stock outstanding : 600,000,000 shares

Then the stock valuation of the company “danieel.id Bersaudara” can be calculated by the Free Cash Flow Valuation Model as follows:

Step 1:

Using the growth number that is the assumption (4%), we calculate the FCF value in 2026, as follows;

FCF₂₀₂₆ = Rp 482.000 x (1 + 4%)

FCF₂₀₂₆ = Rp 501.280

Step 2:

Furthermore, with the approach of constant growth (gordon growth model), we calculate the valuation of free cash flow (FCF) in 2026 onwards – to infinity – (this value is measured at the end of 2025):

Value of FCF₂₀₂₆ = Rp 501.280 / (10,34% – 4%)

Value of FCF₂₀₂₆ = Rp 7.906.625

Step 3:

The amount of FCF valuation value in 2026 to infinity that we get from step two with FCF value in 2025, so that the total value of FCF in 2025 is obtained as follows:

Total FCF₂₀₂₅ = Rp 482.000 + Rp 7.906.625

Total FCF₂₀₂₅ = Rp 8.338.625

Step 4:

Calculate the present value of FCF every year (including the total FCF in 2025).

[Use weighted average cost of capital (WACC) company “danieel.id Bersaudara” (10.34%) as discounted factor]

then add up to obtain a V_C (value of the company as a whole).

For more details, I present it in the table below:

Step 5 :

Calculate the value of the common stock (V_S) with the formula described earlier  

(by subtracting the overall value of this company by the market value of all the company’s debt (VD) and also the market value of its preferred stock (VP).

V_S = V_C – V_D – V_p

V_S = Rp 6.364.845 – Rp 2.250.000 – Rp 300.000

V_S = Rp 3.814.845

To get the value of shares per share, divide that figure by the number of shares outstanding

Note: Remember, as mentioned earlier, all numbers in millions (x Rp 1,000,000)

So the value of shares per share “danieel.id Bersaudara” is:

= (Rp 3.814.845 x 10⁶) /600.000.000 

= Rp 6.358 per share

Let’s continue to page 3, on this page we will discuss Stock Valuation with Market Ratios Method

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