Finance The FCF-based valuation model is based on the following formula:

EBIT (1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

Investopedia, 2012)

is the free cash flow each year, C0 is the original cash outlay, and r is the discount rate. The free cash flows in this type of calculation are only those cash flows that are incremental to the investment decision. Thus, they do not include such non-cash items as depreciation or amortization expense, and they do not include either sunk costs or non-incremental flows like overhead allocations. The r is the discount rate, and the firm can select its discount rate from a number of different options. The most common, and arguably logical, is the firm's weighted average cost of capital. This reflects the firm's cost of equity, its cost of debt and its capital structure, with allowances for preferred shares as well if the firm has issued them.

There are two underlying logics to this model. The first is that the cash flows must be incremental, because the project should always be evaluated on the basis of its own cash flows, not other factors. The second is that the value of cash flows in the future is not as high as the value of cash flows today. This concept, the time value of money, reflects the opportunity cost of capital in that revenue earned in the future cannot be invested today, so it cannot be considered to be of the same value as the initial cash outlays, or even cash flows nearer to today. That the discount rate reflects the opportunity cost of capital is the reason why the firm's weighted average cost of capital is often used as the discount rate. Alternative discount rates include those where the WACC is adjusted for risk specific to the project, division or company. The firm has some flexibility in setting the discount rate.

The dividend discount model is expressed as the following formula:

Value of stock = DPS (1) / Ks-g (Del Vecchio, 2000).

The DPS is the current dividend. K reflects the discount rate, and g is the growth rate of the company's dividends. The underlying logic of this model is that the stock rate should only reflect known cash flows, thus it should only reflect dividends. Capital gains, therefore are ignored. Underlying this theory is the assumption that investors are perfectly rational. The dividend, dividend growth rate and the value of the stock are known, so this equation can be used to solve for the discount rate. If the discount rate is known, the stock can be valued to determine whether its current market value is too high or too low. If there are no dividends, then the value of the stock reflects the expectation of future dividends, regardless of what the company has announced with respect to dividend policy. To invest in a company without any expectation of future cash flow, it is assumed, would be gambling.

Of the two measures, FCF models are more popular and more widely accepted. Francis, Olsson and Oswald (2000) studied these two models and compared them to abnormal earnings equity value models and found the latter to be the most accurate at determining stock price. FCF models, however, were significantly more accurate that the dividend discount model. The authors note that some of the contributing factors to differences in accuracy rates are accounting procedures that result in distortions in book values, as book values "explain a large portion of intrinsic value" (Francis et al., p.47).

The best examples of the weaknesses in the dividend discount model come from firms that do not pay dividends. Google, for example, has never paid a dividend but has a share value over $600. However, for the purposes of illustration, a company that does pay a dividend will be chosen, such as the world's largest retailer, U.S.-based Wal-Mart. Under the dividend discount model, this company's discount rate would be:

59.03 = 1.46 / k -- 13.4%, which solved for k would be 15.8%.

Using the DCF model the discount rate would be 7.1%, based on a FCF of $14.323 billion last year and a market cap of $200.74 billion. The DCF model is much closer to the firms cost of capital, given that the beta is 0.35, and the risk free rate is near zero in the United States. The dividend payout substantial at 32% of EPS, something that makes the discount rate higher than it should be, as the dividend payout is abnormally generous for the company.

Demirakos, Strong and Walker (2004) argue that free cash flow models are still the most popular among analysts. Models based on residual income...

They have posited that some research shows there is little difference between the two models in terms of outcomes, and that the choice between to two comes down to the personal preference of the analyst. Naturally, proponents of either of these two types disagree.
Question 3. There are significant challenges to using FCF analysis. In some cases, determining the non-cash charges can be difficult. Some, such as depreciation and amortization, can be found on the cash flow statement. Others, such as deferred interest or deferred taxes, may only be found in the notes to the financial statements. For the analyst, however, the ability to make an accurate determination of the inputs to the free cash flow equation is one of the challenges that must be overcome.

Another challenge is to adjust for the different degree of gearing. The free cash flows are the cash available for shareholder distributions, but the long-term level of gearing is sometimes disconnected from current interest. The free cash flow in the future, therefore, will not be reflected by the current level of free cash flow and the current rate of growth. In addition, such factors as changes in the firm's growth rate also need to be taken into account, but can be difficult if the firm's free cash flows are particularly volatile. Events such as recessions or booms can skew the numbers significantly.

Free cash flow valuation also relies on access to historic data. It can be difficult to obtain this data for companies that have just recently become public and therefore do not have long-term financial statements, or for companies that have been subject to significant merger and acquisition activity. Berkman, Bradbury & Ferguson (2002), using data from New Zealand, argue that for new issues there is little difference in accuracy between free cash flow models and price-earnings comparable models. The latter are generally not popular in practice, though they are still used, but at least they are effective for new issues.

Penman and Sougiannis (1996) note that terminal value is another challenge of FCF-based valuation models. Many analysts prefer truncated models to those that extend to infinity, but making a terminal value determination is challenging when evaluating stocks that are expected to continue infinitely. The authors argue that approaches based on accrual earnings are superior to those based on free cash flow because this technique can be designed to exclude capital expenditures from the calculation. Remember that in the FCF formula, capital expenditures are subtracted. However, levels of capital expenditure can change considerably over time. Unless the company has a stable level of capital expenditure, this can create distortions in the free cash flow that affect the free cash flow growth rate. The authors suggest utilizing a present value method based on accrual earnings, which itself has flaws, as a solution to FCF methods. Arguably, the issue of capital expenditures can be resolved if there are adjustments made to the free cash flow formula that take into account the fluctuations in capital expenditures.

Penman (2002) later builds on this argument, noting that fundamentally there is no difference between free cash flow models and residual earnings models, other than in the accounting. The latter is based on the type of accounting method, and these are artificial constructions that differ between systems. Cash flows are more universal in nature. There is a problem if the company does not have any free cash flows. Negative free cash flows, which can be caused by substantial capital expenditures.

Overall, free cash flow remains the best approach. If Penman is correct and there are issues with applying terminal value to this type of analysis, this raises two questions. The first would be what method is better. Inherently, there are questions with respect to relying on accrual earnings, simply because there are significant differences between different accounting methods. Even within the context of IFRS or U.S. GAAP, firms can utilize different techniques. The whole point of financial statements is that they are supposed to have a high level of consistency, and therefore be valuable for analysts in making valuation determinations. But if as Penman notes accounting does matter, that would probably make free cash flow analysis more valuable. Certainly, analysts in the practice prefer free cash flow over residual income models, and despite the evidence from New Zealand price/earnings comparable modeling is…