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Another Example:ABC stock has an expected ROE of 12% per year, expected earnings per share of $2, and expected dividends of $1.50 per share. Its market capitalization rate is 10% per year.What are its expected growth rate, price, P/E, and PEG ratio?
23Free Cash Flow ModelAn alternative approach to the DDM for firm valuation is to use free cash flow. This approach is particular useful for firms that pay no dividends.Free Cash Flow for the Firm (FCFF):(29FCFFEBIT1DepreciationCapital expendituresIncrease in NWCct=-+--(29(291FCFFFirm value 1WACC1WACCTtTtTtP==+++∑EBIT = earnings before interest and taxeswhere = the corporate tax rateNWC = net working capitalct1FCFF, assuming a constant-growth modelWACCestimate of terminal valuewhereWACCweighted average cost of capitalTTTPgP+=-==
Example:The EBIT of a firm is $300, the tax rate is 35%, the depreciation is $20, capital expenditures are $60 and the increase in net working capital is $30. What is the free cash flow to the firm?
25Comparing the Valuation Models
Value by comparableq P/E, P/B, P/Cash, Tobin’s QValue by expected dividend growthq DDMq Constant-growth DDM (Gordon Model)q Two-stage DDMValue by P/E ratioq Price= (expected P/E) * (expected E)q P/E ratio measures growth opportunity (PVGO)Value by expected cash flowq Free Cash Flow model26Summary