1 Valuing the Enterprise: Free Cash Flow Valuation Discount estimates of free cash flow that the firm will generate in the future. WACC: after-tax weighted average required return on all types of securities that firm issues. Use weighted average cost of capital (WACC) to discount the free cash flows. Discount We have an estimate of total value of the firm. How can we use this to value the firm’s shares?

2 Value of firm’s shares V S = V F – V D - V P V S = value of firm’s common shares V F = total enterprise value V D = value of firm’s debt V P = value of firm’s preferred stock An example.... Yum! Brands Recently trading between $48 and $50 per share We can use the free cash flow approach to estimate the value of YUM shares.

3 An Example: YUM! Brands YUM YUMs debt market value is $1860 million. No preferred stock 285 million shares outstanding End of 2005 Free cash flow is $647 million. Assume that Yum will experience 15% FCF growth for 2006 and 11% the following 2 years and 10.5% annual growth thereafter. YUM’s WACC is approximately 15%.

4 An Example: Yum! ($millions) End of YearGrowth Status Growth Rate (%) FCF Calculation 0HistoricGiven$647 1Variable15$647 x (1.15) = $744 2Variable11$744 x (1.11) = $826 3Variable11$826 x (1.11) = $917 4Stable10.5$917 x (1.105) = $1013 Use variable growth equation to estimate YUM!s enterprise value.

5 An Example: YUM! Enterprise Value ($millions)

6 An Example: YUM!’s Total Stock Value and Value per Share V F = V D = $1860 V P = $0 V S = V F - V D - V P = Divide total share value by 285 million shares outstanding to obtain per-share value:

7 Common Stock Valuation Other Options Book value The value shown on the balance sheet of the assets of the firm, net of liabilities shown on the balance sheet Liquidation value Actual net amount per share likely to be realized upon liquidation and payment of liabilities P / E multiples Reflects the amount investors will pay for each dollar of earnings per share P / E multiples differ between and within industries. Especially helpful for privately-held firms.

8 Stock Valuation Summary Looked at Dividend Discount Model: Value = PV of future expected dividends. All else equal:  Higher interest rates yields lower stock prices (inverse relationship)  Higher growth rate yields higher stock price. Other Stock Valuation Methods  PE Ratio x expected EPS  PV of all expected future cash flows available to stockholders