ACCT90002 Chap.7 Fundamental Valuation
Fundamental Valuation
Fundamental valuation discounts expected payoffs at a rate consistent with their claim and risk. Dividends and free cash flow to equity belong to shareholders and are discounted at the cost of equity to obtain equity value. Free cash flow to the firm belongs to debt and equity providers and is discounted at WACC to obtain enterprise or net operating asset value; net debt is then deducted once.
Residual-income methods begin with book value and add discounted abnormal earnings. With consistent forecasts and assumptions, these routes describe the same economics. The explicit forecast period captures detailed drivers, while terminal value represents later payoffs under stable assumptions.
A constant-growth terminal value uses the next-period payoff, sits at the end of the explicit horizon and requires the discount rate to exceed growth. Because terminal value often dominates, sensitivity and implied operating performance are essential. This chapter prints the timing, calculates each present value and tests the plausibility of the result.
What this chapter covers
- 01
Claim matching: pair equity payoffs with the cost of equity and operating payoffs with WACC
- 02
FCFE construction: connect equity earnings, operating investment and net debt financing
- 03
FCFF construction: use operating profit after tax less investment in operating assets
- 04
Explicit horizon: discount each forecast payoff from its assumed period end
- 05
Terminal value: use next-period payoff, sustainable growth and a larger discount rate
- 06
Enterprise bridge: subtract net debt once when converting operating value into equity value
- 07
Sensitivity: expose the effect of discount rate, growth, margin and reinvestment assumptions
- 08
Decision margin: compare a defensible value range with price while acknowledging uncertainty
Worked example · free
Value a three-year FCFF stream
- 1Year 4 FCFF = 60 x 1.03 = 61.80.
- 1Terminal value at the end of Year 3 = 61.80 divided by 0.07 = 882.86.
- 1Present value of explicit FCFF = 50 / 1.10 + 55 / 1.10 squared + 60 / 1.10 cubed = 135.99.
- 1Present value of terminal value = 882.86 / 1.10 cubed = 663.30; enterprise value = 799.29.
- 1Equity value = 799.29 - 180 = 619.29.
Key terms
- Equity value
- The present value attributable to shareholders after recognising debt and other senior financial claims.
- Enterprise value
- The value of operating claims available to debt and equity capital providers before net debt is deducted.
- Cost of equity
- The required return used to discount risky payoffs that belong to shareholders.
- WACC
- The value-weighted required return on debt and equity used for operating cash flows.
- FCFE
- Cash flow available to equity holders after operating investment and net debt financing.
- FCFF
- Cash flow from operations available to all capital providers before financing distributions.
Fundamental Valuation FAQ
Why must cash flow and discount rate match?
The rate reflects the risk borne by the capital provider receiving the payoff. Using WACC on an equity-only cash flow or the cost of equity on an operating cash flow mixes claims and produces an inconsistent value.
Which cash flow enters the terminal formula?
Use the payoff for the first period after the explicit horizon. If the final explicit-year amount is given, grow it once. The resulting terminal value is located at the horizon end and must be discounted to the present.
Why is terminal value highly sensitive?
The discount-rate minus growth spread appears in the denominator and represents many distant payoffs. Small changes in either assumption can therefore move value sharply, especially when the terminal component dominates enterprise value.
When is net debt subtracted?
Subtract net debt once after valuing FCFF or another operating payoff to obtain equity value. Do not subtract it from an FCFE or dividend valuation because financing is already reflected in those equity payoffs.
Exam move
Make a claim-matching table before learning formulas: dividend and FCFE with cost of equity produce equity value; FCFF with WACC produces enterprise value. Draw a timeline for every problem and mark the location of terminal value. Recompute the worked example until the explicit cash flows, terminal amount and net-debt bridge reconcile. Then build a two-way sensitivity table for discount rate and growth.
Reject mechanically valid cells that imply unsupported perpetual margins, growth or returns. Report the terminal-value share and an implied multiple as reasonableness checks. Finish with a range and decision margin rather than one unexplained point estimate. The exam-safe sequence is payoff definition, rate match, timing, present value, claim bridge, sensitivity and economic plausibility.
Solve one case through both an equity-payoff route and an enterprise-payoff route, then reconcile the claim bridge. When the answers differ, test timing, rate matching, debt, cash and non-operating assets before blaming rounding. Link every sensitivity range back to a forecast assumption and state the decision implication.
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