How to calculate the market value of equity using DCF and FCFE
About this lesson
In this video, we will discuss how the market value of equity is calculated given a certain amount of Free cash flow to the equity. Our calculation will use a Discounted Cash Flow (DCF) model.
The idea
A share is worth the cash it will give its owners in the future, discounted back to today. Free cash flow to equity (FCFE) is the cash available to shareholders after the company pays its expenses, taxes, investments and lenders.
The constant-growth formula
If FCFE is expected to grow at a steady rate forever:
Value of equity = FCFE₁ ÷ (k − g)
- FCFE₁: next year’s free cash flow to equity
- k: the cost of equity (the return shareholders require, often from the CAPM)
- g: the long-run growth rate, which must be lower than k
Example
- Next year’s FCFE: $10 million
- Cost of equity: 10%
- Growth rate: 4%
Value of equity = 10 ÷ (0.10 − 0.04) = $166.7 million
With 10 million shares outstanding, the value per share is $16.67. If the stock trades at $14, this model suggests it’s undervalued; at $20, overvalued.
If you have this year’s FCFE
Grow it by one year first: FCFE₁ = FCFE₀ × (1 + g).
Two-stage models
Many companies grow fast for a few years before settling down. A two-stage model discounts each year’s FCFE during the high-growth period, then adds a terminal value using the constant-growth formula. The DCF article and the residual income model show full examples.
Keep in mind
The result is very sensitive to k and g. Small changes in either can move the value a lot, so test a range of assumptions.
This lesson is for education only and isn’t investment advice.
Next: stock price using the CAPM.