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Valuing a Firm with Free Cash Flow and the Gordon Growth Model

Article Quant Q&A · Author: Bobby
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Summary

The document distinguishes valuing a dividend-paying stock from valuing an entire corporation. The question supplies projected free cash flow to the firm, a constant perpetual growth assumption, and the weighted average cost of capital. The answer explains that the standard Gordon growth dividend setup should be adapted to a free-cash-flow-to-firm valuation when the target is enterprise value. The relevant cash flow is discounted using WACC, with the perpetual growth rate subtracted from that discount rate.

The stated relation uses next year’s FCFF in the numerator; if the provided figure is current-period FCFF, it must first be grown by one plus the growth rate. This is a constant-growth terminal value method, so it depends on the assumptions that cash flow grows steadily forever and that WACC exceeds the growth rate. The document gives the formula and conceptual distinction, but does not work through the numerical estimate or discuss debt and equity value reconciliation.

Key ideas

  • Dividend-based Gordon growth valuation is distinct from valuing a firm using free cash flow.
  • Free cash flow to the firm is paired with WACC to estimate firm value.
  • The numerator should represent next period’s cash flow, grown from current cash flow when necessary.
  • The perpetual-growth formula assumes a stable growth rate and a discount rate above that growth rate.
  • The answer gives a method but does not calculate the supplied example.

Tags

EquitiesFixed incomePortfolio construction
Full text
# Using Gordon's Growth Model to find value of corporation


# Using Gordon's Growth Model to find value of corporation












This is a question posed to us by my professor in my finance class. I was under the impression that the Gordon Growth Model was used to find the intrinsic value of a stock, but I am unsure how to plug in these values and use it to find the value of this corporation.

The way I learned it was P=D/k-g, where P is the value of the stock, D is the expected dividend per share 1 year from now, k is the required rate of return on equity, and G is the dividend growth rate. What I don't understand is where I would use the values given in the problem in this model, since it's the value of the corporation and not a dividend. Any help would be much appreciated.

Question

Suppose Microsoft Corporation’s projected free cash flow for next year is FCF = $8.75 billion, and due to expected lower revenues from personal computers and slower growth of surface sales FCF is expected to grow at a constant rate of only 4.5% into the infinite future. The company’s weighted average cost of capital is 11.5%. Use the Gordon Growth Model to estimate the value of the corporation

## Answer by chris m (score 1)

https://quant.stackexchange.com/a/17499

Under GGM dividends are used, under the assumption of constant growth. You're given FCF under the assumption of constant growth. So you could use FCFF or FCFE models. Since the question is asking for the value of the corporation, you will want to use the FCFF model

$Firm Value = \frac{FCFF_1}{(WACC-g)}=\frac{FCFF_0(1+g)}{(WACC-g)}$

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.