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Valuation: Cash Flow-Based Approaches
Dr. Nancy MangoldCalifornia State University, East Bay
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Valuation
Security Analyst and Investment Bankers
Make buy, sell, or hold recommendations
Right Price for IPOPrice for a corporate acquisition
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Valuation
Economic TheoryValue of any resource equals the
present value of the returns expected from the resource, discounted at a rate that reflects the risk inherent in those expected returns
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Valuation
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Rationale for Cash-Flow Based Valuation
Cash is the ultimate source of valueCash serves as a measurable
common denominator for comparing the future benefits of alternative investment opportunities
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Cash Flow vs Earnings
Investors cannot spend earnings for future consumption
Accrual earnings are subject to numerous questionable accounting methods Pooling vs purchase in acquisition valuation Expensing of R & D costs
Earnings are subject to purposeful management by a firm
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Cash Flows vs Earnings
Earnings are not as reliable or meaningful as a common denominator for comparing investment alternatives as cash
$1 earnings (Firm 1) not equal to $1 earnings (Firm 2).
$1 Cash (Firm 1) = $1 Cash (Firm 2)
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Cash Flow-Based Valuation
Three elements neededExpected periodic cash flowsResidual (Terminal) value - Expected
cash flow at the end of the forecast horizon
Discount rate used to compute the present value of the future cash flows
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I. Periodic Cash FlowsCash Flow to the Investor vs Cash Flow
to the FirmCash Flow to the Investor: CF dividends
expected to be paid to the investorCash Flow to the Firm (CF dividends + CF
retained by firm) If the rate of return of retained CF equals the
discount rate, either CF will yield the same valuation
Use Cash Flow to the Firm
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Periodic Cash Flows: Relevant Firm Level Cash Flows
Which cash flow amounts from the projected statement of cash flows the analyst should use to discount to present value when valuing a firm
Unleveraged free cash flows leveraged free cash flows
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Periodic Cash Flows: Relevant Firm Level Cash Flows
Unleveraged free CF is CF before considering debt vs equity financing
Unleveraged free cash flows =CFO + interest cost (net of tax)
+(-) Cash flow for investing activitiesThis pool of cash flows is available to
service debt, pay dividends and provide funds to finance future earnings
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Leveraged free cash flows
Leveraged free cash flows = CFO - Cash flow for investing activities
+(-) net change in ST & LT borrowing +(-) Changes and dividends on on preferred stock
Cash flows available to the common shareholders after making all debt service payments to the lenders and paying dividends to preferred shareholders
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Measurement of Unleveraged and Leveraged Free Cash Flows
Unleveraged Free CF Cash Flow from
Operations before subtracting Cash outflows for interest costs (net of tax savings)
=Unleveraged CFO +(-) CF for Investing Act. = Unleveraged Free
Cash Flow to All Providers of Capital
Leveraged Free CF CFO before interest - Cash outflows for interest
costs (net of tax savings) =leveraged CFO +(-) CF for Investing Act. +(-)CF for changes in
ST< borrowing +(-)CF for changes in and
Dividends on preferred stock
= leveraged Free CF to Common Shareholders
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Unleveraged Free Cash Flows
If the objective is to value the assets of a firm, then the unleveraged free cash flow is the appropriate cash flow
Discount rate should be weighted average cost of capital
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Leveraged Free Cash Flows
If the objective is to value the common shareholders’ equity of a firm, then the leveraged free cash flow is the appropriate cash flow
Discount rate should be the cost of equity capital
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Unleveraged vs Leveraged Free Cash Flows
The Valuation Difference = the value of total interest-bearing liabilities and preferred stock
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Unleveraged vs Leveraged Free Cash Flows
Value interest-bearing liabilities by discounting debt service costs (including repayments of principal) at the after tax cost of debt capital
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Unleveraged vs Leveraged Free Cash Flows
Valuing preferred stock by discounting preferred stock dividends at the cost of preferred equity
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Unleveraged vs Leveraged Free Cash Flows
Valuation for total assets (unleveraged Free CF) =
Valuation for common equity (leveraged Free CF)
+ Value of interest-bearing liabilities + Value of preferred stock
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Acquiring the operating assets of of another firmAcquiring firm will replace with its
own financing structurePrice to pay for the division’s assets?
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Acquiring the operating assets of of another firmCF these assets will generateUse unleveraged free cash flows
(Operating cash flows - cash outflow for investing)
Discount these projected cash flows at the weighted average cost of capital of the new division
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Engage in a leveraged buy out (LBO) of a firm
Managers offer to purchase the outstanding common shares of the target firm at a particular price if current shareholders will tender them
The managers invest their own funds for a portion of the purchase price (usualy 20% - 25%) and borrow the remainder from various lenders
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Engage in a leveraged buy out (LBO) of a firm
The managers use the equity and debt capital raised to purchase the tendered shares
After gaining voting control of the firm, the managers direct the firm to engage in sufficient new borrowing to repay the bridge loan obtained to execute LBO
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Engage in a leveraged buy out (LBO) of a firm
The lenders have a direct claim on the assets of the firm
Managers shift any personal guarantees they made on the bridge loans to the firm
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Price of LBO
Use Valuation of common equityLeveraged free cash flows
discounted at the cost of common equity capital
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Price of LBO
Or Use Valuation of total assets and subtract the market value of the debt raised to execute the LBO.
PV of unleveraged free cash flows using the weighted average cost of debt and equity capital
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Price of LBO
The projected debt service costs after the LBO will differ significantly
Valuation of the equity must reflect the new capital structure and the related debt service cost
The cost of equity capital will increase as a result of the higher level of debt in the capital structure
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Nominal Vs Real Cash Flows
Nominal cash flows include inflationary or deflationary components
Real cash flows filter out the effect of changes in general purchasing power
Valuation should be the same whether one uses nominal cash flow amounts or real cash flow amounts, as long as discount rate used is consistent with CF
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Nominal Vs Real Cash Flows
If projected cash flows ignore changes in the general purchasing power of the monetary unit
Then the discount rate should incorporate an inflation component
Nominal CF 1.15 million (land price)Discount rate s/b 1/1.02 /1.1 Interest rate 2% and inflation rate 10%Value 102.5
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Nominal Vs Real Cash Flows
If projected cash flows filter out the effects of general price changes
Then the discount rate should exclude the inflation component
Real CF 1.15 million (land price)/1.1 (inflation rate)
Discount rate s/b 1/1.02 Land Value 102.5
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Nominal Vs Real Cash Flows
A firm owns a tract of land that it expects to sell one year from today for 115 million
The selling price reflects a 15% increase in the selling price of the land
General price level is expected to increase 10%
The real interest rate is 2%
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The Value of Land
Discount rate including expected inflation115m x 1/(1.02)(1.1)= 102.5 million
Discount rate excluding expected inflation(115 million/1.10) x 1/1.02 = 102.5 million
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PreTax vs After-Tax Cash Flows
Discount pretax cash flows at a pretax cost of capital
Discount after-tax cash flows at an after-tax cost of capital
Valuation will be the same
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Selecting a Forecast Horizon
For how many future years should the analyst project periodic cash flows?
Theoretically: the expected life of the resource to be valued (machine, building )
To value the equity claim on the portfolio of net assets of a firm, the resource has indefinite life
Analyst must project the years of CF and residual value at the end of forecast horiz.
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Selecting a Forecast Horizon
Prediction of CF requires assumptions for each item in the IS and BS and then deriving the related CF
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Selecting a Forecast Horizon
Using a relatively short forecast horizon (3-5 years) enhances the likely accuracy of the projected periodic cash flows
near term cash flows is often an extrapolation of the recent past
near term cash flows have the heaviest weight in the PV computation
But a large portion of the total PV will be related to the residual value
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Selecting a Forecast Horizon
The valuation is difficult when near-term cash flows are projected to be negative in rapidly growing firm that finances its growth by issuing common stock
All of the firm’s value relates to the less detailed estimation of the residual value
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Selecting a Forecast Horizon
Selecting a longer period in the forecast of periodic cash flows (10-15 years)
Reduces the influence of the estimated residual value on the total PV
Predictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable
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Selecting a Forecast Horizon
It is best to select as a forecast horizon the point at which a firm’s cash flow pattern has settled into an equilibrium
This equilibrium position could be either no growth in future cash flows or growth at a stable rate
Security analysts typically select a forecast horizon in the range of 4-7 years
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II. Residual Value
Residual Value at end of Forecast Horizon= Periodic Cash Flow n-1 x 1+g
r-gWheren= forecast horizong= annual growth rate in periodic cash
flows after the forecast horizonr= discount rate
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Residual Value
Leveraged free cash flow of a firm in year 5 is 30 millions
0 growth expectedCost of equity capital = 15%Residual value
= 30 x (1+0.0)/(.15-0.0) = 200 millionPV of RV (in Year 5)= 200 x 1/(1.15)5
= 99.4 million
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Residual Value
Add growth rate = 6%Residual value =
30 x (1+0.06)/(.15-0.06) = 353.3 millionPV = 353.3 x 1/(1.15)5 = 175.7
million
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Residual Value
Add growth rate = -6%Residual value =
30 x (1-0.06)/(.15 - (-0.06) = 134.3 millionPV = 134.3 x 1/(1.15)5 = 66.8 millionAnalysts frequently estimate a
residual value using multiples of 6-8 times leveraged free cash flows in the last year
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Difficulty in Using Residual Value
When the discount rate and growth rate are approximately equal
The denominator approaches zero and The multiple becomes exceedingly large.When the growth rate exceeds discount
rateThe denominator becomes negative, the
resulting multiple becomes meaningless
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Alternative Approach to Estimate Residual Value
Use free cash flow multiples for comparable firms that currently trade in the market
this model provides a market validation for the theoretical model
The analyst identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors.
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III. Cost of Capital
The analyst uses the discount rate to compute the present value of the projected cash flows
The discount rate equals the rate of return that lenders and investors require the firm to generate to induce them to commit capital given the level of risk involved
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Cost of Capital
Cost of debt capital equals the after-tax cost of each type of capital provided to a firm
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Cost of Debt Capital
Common practice excludes operating liability accounts from weighted average cost of capital
The present value of unleveraged free cash flows is the value of total assets net of operating liabilities which equals debt plus shareholders’ equity
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Cost of Debt Capital
The cost of debt capital equals (1- marginal tax rate) x yield to maturity
of debtThe yield to maturity is the rate that
discounts the contractual cash flows on the debt to the debt’s current market value
The yield=coupon rate if the debt sells at par(face) value
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Cost of Debt Capital
Capitalized lease obligation have a cost equal to the current interest rate on collateralized borrowing with equivalent risk
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Cost of Debt Capital
The analyst should include the present value of significant operating lease commitment in the calculation of the weighted average cost of capital
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Cost of Debt Capital
If the analyst treats operating leases as part of debt financing, then the cash outflow for rent should be reclassified as interest and repayment of debt in leveraged and unleveraged free cash flow
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Cost of Preferred Equity Capital
Dividend rate on the preferred stock
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Cost of Common Equity Capital
Capital Asset Pricing Model (CAPM)In equilibrium, the cost of common
equity capital equals the market rate of return earned by common equity capital
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Cost of Common Equity Capital
R(i) = R(f) + b (R(m) - R(i))Cost of common equity =
Interest rate on risk free securities + Market beta (Average return on the market portfolio - Interest rate on risk free securities)
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Cost of Equity Capital
b=1R(I)=R(m)The cost ofcommonequity capitalis the averagereturn on themarketportfolio
b>1 greater
systematicrisk,
higher costof equitycapital
b<1 less
systematicrisk
lower costof equitycapital
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Risk Free Interest Rate
Yield on LT US government securitiesNot a good choice, the longer the term to
maturity, more sensitive to changes in inflation and interest rates, greater systematic risk
Common practice to use the yield on either short or intermediate-term US government securities as risk free rate
Historically averaged around 6%
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Market Return
Depends on period studiedHistorically the market rate of return
has varied between 9 and 13%The excess return over the risk free
rate has varied between 3 and 7 percentage points
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Market Returns
Financial reference sources publish market equity beta for publicly traded firms
Standard & Poor’s Stock ReportsValue Line, Moody’sConsiderable variation in the published
amounts for market beta among different sources due to period used to calculate the betas
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Adjusting Market Equity Beta
to Reflect a New Capital Structure The market equity beta computed
using past market price data reflects the capital structure in place at a particular time
Analyst can adjust this equity beta to approximate what it is likely to be after a change in the capital structure
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Adjusting Market Equity Beta
Unleverage the current betathen releverage it to reflect the new
capital structureCurrent leveraged equity beta =
Unleveraged Equity beta [1+(1-income tax rate) ( Current market value of debt)/ current market value of equity)]
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Adjusting Market Equity Beta
Equity Beta = 0.9Income tax rate = .35Debt/equity ratio = .60Change D/E ratio to 140%Unleveraged equity beta x0.9 = X [1+ (1 - 0.35) (0.60/1.0)]X = 0.65
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Adjusting Market Equity Beta
Releveraged market betaY = 0.65 [ 1 + (1- 0.35)(1.4/1.0)]Y= 1.24
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Evaluating the Cost of Equity Capital Using CAPM: Criticisms
Market betas do not appear to be stable over time and are sensitive to the time period used in their computation
The excess market rate of return is not stable over time and is likewise sensitive to the time period
Fama and French suggests that during the 1980s size was a better proxy for risk than market beta
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Weights Used for Weighted Average Cost of Capital
Should use the market values of each type of capital
Market value of debt securities is disclosed in notes to financial statements
Market price quotations for equity securities provide the amounts for determining the market value of equity
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A Firm’s Capital Structure on Balance Sheet
Long Term Debt 10% annualcouponPreferred Stock, 4% dividendCommon StockRetained Earnings
$20,000,000
5,000,000 10,000,000 15,000,000 $50,000,000
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Cost of Capital
LT Debt 8% x (1-.35) = 5.2%Preferred Equity4%Common Equity6% + .9 (13% - 6%) = 12.3%
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Weighted AverageCost of Capital
Security
LT DebtPref. EqCom.EqTotal
Amount
22,000,0005,000,00033,000,00060,000,000
Proport
37%8%55%100%
Cost
5.2%4%12.3%
WeighAverage1.92%0.32%6.77%9.01%
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Valuation of a Single Project
Investment = 10 millionUnleveraged CF 2 million/year foreverFinancing 6 million debtFinancing 4 million Common EquityDebt interest rate 10%Tax rate 40%Cost of Capital 25.625%
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Value of Common Equity
Unleveraged Free Cash Flow
2,000,000
Interest paid on Debt.10*6,000,000
(600,000)
Income Tax Savings on Interest .4*600,000
240,000
Leveraged Free CF 1,640,000
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Value of Common Equity
The value of the project to the common equity
1640000/.25625=6,400,000Excess over investment6,400,000-4,000,000=2,400,000The factor of PV of an annuity that
last forever is 1/r
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Value of Debt + Equity
Value of DebtAfter tax cost for debt is 6% 6% = (10% * (1-40%))The common equity cost .25625%
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Value of Debt + Equity
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Value of Debt + Equity
Type of Capital
Amt Weight
Cost WeightedAverage
Debt 6M .48387
.06 .02903
Common Equity
6.4M .51613
.25625
.13226
Total 12.4 M
1.00 .16129
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Value of Debt + Equity
PV (Debt + Equity) is2,000,000/.16129 = 12,400,000Subtracting 6 million of debt Common Equity is 6.4 million
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Valuation of Coke
Yr 8 Yr 9 Yr 10 Yr 11 Yr 12
CF from Operations
3,610 3,788 3,974 4,166 4,366
CF from Investing
-1,198
-1,390
-1,534
-1,691
-1,866
CF from Debt Financing
1,017 1,355 1,619 1,835 1,988
Leveraged Free CF
3,429 3,753 4,059 4,310 4,488
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Year 12 Residual Value
The analyst make assumption about net cash flows after year 12
The average compound growth rate of leveraged free CF between year 8-12 is 7%, assume it will remain at 7%
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Year 12 Residual Value
Yr 7 market beta is .97Risk free rate = 6%Excess Mkt Return over Risk Free
Rate = 7%Cost of Equity Capital =6% + .97(7%) = 12.8%4,488 x 1+.07 = $82,796
0.128 - .070
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Present Value
Year CF 12.8 Factor
PV
8 3,429 .88652 3,040
9 3,753 .79719 2,992
10 4,059 .69674 2,828
11 4,310 .61768 2,662
12 4,488 .54759 2,458
Aft 12
82,796 (4488x(1.07/0.128-.07))
.54759 45,338
Total 59,318
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Price per Share
price per share 59,318 million/2,481 million shares =
23.91Coke’s market price in yr 7 = 52.63
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Price Difference
Inaccurate projections of future cash flow
Errors in measuring the cost of equity capital
Market inefficiencies in the pricing of Coke
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Advantages- Present Value of Cash Flow Valuation
Focus on cash flowsProjected amounts of CF result from
projecting likely amounts of revenues, expenses, assets, liabilities and shareholders’ equity which require the analyst to think through many future operating, investing and financing decisions of a firm
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Disadvantages of the PV of Future Cash Flow Valuation
The residual or terminal value tends to dominate the total value in many cases
This residual value is sensitive to assumptions made about growth rates after the forecast horizon
The projection of cash flows can be time consuming and costly when analyst follow many companies and identify under and overvalued firms regularly.
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