Decisions to invest can be made based on simple analysis such as finding a company you like with a product you think will be in demand in the future. The decision might not be based on scouring the financial statements, but the underlying reason for picking this type of company over another is still sound. Your underlying prediction is that the company will continue to produce and sell highdemand products and thus will have cash flowing back to the business. The second, and very important, part of the equation is that the company's management knows where to spend this cash to continue operations. A third assumption is that all of these potential future cash flows are worth more today than the stock's current price.
TUTORIAL: Cash Flow Indicator Ratios
To place numbers into this idea, we could look at these potential cash flows from the operations, and find what they are worth based on their present value. In order to determine the value of a firm, an investor must determine the present value of operating free cash flows. Of course, we need to find the cash flows before we can discount them to the present value.
Calculating Operating Free Cash Flow
Operating free cash flow (OFCF) is the cash generated by operations, which is attributed to all providers of capital in the firm's capital structure. This includes debt providers as well as equity. Calculating the OFCF is done by taking earnings before interest and taxes and adjusting for the tax rate, then adding depreciation and taking away capital expenditure, minus change in working capital and minus changes in other assets. Here is the actual formula:
OFCF = EBIT(1T) + depreciation  CAPEX  D working capital  D any other assets 
Where:
EBIT = earnings before interest and taxes
T= tax rate
CAPEX = capital expenditure
This is also referred to as the free cash flow to the firm, and is calculated in such as way to reflect the overall cashgenerating capabilities of the firm before deducting debt related interest expenses and noncash items. Once we have calculated this number, we can calculate the other metrics needed such as the growth rate. (These five qualitative measures allow investors to draw conclusions about a corporation that are not apparent on the balance sheet. check out Using Porter's 5 Forces To Analyze Stocks.)
Calculating the Growth Rate
The growth rate can be difficult to predict and can have a drastic effect on the resulting value of the firm. One way to calculate it is to take the return on the invested capital (ROIC) multiplied by the retention rate. The retention is the percent of earnings that are held within the company and are not paid out as dividends. This is the basic formula:
g = RR x ROIC 
Where:
RR= average retention rate, or (1 payout ratio)
ROIC= EBIT(1tax)/total capital
Present Value of Operating Free Cash Flows
The valuation method is based on the operating cash flows coming in after deducting the capital expenditures, which are the costs of maintaining the asset base. This cash flow is taken before the interest payments to debt holders in order to value the total firm. Only factoring in equity, for example, would provide the growing value to equity holders. Discounting any stream of cash flows requires a discount rate, and in this case it is the cost of financing projects at the firm. The weighted average cost of capital (WACC) is used for this discount rate. The operating free cash flow is then discounted at this cost of capital rate using three potential growth scenarios; no growth, constant growth and changing growth rate.
No Growth
To find the value of the firm, discount the OFCF by the WACC. This discounts the cash flows that are expected to continue for as long as a reasonable forecasting model exists.
Firm Value = S Operating Free Cash Flows_{t} (1+WACC)^{t} 
Where:
Operating Free Cash Flows = the operating free cash flows in period t
WACC = weighted average cost of capital
If you are looking to find an estimate for the value of the firm's equity, subtract the market value of the firm's debt.
Constant Growth
In a more mature company you might find it more appropriate to include a constant growth rate in the calculation. To calculate the value, take the OFCF of next period and discount it at WACC minus the longterm constant growth rate of the OFCF.
Value of the firm = SOFCF_{1}kg 
Where:
OFCF_{1} = operating free cash flow
k = discount rate (in this case WACC)
g = expected growth rate in OFCF
Multiple Growth Periods
Assuming the firm is about to see more than one growth stage, the calculation is a combination of each of these stages. Using the supernormal dividend growth model for the calculation, the analyst needs to predict the higherthannormal growth and the expected duration of such activity. After this high growth, the firm might be expected to go back into a normal steady growth into perpetuity. To see the resulting calculations, assume a firm has operating free cash flows of $200 million, which is expected to grow at 12% for four years. After four years, it will return to a normal growth rate of 5%. We will assume that the weighted average cost of capital is 10%. (Learn about the components of the statement of financial position and how they relate to each other. See Reading The Balance Sheet.)
MultiGrowth Periods of Operating Free Cash Flow (in Millions)
Period  OFCF  Calculation  Amount  Present Value 
1  OFCF_{1}  $200 x 1.12^{1}  $224.00  $203.64 
2  OFCF_{ 2}  $200 x 1.12^{2}  $250.88  $207.34 
3  OFCF_{ 3}  $200 x 1.12^{3}  $280.99  $211.11 
4  OFCF_{ 4}  $200 x 1.12^{4}  $314.70  $214.95 
5  OFCF_{ 5 }…  $314.7 x 1.05  $330.44  
$330.44 / (0.10  0.05)  $6,608.78  
$6,608.78 / 1.10^{4}  $4,513.89  
NPV  $5,350.92 
Table 1: The two stages of the OFCF goes from a high growth rate (12%) for four years followed by a perpetual constant 5% growth from the fifth year on. It is discounted back to the present value and summed up to $5.35 billion dollars. 
Both the twostage dividend discount model (DDM) and FCFE model allow for two distinct phases of growth: an initial finite period where the growth is abnormal, followed by a stable growth period that is expected to last forever. In order to determine the longterm sustainable growth rate, one would usually assume that the rate of growth will equal the longterm forecasted GDP growth. In each case the cash flow is discounted to the present dollar amount and added together to get a net present value.
Comparing this to the company's current stock price can be a valid way of determining the company's intrinsic value. Recall that we need to subtract the total current value of the firm's debt to get the value of the equity. Then, divide the equity value by common shares outstanding to get the value of equity per share. This value can then be compared to how much the stock is selling for in the market to see if it is over or undervalued.
The Bottom Line
Calculations dealing with the value of a firm will always use unique methods based on the firm being examined. Growth companies might need a twoperiod method when there is higher growth for a couple years. In a larger, more mature company you can use a more stable growth technique. It always comes down to determining the value of the free cash flows and discounting them to today. (Calculate whether the market is paying too much for a particular stock. check out DCF Valuation: The Stock Market Sanity Check.)

Professionals
Chinese Slowdown Affects Iron Ore Market
The Chinese economy's ongoing slowdown is having a major impact on iron ore demand. 
Investing Basics
Why do Debt to Equity Ratios Vary From Industry to Industry?
Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries. 
Credit & Loans
What's a Nonperforming Loan?
A nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days. 
Economics
Understanding Cost of Revenue
The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service. 
Economics
Understanding Cash and Cash Equivalents
Cash and cash equivalents are items that are either physical currency or liquid investments that can be immediately converted into cash. 
Economics
Explaining Carrying Cost of Inventory
The carrying cost of inventory is the cost a business pays for holding goods in stock. 
Fundamental Analysis
Is India the Next Emerging Markets Superstar?
With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP. 
Personal Finance
A Day in the Life of an Equity Research Analyst
What does an equity research analyst do on an everyday basis? 
Mutual Funds & ETFs
ETF Analysis: SPDR S&P Insurance
Learn about the SPDR S&P Insurance exchangetraded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers. 
Mutual Funds & ETFs
ETF Analysis: iShares Morningstar SmallCap Value
Find out about the Shares Morningstar SmallCap Value ETF, and learn detailed information about this exchangetraded fund that focuses on smallcap equities.

Supply
A fundamental economic concept that describes the total amount ... 
Gross Profit
A company's total revenue (equivalent to total sales) minus the ... 
Receivables Turnover Ratio
An accounting measure used to quantify a firm's effectiveness ... 
International Financial Reporting ...
A set of international accounting standards stating how particular ... 
Balance Sheet
A financial statement that summarizes a company's assets, liabilities ... 
Equity
The value of an asset less the value of all liabilities on that ...

What is the formula for calculating compound annual growth rate (CAGR) in Excel?
The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >> 
What are some examples of general and administrative expenses?
In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >> 
When does the fixed charge coverage ratio suggest that a company should stop borrowing ...
Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >> 
What is the difference between the return on total assets and an interest rate?
Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >> 
What is the utility function and how is it calculated?
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >> 
How can a company execute a taxfree spinoff?
The two commonly used methods for doing a taxfree spinoff are either to distribute shares of the spinoff company to existing ... Read Full Answer >>