How to Calculate Value of Operations Using Free Cash Flows

Estimating the value of a company’s operations is essential for investors and analysts assessing financial health or making investment decisions. One widely used approach involves discounting future free cash flows, which represent the cash available after operating expenses and capital expenditures.

Identifying Relevant Cash Flow Projections

Projecting future cash flows requires analyzing a company’s financial history, industry trends, and strategic direction. Historical financial statements provide a baseline, but adjustments must account for expected shifts in revenue, costs, and capital expenditures. For example, if a company has consistently grown sales by 5% annually but recently launched a new product, future projections should reflect potential revenue acceleration.

External factors also influence cash flow estimates. Inflation, interest rates, and regulatory changes can affect profitability. A healthcare company may face rising compliance costs, while a manufacturer reliant on steel must consider price volatility.

Seasonality and economic cycles also play a role. Retailers typically see higher sales during the holiday season, while construction firms may experience slowdowns in winter. Ignoring these patterns can lead to inaccurate projections.

Selecting an Appropriate Discount Rate

The discount rate reflects the return investors expect given the risk involved. The weighted average cost of capital (WACC) is commonly used, incorporating both debt and equity financing.

WACC requires estimating the cost of equity, often calculated using the Capital Asset Pricing Model (CAPM). This model considers the risk-free rate (based on U.S. Treasury yields), the company’s beta (measuring stock volatility relative to the market), and the equity risk premium (the additional return investors demand for holding stocks). If a company has a beta of 1.2, a risk-free rate of 4%, and an equity risk premium of 6%, the cost of equity is 4% + (1.2 × 6%) = 11.2%.

The cost of debt is based on interest rates on loans and bonds, adjusted for tax benefits from interest deductions. If a firm’s borrowing rate is 5% and its corporate tax rate is 21%, the after-tax cost of debt is 5% × (1 – 21%) = 3.95%. WACC is then calculated by weighting these costs according to the firm’s capital structure. If a company is financed 60% by equity and 40% by debt, its WACC would be (60% × 11.2%) + (40% × 3.95%) = 7.96%.

Companies in volatile industries or with uncertain cash flows often require a higher discount rate. Startups with unpredictable earnings typically face higher capital costs than established firms with stable revenue. Businesses in emerging markets may also adjust for political and economic risks.

Determining Terminal Value

Since projecting cash flows indefinitely is impractical, a terminal value estimates a company’s worth beyond the forecast period. This figure often represents a significant portion of a firm’s valuation. Two common methods for calculating terminal value are the perpetuity growth method and the exit multiple method.

The perpetuity growth method assumes cash flows grow at a constant rate indefinitely, using the Gordon Growth Model. This model divides the final projected year’s free cash flow by the difference between the discount rate and the assumed long-term growth rate. If a company expects $50 million in free cash flow in its final forecasted year, with a 3% perpetual growth rate and an 8% discount rate, the terminal value is $50 million ÷ (8% – 3%) = $1 billion. The growth rate should align with long-term GDP growth to avoid overvaluation.

The exit multiple method bases terminal value on a financial metric such as earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue. A multiple is applied based on comparable company transactions. If similar firms trade at 10 times EBITDA and the company is projected to generate $120 million in EBITDA in the final forecast year, the terminal value is $120 million × 10 = $1.2 billion. This approach is commonly used in mergers, acquisitions, and private equity.

Summing the Discounted Values

Once cash flows and terminal value are determined, they must be converted into present value terms to reflect the time value of money.

Each projected free cash flow is discounted using the selected rate, with earlier cash flows contributing more to the final valuation than those further in the future. The discounting formula divides each year’s cash flow by (1 + discount rate) raised to the corresponding period’s exponent. For example, if a company expects $80 million in free cash flow three years from now and the discount rate is 9%, the present value of that cash flow is $80 million ÷ (1.09)^3 = $61.7 million.

After discounting all projected cash flows, the present value of the terminal value is calculated separately and added to the sum. Since terminal value often represents a large portion of the total valuation, small changes in the discount rate or growth assumptions can significantly impact results.

Interpreting the Calculated Figure

The final valuation represents the estimated worth of a company’s operations. This figure informs investment decisions, mergers, acquisitions, and strategic planning. However, context is necessary—comparing the valuation to market conditions, industry benchmarks, and alternative valuation methods helps assess its reliability.

One way to validate the result is by comparing it to the company’s market capitalization, which reflects investor sentiment and stock pricing. If the calculated valuation is significantly higher or lower than market value, it may indicate overly optimistic or conservative assumptions. Comparing the result to similar businesses using valuation multiples—such as price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA)—can also highlight discrepancies. If a company is valued at 12 times EBITDA while peers trade at 8 times, further analysis is needed to justify the difference.