CFA Level IEquity InvestmentsHard
A company's current free cash flow to equity (FCFE) is $2.00 per share. FCFE is expected to grow at a constant rate of 5% per year indefinitely, and the required rate of return on equity is 11%. Using a single-stage FCFE valuation model, what is the estimated intrinsic value per share?
- A$18.18
- B$40.00
- C$35.00
- D$33.33
Show answer & explanationAnswer & explanation
Correct answer: C. $35.00
Single-stage FCFE valuation: V0 = FCFE1 / (r − g). First compute FCFE1 = FCFE0 × (1+g) = $2.00 × 1.05 = $2.10. Then V0 = $2.10 / (0.11 − 0.05) = $2.10 / 0.06 = $35.00.
Why the other options are wrong
- A. Incorrect; this results from dividing FCFE0 (not FCFE1) by the required return alone, ignoring growth adjustment.
- B. Incorrect; this results from using an incorrect denominator, such as (r-g)=0.0525.
- D. Incorrect; this uses FCFE0 instead of FCFE1 in the numerator: $2.00/0.06.
Single-Stage FCFE Valuation Model
A valuation model that discounts free cash flow to equity, growing at a constant rate, using the required return on equity minus the growth rate: V0 = FCFE1 / (r − g), analogous to the Gordon Growth DDM but using FCFE instead of dividends.
- Must use FCFE1 (next period), not FCFE0, in numerator
- Appropriate for stable, mature companies with constant FCFE growth
- Requires r > g for the model to produce a meaningful finite value
Memory trick: Grow the cash first, then divide by the gap between return and growth.