Equity Valuation versus Firm Valuation

There are two paths to discounted cash flow valuation -- the first is to value just the equity stake in the business; the second is to value the entire firm, including equity and any other claimholders in the firm (bondholders,

Value of Equity: This is the value of the equity stake in a business; in the context of a publicly traded firm, it is the value of the common stock in the firm.

preferred stockholders, etc.). While both approaches discount expected cash flows, the relevant cash flows and discount rates are different for each.

The value of equity is obtained by discounting expected cash flows to equity — i.e., the residual cash flows after meeting all expenses, tax obligations, and interest and principal payments — at the cost of equity — i.e., the rate of return required by equity investors in the firm.

_ ^CF to Equity. Value of Equity = !-^ tJt t=l (l+ke)

where

CF to Equityt = Expected Cash flow to Equity in period t ke = Cost of Equity

The dividend discount model is a specialized case of equity valuation, where the value of a stock is the present value of expected future dividends.

The value of the firm is obtained by discounting expected cash flows to the firm, i.e., residual cash flows after meeting all operating expenses and taxes, but prior to debt payments — at the weighted average cost of capital — i.e., the cost

Value of Firm: The value of the firm is the value of all investors who have claims on the firm; thus, it includes lenders and debt-holders, who have fixed claims and equity investors, who have residual claims.

of the different components of financing used by the firm, weighted by their market value proportions.

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