An analyst is attempting to value shares of a regional bank, and has solicited the help of a senior financial analyst. During their conversation, the senior financial analyst provides the following information about the regional bank under examination:
Required rate of return on the bank's equity: 12.75% per year
Free cash flow to equity multiple at t4: 20
1,500,000 shares outstanding
Additionally, the analyst has obtained the following estimates of free cash flow to equity over the next four years:
Year 1: $1,750,000 -
Year 2: $2,225,000 -
Year 3: $2,500,000 -
Year 4: $2,650,000 -
Using this information, what is the value per share of this regional bank according to the free cash flow to equity model?
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A. B. C. D. E. F.F
When determining the value of a common stock using the free cash flow to equity model, it is necessary to determine three things:
1. The required rate of return on equity investments.
2. The estimated free cash flow to equity multiple at time "k."
3. The estimated free cash flows figures for the time periods leading up to "k."
In this example, the calculation must begin with the discounting the free cash flow to equity figures for each of the four years provided. These figures are discounted each period by the required return on equity investments, and the final answer is converted to a per-share basis. This process is illustrated below:
Year 1: ($1,750,000 / 1.1275) / 1,500,000 shares outstanding = $1.03
Year 2: [$2,225,000 / (1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.17
Year 3: [$2,500,000 / (1.1275)(1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.16
Year 4: [$2,650,000 / (1.1275)(1.1275)(1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.09
Now that the free cash-flow-to-equity figures have been discounted and converted to a per-share basis, the next step in the valuation process is to determine the value of the final cash flow, which is defined as:
[(Free cash flow to equity multiple * Final free cash flow) / (1 + r)(1+r)...(1 + k)]
In the body of this question, we were given the anticipated multiple of free cash to equity that shares of Intelligent Semiconductor will sell for at time period: specifically, 20 times. Imputing this information into the terminal cash flow equation will yield the following:
{[20 * ($2,650,000 / 1,500,000 shares outstanding)] / [(1.1275) (1.1275)(1.1275)(1.1275)]} = $21.86
Adding the answers from step 1 to the final year cash flow will yield the following:
Value of Intelligent Semiconductor = [$1.03 + $1.17 + $1.16 + $1.09 + $21.86] = $26.31 per share.