200  Frameworks for Valuation
Cash-Flow-to-Equity Valuation Model
Each of the preceding valuation models determined the value of equity indirectly 
by subtracting debt and other nonequity claims from enterprise value. The eq-
uity cash flow model values equity directly by discounting cash flows to equity 
(CFE) at the cost of equity, rather than at the weighted average cost of capital.16
Exhibit 10.17 details the cash flow to equity for GlobalCo. Cash flow to equity 
starts with net income. To this, add back noncash expenses to determine gross cash 
flow. Next, subtract investments in working capital, fixed assets, and nonoperating 
assets. Finally, add any increases in debt and other nonequity claims, and subtract 
decreases in debt and other nonequity claims. Unlike free cash flow, cash flow to eq-
uity includes operating, nonoperating, and financing items in the calculation. Alter-
natively, you can compute cash flow to equity as dividends plus share repurchases 
minus new equity issues. The two methods generate identical results.17
To value GlobalCo using cash flow to equity holders, discount projected eq-
uity cash flows at the cost of equity (see Exhibit 10.18). Unlike enterprise-based 
models, this method makes no adjustments to the DCF value for nonoperating 
assets or debt. Rather, they are embedded as part of the equity cash flow.
16 The equity method can be difficult to implement correctly, because capital structure is embedded in the 
cash flow, so forecasting is difficult. For companies whose operations are related to financing, such as fi-
nancial institutions, the equity method is appropriate. Chapter 38 discusses valuing financial institutions.
17 Calculate the continuing value using an equity-based variant of the key value driver formula:
V
g
ke
g
e =
−




−
Net Income
ROE
1
EXHIBIT 10.17  GlobalCo: Equity Cash Flow Summary
$ million
Forecast 
Year 1
Year 2
Year 3
Net income
52.0
60.4
63.3
Depreciation
20.0
25.0
28.8
Gross cash flow
72.0
85.4
92.1
Decrease (increase) in operating working capital
(12.0)
(9.0)
(3.4)
Capital expenditures, net of disposals
(70.0)
(62.5)
(43.1)
Increase (decrease) in short-term debt
–
15.4
8.6
Increase (decrease) in long-term debt
20.0
–
–
Cash flow to equity holders
10.0
29.3
54.1
Reconciliation of cash flow to equity
Cash dividends
10.0
14.3
24.1
Repurchased (issued) shares
–
15.0
30.0
Cash flow to equity holders
10.0
29.3
54.1

Cash-Flow-to-Equity Valuation Model  201
EXHIBIT 10.18  GlobalCo: Valuation Using Cash Flow to Equity
$ million, except where noted
Forecast year
Cash flow 
to equity (CFE)
Discount 
factor 
at 8.9%
Present 
value of CFE
2014
10.0
0.915
9.1
2015
29.3
0.837
24.5
2016
54.1
0.765
41.4
Continuing value
882.1
0.765
675.0
Present value of equity cash flows
750.0
Less: Value of noncontrolling interest
–
Equity value
750.0
Once again, note how the valuation, derived using equity cash flows, 
matches each of the prior valuations. This occurs because we have carefully 
modeled GlobalCo’s debt-to-value ratio at a constant level. If leverage is ex-
pected to change, the cost of equity must be appropriately adjusted to reflect 
the change in risk imposed on equity holders. Although formulas exist to ad-
just the cost of equity (as done in the APV section earlier in this chapter), 
many of the best-known formulas are built under restrictions that may be 
inconsistent with the way you are implicitly forecasting the company’s capital 
structure via the cash flows. This will cause a mismatch between cash flows 
and the cost of equity, resulting in an incorrect valuation.
It is quite easy to change the company’s capital structure without real-
izing it when using the cash-flow-to-equity model—and that is what makes 
implementing the equity model so risky. Suppose you plan to value a com-
pany whose debt-to-value ratio is 25 percent. You believe the company will 
pay extra dividends, so you increase debt to raise the dividend payout ratio. 
Presto! Increased dividends lead to higher equity cash flows and a higher 
valuation. Even though operating performance has not changed, the equity 
value has mistakenly increased. What is happening? Using new debt to pay 
dividends causes a rise in the debt-to-value ratio. Unless you adjust the cost 
of equity, the valuation will rise incorrectly.
A second major shortcoming of the equity cash flow model is how it values 
nonoperating assets. Imagine a company that holds a significant amount of low-
risk, low-return excess cash. Since operating and nonoperating cash flows are com-
bined in cash flows to equity, they will both be discounted at the same rate, the cost 
of equity. Since the cost of equity exceeds the rate of return on cash, it appears as if 
the nonoperating asset is destroying value, and the asset will be incorrectly valued 
below its book value, even if the asset in actuality is earning a fair rate of return.
A third shortcoming of the cash-flow-to-equity model emerges when valu-
ing a company by business unit. The direct equity approach requires allocating 
debt and interest expense to each unit. This creates extra work yet provides 
few additional insights.