Sensitivity Analysis in FCFF and FCFE Valuations

Sales growth and profit margins depend on the growth phase of the firm and the profitability of the industry. Growth rates and duration of growth are difficult to forecast. The base year values of FCFF and FCFE growth models are important as the firm’s value will increase/decrease proportionately with the initial value of FCFF or FCFE.

Analysts perform a sensitivity analysis to determine how sensitive the final value is to changes in each of a valuation model’s inputs. Some inputs have a more significant impact on stock than others, e.g., revenue growth rate.

Some sources of errors in valuation results include:

• Estimating the future growth rate of FCFF and FCFE.
• Choosing the correct base years for the FCFF and FCFE growth forecasts.

Question

Which of the following is the least likely source of error in valuation results?

1. The duration of growth rate.
2. Estimating the future growth rate of FCFF and FCFE.
3. Choosing the correct base year for the FCFF and FCFE growth forecasts.

Solution

The correct answer is A. 

The duration of growth rate is not a source of error in valuation. However it is difficult to forecast.

B is incorrect. Estimating the future growth rate of FCFF and FCFE is a source of error in valuation results as a small change in growth rate results in a substantial difference in the computed value.

C is incorrect. Choosing the correct base year for the FCFF and FCFE growth forecasts is a source of error as the firm’s value will increase/decrease proportionately with the initial value of FCFF and FCFE.

Reading 24: Free Cash Flow Valuation

LOS 24 (k) Explain the use of sensitivity analysis in FCFF and FCFE valuations.