Question #17
Reading: Reading 21 Free Cash Flow Valuation
PDF File: Reading 21 Free Cash Flow Valuation.pdf
Page: 7
Status: Correct
Correct Answer: A
Question
Which of the following types of company is the E-Model, a three-stage free cash flow to equity (FCFE) Model, best suited for? Companies:
Answer Choices:
A. with patents or firms in an industry with significant barriers to entry
B. growing at a rate similar to or less than the nominal growth rate of the economy
C. in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level
Explanation
The three-stage FCFE model, or E-Model, is most suited to analyzing firms currently
experiencing high growth that will face increasing competitive pressures over time, leading
to a gradual decline in growth to a stable level. The two-stage model is best suited to
analyzing firms in a high growth phase that will maintain that growth for a specific period,
such as firms with patents or firms in an industry with significant barriers to entry.
Companies growing at a rate similar to or less than the nominal growth rate of the
economy are best suited for the Stable Growth FCFE Model. A firm that pays out all of its
earnings as dividends will have a growth rate of zero (remember g = RR × ROE) and would
not be valued using the three-stage FCFE model.