- 1. The Discounted Cash Flow Valuation
- 2. DCF History: DCF calculations have been used in financial calculations as far back as ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. After the stock market crash of 1929, DCF analysis gained popularity for stock valuation. In its more current economic form, Irving Fisher’s 1930 text “The Theory of Interest” first discussed DCF as a viable method of valuation.
- 3. Discounted Cash Flow (DCF) valuation is: Discounted Cash Flow (DCF) valuation is a tool for estimating the value of a company or its shares. Discounted cash flow (DCF) analysis is a method of valuing a project (or a Company) using the concept of time value of money and risk
- 4. Discounted Cash Flow (DCF) valuation is: •a method of evaluating an investment opportunity •by discounting predicted future cash flows generated by the investment at certain discount rates •to find out the present value of the investment in monetary term Application: Mostly used in valuating securities (bonds or shares), companies and business projects. Valuation of bonds using DCF is simple and straightforward while DCF valuation of shares, companies and business projects is quite complex leading several issues for debates exploration.
- 5. 1. DCF Model (Theory of Interest) by Fisher (1930): Where: PV0 : Present value of cash flows (at time t = 0) CFt : Cash flow at time t ki : Discount rate or required rate of return for the period i n : Number of periods generating cash flows
- 6. 2. Value Additivity principle The summation of present values of cash flows divided from the same original cash flow will always equal the present value of the original. This principle is first demonstrated in MM Proposition I with tax of Modigliani and Miller (1958) : Vt = Dt + Et = Vut + VTSt (1) Where: Vt : value of the firm at time t Dt : value of debt at time t Et : value of equity at time t Vut : value of unlevered equity at time t (value of the firm when there is no leverage, i.e. 100% equity) VTSt : value of interest tax shield at time t
- 7. ASSUMPTIONS OF DCF ANALYSIS According to Ronald W. Hilton All cash flows are treated as though they occur at the end of the year. DCF methods treat cash flows associated with investment projects as though they were known with certainty, whereas risk adjustments can be made in an NPV analysis to account—in part—for cash flow uncertainties. Methods assume that all cash inflows are reinvested in other projects that earn returns for the company. DCF analysis assumes a perfect capital market.
- 8. • Invest in projects that yield a return greater than the minimum acceptable hurdle rate • Return on projects should be measured based on: – cash flows generated: Why cash flows and not earnings? – the timing of these cash flows: cash flows that occur earlier value more than cash flows that occur later. – incremental cash flows: use cash flows that are incremental related to the investment decision. Discounted Cash Flow (DCF)
- 9. Why Cash Flows vs Accounting Earnings? Accounting Earnings One cannot spend earnings. Shows revenues when products and services are sold or provided, not when they are paid for. Shows expenses associated with these revenues, not when expenses are paid. Net income includes a number of non-cash adjustments to approximate economic activity as of (or over) a period of time. Accounting adjustments do not necessarily reflect the company’s ability to pay its obligations or invest for future growth. Cash Flows Cash flow reflects the company’s ability to generate funds in order to pay its obligations or invest for future growth Various Cash Flow measures (i.e. - Free Cash Flow) adjusts accounting income to arrive at the funds available to pay stock and debt holders. For example, taking out Dividends provides one way to compare cash flows across Companies.
- 10. Discounted Cash Flow Valuation - DCF • What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flow on the asset. • Philosophical basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. • Information needed: To use DSF valuation, you need – To estimate the life of the asset – To estimate the cash flow during the life of the asset – To estimate the discount rate to apply to these cash flows to get present value • Market inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.
- 11. Valuing a company using a DCF model Steps: 1. Understand the business of the company you are valuing 2. Find Inputs: a) Calculate the Discount Rate – Weighted Average Cost of Capital (WACC) b) Build Future (Pro forma) Cash Flow and find the PV of these cash flow – Free Cash Flow (FCF) c) Calculate Terminal Value – EBITDA Multiple 3. Analyze Outputs: a) Enterprise value (EV) b) Equity (share price) c) Perform Sensitivity Analysis • There are many correct answers and many variations on methods and which numbers to use (academics vs. practitioners).
- 12. Relevant & Irrelevant Cash Flows Relevant Cash Flow Flows that will be incurred as a direct result of the project (incremental cash flows) Tax benefits (tax shield on depreciation) Opportunity Cost Irrelevant Cash Flow Flows that do not change as a results of the project Flows that have already occurred (sunk costs) Flows that would be incurred regardless of the project activities (replace equipment) Non-cash items (depreciation)
- 13. Depreciation / Amortization / Capital •While depreciation reduces taxable income and taxes, it does not reduce cash flows. •It is a non-cash expense; therefore, it needs to be added back. •There is a cash flow benefit associated with depreciation – the tax benefit. In general, the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate •Capital expenditures (CAPEX) are not treated as accounting expenses, but they do cause cash outflows.
- 14. Working Capital •The cash available for day-to-day operations of an organization. Strictly speaking, one borrows cash (and not working capital) to be able to buy assets or to pay for obligations. •Intuitively, money invested in inventory or in accounts receivable cannot be used elsewhere. Therefore, it represents a drain on cash flows.
- 15. To get from accounting earnings to cash flows: Free Cash Flow =Before Tax Profit (BTP) or EBIT - Taxes + Add back Depreciation/Amortization +/- Change in Working Capital - Capital Expenditures
- 16. Fundamentals of any Discounted Cash Flow Valuation Expected cashflow in each period Divided by the appropriate discount factor that reflects the riskiness of the estimated cashflows Example: How much is an infinite stream of ISK 15 million/year worth? Assuming a 10% discount rate: ... ) 1 ( ) 1 ( ) 1 ( ) 1 ( Value 4 4 3 3 2 2 1 1 r CF r CF r CF r CF 150 ... 46 . 1 15 33 . 1 15 21 . 1 15 10 . 1 15 ... ) 1 . 1 ( 15 ) 1 . 1 ( 15 ) 1 . 1 ( 15 ) 1 . 1 ( 15 Value 4 3 2 1 Expected cashflow Discount rate Year
- 18. Structure of a DCF model Year 2011 2012 2013 2014 2015 2016 …….. Period 0 1 2 3 4 5 …….. FCF C1 C2 C3 C4 C5 …….. …….. Terminal value (TV) PV (CF) C1/ (1+r)1 C1/ (1+r)1 C1/ (1+r)1 C1/ (1+r)1 (C1+TV) /(1+r)1 Sum of PV(CF) EV Input: Cash Flow Output: Value (Enterprise Value) EV of the company as of the end of year 2011 Company enters steady state Year 1 to 5: Capture changes and volatility in the business (cash flow) Industry standard: 5 to 10 yr horizon
- 19. DCF Example Lemonade Stand Business Year 0 Year 1 Year 2 Year 3 Initial Cost (50,000) Taxes (34%) (25,500) (28,560) (34,000) Operating Income 75,000 84,000 100,000 Income $49,500 $55,440 $66,000 Plus: Depreciation 3,750 4,200 5,000 Minus: working capital 1,500 1,000 1,600 Minus: CapEx 3,000 4,040 4,400 Free Cash Flow ($50,000) $48,750 $54,600 $65,000 Discount Rate 10% Discounted Values ($50,000) $44,318 $45,123 $48,835 Present Value $88,277
- 20. What Rate Should We Use to Discount Cash Flows?
- 21. Determining Discount Rates The discount rate should be determined in accordance with the following factors: Riskiness of the business or project—The higher the risk, the higher the required rate of return. Size of the company—Studies indicate that returns are also related inversely to the size of the entity. That is, a larger company will provide lower rates of return than a smaller company of otherwise similar nature. Time horizon—Generally, yield curves are upward sloping (longer term instruments command a higher interest rate); therefore, cash flows to be received over longer periods may require a slight premium in interest, or discount, rate.
- 22. •Debt/equity ratio—The leverage of the company drives the mix of debt and equity rates in the overall cost of capital equation. This is a factor that can be of considerable importance, since rates of return on debt and equity within a company can vary considerably. •Real or nominal basis—Market rates of interest or return are on a nominal basis. If the cash flow projections are done on a real basis (non-inflation adjusted), then the discount rate must be converted to real terms. • Income tax considerations—If the cash flows under consideration are on an after-tax basis, then the discount rate should be calculated using an after-tax cost of debt in the cost of capital equation.
- 23. Weighted Average Cost of Capital Definition •Weighted Average Cost of Capital (WACC) is •the minimum rate of return that must be realized •in order to satisfy investors: both debt holders and shareholders. Project Returns > Cost of Equity + Cost of Debt
- 24. Calculating WACC Cost of Capital has two components: Cost of equity (rk) After tax Cost of debt (rd) These are multiplied by the relative weight of their market values to arrive at an average cost: WACC = rk * (E/(D+E)) + rd * (D/(D+E)) E = market value of equity D = market value of debt
- 25. Advantages of DCF valuation • Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions. • If good investors buy businesses, rather than stocks, discounted cash flow valuation is the right way to think about what you are getting when you buy asset. • DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.
- 26. Advantages of DCF valuation Can offer a more accurate picture of fundamental valuation drivers Can evaluate different scenarios Uses cash flows, not earnings or accounting measures Useful as a sanity check of over/under valued
- 27. Disadvantages of DCF valuation • Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. • These inputs and information are not only difficult to estimate, but can be manipulated by analyst to provide the conclusion he or she wants. • In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued . This can be a problem for – Equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks – Equity portfolio managers, who have to be fully (or close to fully) invested in equities.
- 28. Disadvantages of DCF valuation Highly sensitive to discount rate Highly sensitive to terminal growth rate Discount rate changes over time Difficult to apply for early stage companies without cash flows
- 29. DCF Strengths: • Captures the time value of money and opportunity cost • Scientific • Widely used • Based on cash flow • Weaknesses: • Almost always results in overvaluation. Why? • Can we ever predict the future? • “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Warren Buffett • Based on many assumptions • Which assumptions are the most critical? • 5 years vs. 10 years estimation
- 30. 6 Steps to Build a DCF 1. Calculate a free cash flow: 2. Discounting a single cash flow: – PV = CF1 / (1+r) 3. Discounting a single cash flow in “n” years from now: – PV = CFn / (1+r)n 4. Multiple cash flows in future: – PV = CF1 / (1+r) + CF2 / (1+r)2 + CF3 / (1+r)3 + … 5. Growing Perpetuity: TV – PV = CF / (r-g) (1st CF at end of year 1, then grow at g) 6. Deduct Net Debt from Enterprise Value to calculate Equity Value: – Enterprise Value - Net Debt = Equity Value
- 31. Cashflow to Firm EBIT (1-t) - (Cap Ex - Depr) - Change in WC = FCFF Expected Growth Reinvestment Rate * Return on Capital FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 Forever Firm is in stable growth: Grows at constant rate forever Terminal Value= FCFF n+1/(r-gn) FCFFn ......... Cost of Equity Cost of Debt (Riskfree Rate + Default Spread) (1-t) Weights Based on Market Value Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) Value of Operating Assets + Cash & Non-op Assets = Value of Firm - Value of Debt = Value of Equity Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows + Beta - Measures market risk X Risk Premium - Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium VALUING A FIRM
- 32. Thanks