Corporate Valuation-DCF Approach

8/2/2019 Corporate Valuation-DCF Approach

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Cash Flow Approach of Corporate Valuation

FCFE & FCFF Models


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STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST

PERIOD

1. Selection of explicit forecast period

Ideally should be such that the business reaches a steady state at the end of this period. This is

required because continuing value formula is based on the following assumption

Firm earns a fixed profit margin, achieves constant asset turnover and hence earns

constant rate of return on the invested capital

Re-investment rate (proportion of gross cash invested annually) and the growth rateremain constant

Theoretically, length of explicit forecast period has no bearing on total value; it merely influences

distribution of the total value between its two components viz. the value of cash flows during

explicit forecast period and the continuing value

In practice, choice of the forecast horizon may have an indirect impact on value as it may subtlyinfluence the underlying economic assumptions


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PERIOD

2. Define free cash flow to the firm

Sum of the cash flows to all investors (lenders and shareholders) of the firm

Free Cash Flow to the Firm (FCFF)

Operating Free Cash Flow (FCF) Non-operating Free Cash Flow

NOPLAT

- Net Investment


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PERIOD

Operating FCF : refers to post-tax cash flow generated from operations of the firm after providing for investments in fixed assets + NWC requirements

FCF = NOPLAT (net operating profit less adjusted taxes) Net Investment

= (NOPLAT + Depreciation) (net investment +depreciation)

FCF = gross cash flow gross investment

NOPLAT = EBIT Taxes on EBIT (considering only operating income)

Taxes on EBIT = tax after adjusting income tax provision for tax attributable to interest income

and expense and other income/ loss.

Net Investment = Gross Investment (incremental capex + NWC) Depreciation

In case gross investment information not available, thenNet Investment = (NFA + NWC) at end of year - (NFA + NWC) at beginning of year

Non- Operating FCF : to be considered after adjusting for taxes


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PERIOD

3. Drivers of FCF

FCF = NOPLAT Net Investment

= Invested Capital (NOPLAT/ Invested Capital)(1 [(Net Investment/ Invested Capital)/ (NOPLAT/ Invested

Capital )]

Invested Capital = NFA + NWC

NOPLAT/ Invested Capital = Return on Invested Capital (ROIC)

Net Investment/ Invested Capital = growth rate

Invested capital, ROIC and growth rate are basic drivers of FCF

ROIC = NOPLAT/ Invested Capital = NOPLAT/ Turnover * Turnover / Capital

Post tax operating

margin

Capital turnover


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PERIOD

4. Develop the FCF forecast

Develop credible sales forecast

Complete projections including income statement and balance sheet

Treat inflation consistently

Look at multiple scenarios : scenario building based on different industry structures and company

capabilities


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STEP 2. ESTABLISH COST OF CAPITAL

Providers of capital want to be suitable rewarded / compensated for invested funds in the firm.

Cost of capital is the discount rate used for converting expected FCF into its present values

WACC = rE (S/V ) + r P (P/V ) + r D (1-T)(B/V)

rE = cost of equity capital

rP = cost of preference capital

S/V = market value of equity/ market value of firm

B = Market value of interest bearing debt


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STEP 3. CONTINUING VALUE

Company Value = PV of cash flow during forecast period + PV of cash flow after explicit forecast period

Continuing/Terminal value

Typically, terminal value is the dominant component in a companys value. Hence it should be estimated

carefully and realistically.

2 steps in estimating continuing value

Choose appropriate method

Estimate evaluation parameters and calculate continuing value

Choose appropriate method :

Cash Flow Methods : Growing free cash flow perpetuity method; Value driver method

Non-cash flow methods Replacement cost method, Price PBIT method, Market to book ratio

method


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Growing free cash flow perpetuity method : assumes that the free cash flow would grow at a constant rate

for ever, after the explicit period T. Hence the continuing value of such a stream can be established by

applying the constant growth valuation model

CVT = FCFT+1 / (WACC g)

CVT = continuing value at the end of year T

FCFT+1 = expected free cash flow for the first year after the explicit forecast period

g = expected growth rate of free cash flow for ever

Value Driver method : uses the growing free cash flow perpetuity formula but expresses it in terms of value

drivers as follows

CVT = NOPLAT T+1 (1-g/r) / (WACC g)

NOPLATT+1 = expected NOPLAT for the first year after the explicit forecast period

WACC = constant growth rate of NOPLAT after the explicit forecast period

r = expected rate of return on net new investment


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Replacement cost method : continuing value equated with replacement cost of fixed assets of the company.

Two major drawbacks a) considers only tangible assets; could lead to understatement of the value of the

firm. b) at times may be uneconomical for the firm to replace the asset

Price to PBIT ratio method : expected PBIT in the first year after the explicit period is multiplied by a

suitable price to PBIT ratio. Drawbacks a) no reliable method available for forecasting the price to PBIT ratio

b) assumption that PBIT drives prices is flawed

Market to book ratio method : continuing value assumed to be a multiple of the book value

Hence, on an overall basis cash flow methods superior to non-cash flow methods for estimating continuing

value


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STEP 4. FIRM VALUE

The value of the firm is equal to the sum of the following three components

PV of the free cash flow during the explicit forecast period

PV of the continuing value

Value of non-operating assets (like excess marketable securities, which were ignored in the free cash

flow analysis


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FREE CASH FLOW TO EQUITY (FCFE) VALUATION

Equity value of the firm can be determined as follows

Equity Value = Firm value Debt value

Alternatively the FCFE which is the cash flow lest for equity shareholders after the firm has covered

its capital expenditure and working capital needs and met all its obligations towards lenders and

preference shareholders

FCFE = PAT Pref. Div (Capex Dep) Change in NWC + (new debt issues debt repayment)+

(new preference issue pref repayment)-change in investment in marketable securities

Equity value = FCFE/ (1+ re)t

t = 1


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The dividend discount model is a specialized case of equity valuation, and the value of a stock is the

present value of expected future dividends.

Cash Flows and Discount Rates

Assume that you are analyzing a company with the following cashflows for the next five years.

Year CF to Equity Int Exp (1-t) CF to Firm

1 $50 $40 $90

2 $ 60 $ 40 $ 100

3 $ 68 $ 40 $ 108

4 $ 76.2 $ 40 $ 116.2

5 $ 83.49 $ 40 $ 123.49

Terminal Value $ 1603.008 $ 2363.008

Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax

rate for the firm is 50%.)

The current market value of equity is $1,073 and the value of debt outstanding is $800.


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Equity versus Firm Valuation

Method 1: Discount CF to Equity at Cost of Equity to get value of equity

Cost of Equity = 13.625%

PV of Equity = 50/1.13625 + 60/1.13625^2 + 68/1.13625^3 + 76.2/ 1.13625^4 + (83.49+1603)/1.13625^5 =

$1073

Method 2: Discount CF to Firm at Cost of Capital to get value of firm

Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%

WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94%

PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 +

(123.49+2363)/1.09945 = $1873

PV of Equity = PV of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073


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First Principle of Valuation

Never mix and match cash flows and discount rates. The key error to avoid is mismatching cashflows

and discount rates, since discounting cashflows to equity at the weighted average cost of capital will

lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at

the cost of equity will yield a downward biased estimate of the value of the firm.

The Effects of Mismatching Cash Flows and Discount Rates

Error 1: Discount CF to Equity at Cost of Capital to get equity value

PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 + (83.49+1603)/1.09945 = $1248

Value of equity is overstated by $175.

Error 2: Discount CF to Firm at Cost of Equity to get firm value

l PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 + (123.49+2363)/1.136255 =

$1613

PV of Equity = $1612.86 - $800 = $813

Value of Equity is understated by $ 260.

Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity

Value of Equity = $ 1613

Value of Equity is overstated by $ 540


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GUIDELINES FOR CORPORATE VALUATION

Discounted Cash Flow Valuation: The Steps

Estimate the discount rate or rates to use in the valuation

Discount rate can be either a cost of equity (if doing equity valuation) or a cost of

capital (if valuing the firm)

Discount rate can be in nominal terms or real terms, depending upon whether the cash

flows are nominal or real

Discount rate can vary across time.

Estimate the current earnings and cash flows on the asset, to either equity investors (CF

to Equity) or to all claimholders (CF to Firm)

Estimate the future earnings and cash flows on the asset being valued, generally by

estimating an expected growth rate in earnings.

Estimate when the firm will reach stable growth and what characteristics (risk & cashflow) it will have when it does.

Choose the right DCF model for this asset and value it.


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GUIDELINES FOR CORPORATE VALUATION

Understand how the various approaches compare

Use at least two different approaches

Work with a value range

Go behind numbers

Value flexibility Blend theory with judgment

Avoid reverse financial engineering

Beware of common pitfalls

Control premia & non-marketability factor for partial interest and control add 20-60% as

premium to pro-rata value of the firm and deduct non-marketability discount for minority

stake without control rights

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Corporate Valuation-DCF Approach