Valuation: Discounted Cash Flow analysis

There are many ways in which we can value a firm.Among the most common models that are extremely popular are Discounted Cash flow model , Relative valuation model,Black-Scholes model with each having its own merits.This article will help one understand on how to value a company using a DCF approach.In Discounted cash flow model,the value of an asset is the present value of the expected cash flows on the asset.So, lets have a look at some of the advantages of DCF valuation: It is less exposed to market perceptions. It consider the fundamental characteristics of the firm. It works best for the investors who have a long time horizon.

DCF CONCEPT The DCF concept is simple.We forecast the future cash flows and discount them back to present value using the weighted average cost of capital (WACC) for a firm.Following steps will completely explain DCF approach . 1. Forecasting Free Cash Flows-To produce revenue,a firm not only incurs operating expenses, but it also must invest money in real estate, buildings and equipment, and in working capital to support its business activities. Also, the corporation must pay income taxes on its earnings. The amount of cash that's left over after the payment of these investments and taxes is known as Free Cash Flow to the Firm (FCFF). To value the operations of a firm using a discounted cash flow model,Unlevered free cash flows are used.The unlevered free cash flow represents the cash generated by the firms operations and is the cash that is free to be paid to the stock and bond holders.Unlevered free cash flows are calculated as follows: Unlevered Free Cash Flows=Tax-effected EBIT + Non-Cash Expense(like Depreciation and Amortization)-Capital Expenditure(+/-)Change in working Capital (Source: Madison Street Capital) .......(A) Forecasting free cash flows is an art. All the things that are affecting free cash flows should be taken into account while forecasting free cash flows.Before forecasting free cash flows we need to forecast revenue growth rates and EBIT margins for a firm.These can be forecasted if we try to answer these questions: What is the outlook for the company and its industry? What is the outlook for the economy as a whole? Is there any factors that make the company more or less competitive within its industry?

Lets take a hypothetical company for which we take following assumptions: Normal Economic outlook Positive Industry outlook Average Company Outlook

Given these assumptions, we can simply look at our companys historical performance and we can calculate compound annual growth rate (CAGR) and use it to forecast revenue .The CAGR is calculated as follows: CAGR=(Final year revenue / Base year Revenue)^1/(Final Year - Base Year) -1 (Source: Wikipedia) For instance: Let say a hypothetical company has following revenue over the 4 years : YEAR Revenues 2007 100 2008 115 2009 150 2010 200

Here Base year=2007, Final year=2010,CAGR comes out to be 25.99%. Next step will be to determine all the items in COGS and SG&A as a percentage of revenue for the historicals only. Since,we have already calculated the forecasted revenues and we also have calculated each item a %age of revenue,we can simply forecast about each item in the income statement by simply multiplying the forecasted revenues with the %age calculated for each item.For instance, consider the case below where we need to forecast the materials costs: 2007 100 20 20 2008 115 80 69 2009 150 60 40 2010 200 50 25 2011 250 96 38.4 2012 314 120 38.4 2013 394 151 38.4

YEAR Revenue Material %age

Note-Forecasted material costs for 2011,2012 and 2013 Continuing the above procedure , we will calculate the EBIT and ultimately the net income. Then we will forecast the working capital and capital expenditure with proper justification given to each. Finally , we will put all the values in the equation A to calculate Unleveraged free cash flows.

2.

Understanding WACC

The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect.Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company

produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. The weighted average cost of capital or WACC represents weighted average price a company must pay for debt or equity capital. The formula for WACC is straightforward: WACC = Cost of Debt * Debt / (Debt + Equity) + Cost of Equity * Equity / (Debt + Equity) The weightings of capital in this equation are very easy to calculate based on the companys current balance sheet. The cost of debt is a little more involved, but pretty straightforward, but the cost of equity calculation can be difficult. (a) Cost of Equity-The cost of equity in our WACC computation can be represented by the capital asset pricing model (CAPM): Ke = Rf + Beta (market risk premium) + (other premiums) In this equation, Ke is the cost of equity and Beta is a measure of how the value of a company moves with respect to the value of the overall market. The market risk premium is the premium that investors demand to invest in the stock market versus the treasury market of the country.Other Premiums include small stock premium and Specific company risk.We will talk about each one of them in detail in the following section: Risk Free Rate(Rf)-Theoratically,Risk free rate of return is the return on an investment where the investor takes no risk.For instance ,we can take the 10 year government bond rate as the risk free rate. Beta- Beta is a measure of how a stock moves with the overall market.. Fortunately, many stock information services such as Bloomberg or Yahoo Finance have already calculated Beta for stocks.The problem with these Betas is that they are levered Betas. We need an unlevered Beta for our cost of equity calculation. The reason we need an unlevered Beta is that the amount of debt or leverage that a company has can affect its Beta. And since a potential acquirer of a company could choose to significantly alter its capital structure, we should take out the effect of leverage to have a better sense of the companys value. Unlevered Beta= Levered Beta/[1+(1-tax rate)*Debt/Equity} Beta for an unlisted company-For an unlisted company,we need to look up (similar)public comps for our company, calculate each of their unlevered Betas and take an average. Market risk Premium-Risk premium is the added compensation an investor receives for placing his money at risk of loss. The greater the risk of an investment, the greater the risk premium the investor receives.It is calculates as : Market risk premium=Rm-Rf where Rf is the risk free rate of return and Rm is the market rate of return

Small stock risk premium- It i the difference between the return on the smallest stock of a company belonging to the same industry to which the firm we are trying to valuate and the risk free rate. Specific company risk- It takes following seven factors into account.:

Source:Highland Global Business Valuation Website

In the above figure , weighting percentage =Risk free rate + Small stock Risk Premium
(Source:Highland Global Business Valuation Website)

3. Net Present Value Now that we have our free cash flows forecasted and our WACC calculated, we can calculate the net present value of these cash flows using WACC to get our companys enterprise value. The net present value is the sum of the present values of each of the cash flows. The formula for present value is as follows: Present Value = Future Value / (1 + Discount Rate) ^ Number of periods For our cash flows, the future value will be the free cash flow that we projected for each year. The discount rate will be equal to WACC. And the number of periods will correspond to the year of each cash flow (year five cash flow equals five). 4. Terminal Value Terminal Value can be calculated by 2 methods:

(a) EBITDA Multiple Method - It can be calculated as follows:

Terminal value= (EV/EBITDA Multiple * EBITDA value in the terminal year)/ (1+WACC)^n (Discounted Value) where EV/EBITDA is calculated by comparisons ( Trade Comps) n is the number of period for which we are we have forecasted

Enterprise Value= NPV + Terminal Value Equity value= Enterprise Value- Net Debt (where Net Debt= Total debt - Cash) (b) Perpetuity Growth method- It can be calculated as follows:

Terminal value= ((1+g)* Unlevered Cash flow value in the terminal year)/ WACC-g where g is the perpetuity growth rate of a firm ( Undiscounted Value)

For Discounted Value ,we have to divide it by (1+WACC)^n Enterprise Value= NPV + Terminal Value Equity value= Enterprise Value- Net Debt (where Net Debt= Total debt - Cash) Although DCF is one of the best methods of Valuation, but a good DCF model depends on how precisely the assumptions are made.Inputs play a key role in shaping up a good DCF model.In most cases one should attempt to perform a variety of valuation methods comparable companies, DCF to make an informed ddetermination of a companys value.

CASE STUDY
Let us have an illustrative understanding of WACC and Terminal Value by considering a hypothetical Company .

Capital Structure of a Firm Secured Loan$(ooo) Unsecured Loan$(ooo) Total Debt$(ooo) Book Equity$(ooo) Total Capital$(ooo) 1983 2194 4177 573 4750

Noe let us calculate the percentage of debt and equity: % Debt= Debt/Total Capital=4177/4750=87.9% %Equity=Equity/Total Capital=(1-.879) * 100=12.1% Since we know that cost of debt is the equivalent to the interest rate on the companys debt. Because there are two kinds of debt with different interest rates, we have to weight the different interest rates associated with each kind of debt by the relevant proportion of debt that each comprises. Assuming the interest rates for the secured and unsecured loans to be 7% and 11% respectively

Loan to Debt

Weights

Interest Rate 7% 11%

Cost of Debt-Interst Rate * Weights 3.3% 5.8%

Secured Loans /Total .474 Debt Unsecured loan/Total .525 Debt

Total Cost of Debt=3.3% + 5.8%=9.1% if we assume Tax rate=30% Actual Cost of Debt=9.1%(1-..3)==6.4% Cost of Equity can be calculated as follows: Assumptions Beta=1.99, Rm=9.24,Return on small stock of the company belonging to same sector=26.54% and SCR taking all the seven factors into consideration as discussed above has come out to be around 8.5% Risk free Rate Market Risk Premium Small Stock Premium Specific Company Risk 8% 1.24% 18.6% 8.5%

As discussed above the cost of equity can be calculated as follows: Ke = Rf + Beta (market risk premium) + (other premiums) Putting the above values in the equation, it comes out to be : Cost of Equity,Ke= 37.6% Hence WACC can be calculated as follows:

In the figure given below the future cash flows of the company are forecasted and accordingly NPV is calculated as discussed above in the article.

Now we will calculate the terminal Value using the EBITDA MULTIPLE METHOD and PERPETUITY GROWTH METHOD. Assuming the EV/EBITDA Multible to be 2.33 and 2.77.and perpetuity growth rate to be 6% and 7%.Accordingly the Enterprise and Equity Value will be:

Thus enterprise value has come out to be $32 and $143 million in case of EBITDA multiple Method and Perpetuity Growth Rate Method respectively.I hope with the above approach ,the concepts of DCF analysis should have been cleared upto a certain extent.

DAKSH MAHAJAN FISB MBA-2nd Sem