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Cash Flow Method
Overview of DCF
Issues in DCF
CA. Pinkesh Billimoria
17th September 2011
Table of contents
Objective
Valuation in General
Valuation Approach & Methodologies
Discounted Cash Flow (DCF) – Demystified
Wrap Up
2 DCF
Objective
3
Objective
Discussing and understanding the
technique of Discounted Cash Flow
Valuations.
Practical Insight from an operational
perspective of the key issues & factors
that one could consider for the
DCF.
4
Valuation in General
5
Valuation – Principles
6 DCF
Extent of
control
Timing Basis
Context
Principles
Value different
from Price
What is being valued
Why it is being valued
Secure definition of “value” Valuation is relative to
a specific point in time
Going concern vis-à-vis
liquidation
Premium for control,
efficiency and synergy
Valuation – Principles
Valuation is not just a science, but an
art. Though quantitative in nature, the
valuation methods require inputs that
are based on subjective judgment.
Hence, any preconception or bias of
the analyst is reflected in the value.
Value of any asset will depend on the
earnings / cashflows that it is expected
to generate in the future – forward
looking
7 DCF
Valuation is not just a
SCIENCE, but an ART
Value not a precise estimate, always in a range
Valuation Approach &
Methodologies
8
Valuation Approach & Methodologies
9 DCF
Asset based
valuation
Net Asset (book) value
Net Asset Value -
Adjusted
Market multiples
Recent market
transactions
Market based
valuation
Valuation
methods
Discounted Cash flow
Capitalisation of earnings
Earnings based
valuation
Net Asset Value -
Replacement
Liquidation value
Market price
More than one right
way to value
Approaches are not
exclusive; but
complement
each other
Discounted Cash Flow
Methodology
- Demystified
10
Income Approach – Discounted Cash Flow (DCF)
The DCF Method is based on the premise that the value of the
business / enterprise / asset is the present value of the future
economic benefits / income (i.e) cash flows to be derived by the
owners of the business. This method analyses discretely three
factors which directly determine value
The amount of cash expected to be generated;
The timing of the cash flow; and
The riskiness of the projected cash flows
This method entails review of the projections - analysis of
revenues, expenses, working capital investments, capital
expenditures and asset efficiency, capital structure
11 DCF
DCF – Usage Rationale
DCF Methodology is the most scientific method and one of the
most rigorous approaches for the valuation of a business
Value of any asset / business will depend on the earnings / cash
flows that it is expected to generate in the future.
Investors assign value based on the cash flow they expect to
receive in the future in the form of .
Dividends / Distributions
Proceeds on Sale / Liquidation proceeds of Investments
In this technique the projected free cash flows from business
operations are discounted back to the present value at the
investors rate of return expectation and the sum of such
discounted free cash flows is the value of the business / equity /
asset. 12
DCF
DCF Methodology – Imperative Usage
Merger & Acquisition Transactions
Strategic Implications – Control Valuations
Valuation for Synergy Benefits available to the specific purchaser
Start up Ventures – Fledglings.
Companies / Businesses with Negative earnings.
Companies / Businesses engaged in extractive industries – depleting
assets with limited life – Mines.
Companies / Businesses with PPAs, BOOT / BOT Agreements
Unique Business Models – Absence of Listed Comparable Companies
Intangibles such as Brand / Trademarks / Customer contracts etc.
Valuation of Companies undergoing financial reengineering / debt
restructuring – Post money valuations.
Liquidation cases – phased out disposal of assets
13 DCF
DCF Valuation – the key terms
14 DCF
• Valuation Date
• Projections & Free Cash
Flows
• Free Cash Flows to
the Firm (FCFF)
• Free Cash Flows to
Equity (FCFE)
• Discrete Period
• Terminal Period
• Terminal Value /
Continuity Value
• Terminal Growth Rate
• Discount Rate
• Sensitivities / Scenarios
• Cash Accrual Timing Factor
– Present Value Factor
• Exit Multiples
Key terms
DCF – Valuation & Cash Flow Approaches
15 DCF
Enterprise Value
Equity Value
Value of Business
Value of Equity
Free Cash Flows to the
Firm (FCFF)
• Most Commonly used
• Discount rate –
Weighted Average Cost
of Capital`
Free Cash Flows to
Equity (FCFE)
• Less Commonly used
• Relevant for Financing
Companies, Complex
capital structures
• Discount rate – Cost of
Equity
Equity Value
Free Cash Flows – FCFF
16 DCF
= PAT (Profit after Tax)
PLUS
NON-CASH ITEMS
(DEPRECIATION, AMORTIZATION,
DEFERRED TAX ENTRIES)
INVESTMENT IN
INCREMENTAL WORKING CAPITAL
CAPITAL ASSETS & INVESTMENTS
MINUS
FREE CASH FLOWS TO THE FIRM
Overcoming the impact of capital structure on the
business value
INTEREST *(1-Tax Rate)
PLUS
DCF – Value & Components
17 DCF
VALUATION DATE
DISCRETE PERIOD TERMINAL PERIOD
Represents the Present Value
of all free cash flows beyond
the forecast period
Years one through ..n TERMINAL VALUE
Present value of free cash flows
calculated based on the Projections
for the discrete period by using an
appropriate Discount Rate.
Terminal value of the Terminal
period based on
• the market,
• Asset, or
• Income approach
Operating Business / Enterprise Value = PV (Discrete Period) +
Terminal Value
Free Cash Flows – a few pointers
18 DCF
• Projections primarily belong to the Management, should be corroborated with past data / industry data / research reports.
• Exclusion of non recurring items of income and expenditure relevant from a Terminal Value Calculation.
• Nominal / real
• Accounting GAAP consistency – past and projected
• Interest / investment income on surplus funds should be excluded from the profits to be considered for cash flows as the investments will generally be separately considered in the valuation.
Pointers
The Valuers Questions & Counter
19 DCF
THE VALUER’S COUNTER
Discuss issues to make necessary adjustments in order to make projections
more reasonable.
Different scenarios are built up to study the sensitivity and changes in income
& expense & profitability.
Forecasting
Free Cash
Flows – The
Valuers
Questions
Whether the assumptions consider realistic growth of the
industry and the company’s market share?
Whether the company intends to venture into new lines of
businesses?
Whether the company plans to expand its existing
infrastructure?
Are the assumptions sketched: Reasonable?
Comparable in relation with the past trend of the company / industry / peer group?
Whether growth in different heads of expenses is
reasonable and correlated to the growth in revenues /
operations where applicable?
Discrete Period – a few pointers
Discrete Period –
usually several
years since the
Valuation Date
20 DCF
Pointers
Length of discrete period – determining
factors
Steady state performance
Generally covers a business cycle of 3 to 5 years
Project businesses / agreement based business -
the entire period of the life of the project /
agreement.
Depleting resources (Mines) – the entire period
of the life of the resources available for
extraction.
Commodity cycle – 5 to 7 years – discreet period
should cover the entire average length of the
commodity cycle.
Terminal Period
Businesses potentially have an infinite life. The value of a
Business is the present value of
cash flows forever
Since we cannot estimate cash flows forever, we estimate cash flows for the
discrete period and then estimate a
terminal value, to capture the value at
the end of the discrete period
The period beginning at the
end of the discrete period
and continuing to infinity is the
terminal period
Once the business reaches a steady state – determines the
beginning of the terminal period
21 DCF
Business / Company
grows at a constant rate
Reinvests a constant
proportion of its
operating profits into
business
Earns a constant return
on it base level of
invested capital
DCF
Terminal Value
22
Asset
Ap
pro
ach
Income
Approach
Growth
Inco
me
Ap
pro
ach
Co
nverg
en
ce
Market Approach
T V
- Capitalization of earnings
(exit multiple)
- Assets – Regulated asset /
net tangible asset base.
- General Industry Rules of
Thumb (% of AUM)
‒ Liquidation / realization of
assets – based on
forecast balance sheet.
‒ Generally more useful
when assets are
separable and
marketable / more liquid
in nature.
‒ Continuing value formula such as
perpetuity formula using the
convergence approach or the growth
model – judgmental call on case to
case basis.
Growth – Capitalisation of the free
cash flows after considering a
terminal growth rate (WACC – g)
Convergence – Steady
state capitalisation of
NOPLAT (Net operating
profit (EBIT) less
adjustments for taxes)
Terminal Growth Rate – Key Considerations
23
Key Considerations
Natural limits (e.g.
demographics, market share)
Product life cycle / market stage
GDP growth (cannot
exceed long term GDP
growth indefinitely) Capital
expenditure – benefits not
fully captured in the
projections
Optimum Capacity / Potential utilisation
Has the company reached a
steady state.
Discount Rate – Definition
24 DCF
In the context of a business valuation, the discount rate is the rate of
return that would be required by an investor to purchase the stream
of expected benefits (e.g. future cash flows), given the risk of
achieving those benefits
The discount rate is used to determine the amount an investor would
pay today (present value) for the right to receive an anticipated
stream of payments (e.g., cash flows) in the future.
What discount rate is used depends on the type of the “income”
stream
Discount Rate – WACC
25 DCF
Capital Asset Pricing Method
• The main components of the Discount Rate will be
− Cost of Debt (Kd)
− Cost of Equity Capital (Ke)
WACC = [D / (D+E) * Kd * (1-t)] + [E / (D+E) * Ke]
Discount rate to reflect weighted share of Equity
& Debt in the Capital
Discount Rate – Cost of Equity
26 DCF
Ke = Rf + (Rm-Rf) * β + SCRP
Risk
Free
Rate
Beta (β)
Equity
Market
Risk
Premium
Specific
Company
Risk
Premium
(Alpha)
Capital Asset Pricing Method
Discount Rate – A few Pointers
Buyer’s Discount Rate
Seller’s Discount Rate
Normative Discount Rate
27 DCF
Interpretation of Discount Rates
DCF
Enterprise to Equity Value – Final Adjustments
28
Non-
operating
assets
Surplus
Assets
Value
of
EQUITY
Contingent
Liabilities
+
Equity
Dilutants
Non
Convertible
Debt
+
Redeemable
Preference
Capital
Enterprise Value
= Present value of
Free Cash Flows
for the Explicit
Period
+ Terminal Value
+ Post Explicit Tax
Benefits
The DCF model results in the value of a 100% ownership in the business
A range of values can be developed by sensitizing the forecast or the WACC
+ - = -
DCF
The Closing pointers
29
Projections,
Discount Rate
Terminal growth rate
Sensitivity / Scenario Analysis
Reasonableness of the Implied Multiples (historical) & the Exit multiple (terminal value)
Industry benchmarks
Analyst expectations
Relative benchmarks
Valuation Cross
checks
Keeping in mind the various sensitivities and cross checks
Conclusion on Range of Values
– A well accepted practice
DCF
FEMA Valuations – Inbound (FDI)
30
Issue
Transfer
Resident Non-resident
The DCF value so arrived will be
the minimum price at which the
transfer can take place
Resident Non-resident
The DCF value so arrived will be
the maximum price at which the
transfer can take place
Transfer
Non-resident Non-resident
Convertible Instruments –
conversion formula
Transfer
Buyback
Not applicable
Rights
issue
DCF Valuation – Some pitfalls
Garbage IN Garbage OUT
Projections – Management’s biased perception
Risk of Achievability of projections
Discount rate & Terminal value – Subjective matters more based on each
Valuer’s Judgmental call
Not Directly linked to the Market
Generally gives a control value - Subjective discounting for minority value
31
Conclusions
32 DCF
DCF - Disadvantages
• Projections – biased
perception (Subjectivity)
• Achievability of projections
• Discount rate
• Terminal Value
DCF - Advantages
• Considers Cashflow
• Considers Present value
• Considers additional capex,
working capital
• Permits sensitivity /
scenarios
Final recommendation – common sense & reasonableness
33
34
Thank You
This document discusses various methods and process of valuation. The style contained herein is intended to make aware the valuation process in relation to general issues and concerns. The approach might be different in light of specific issues that are in nature different in context and character. Further, the information contained in this document is intended only to provide a perspective on valuation methods and the process followed in relation to such and related engagements. It should be in no way construed to be an opinion or advise of any character and is in no way represented as such. The information provided herein should not be used and reproduced and should be considered privileged and only for the intended recipients.