Company Valuation using free cash flow technique: A case

Journal of Advance Management Research, ISSN: 2393-9664

Vol.06 Issue-03, (March 2018), Impact Factor: 4.73

Double-Blind Peer Reviewed Refereed International Journal - Included in the International Serial Directories

Journal of Advance Management Research, ISSN: 2393-9664 (JAMR) http://www.jamrpublication.com email id- [email protected] Page 110

Company Valuation using free cash flow technique: A case study of National Thermal

Power Corporation Limited

*Dr.S.K.Khatik

Professor and Head, Department of Commerce ,Dean Faculty of Commerce,Chairman Board of Studies in Applied Economics and Business Management, Barkatullah University, Bhopal 462026

India.

**Mr.Milind Patil

Research Scholar, Department of Commerce Barkatullah University and Assistant Professor in Finance,

Institute of Professional Education and Research (IPER), Bhopal 462026 India,

Abstract

On this earth, every day lakhs of peoples like investors, regulators, portfolio managers and researchers

face a common and difficult question what is the value of particular company. The answer to this

question lies in understanding not only what is the value but also the sources of the value. From case

to case any company whether public or private can be valued. Some companies are easy to value and

some are difficult to value. Thus company valuation is the estimation of a company’s asset’s value

based on future cash flows or comparing the similar assets.

There are number of methods are available to value the company. In general, there are three methods

for company valuation. The first is predict the future free cash flow and then discounted at the

appropriate rate. The second, is estimates the value of the company by comparing the peer companies

on the basis of multiples like price to earnings, enterprise value, book value, sales etc.The third, is

option pricing method to value the company that share the option characteristic. By using these above

mentioned methods in valuation the outcome can be varied depending on the valuation method that

is used.

The purpose of this research paper is to define the concept of free cash flow valuation method which

is divided in to free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) and then presenting

the valuation method by discounting at the appropriate rate. This section investigates the constant

growth and multistage method for valuing free cash flow to firm and free cash flow to equity.





INTRODUCTION

Free Cash Flow to the Firm(FCFF) is the cash available to the supplier’s of capital i.e. debt holder and

equity holder after meeting all obligation of the company i.e. all operating expenses, working capital

investment and fixed capital. On the basis of accounting information available the free cash flow of

the company is calculated.

Free cash Flow to the Equity (FCFE) is the cash available to the equity shareholders after meeting all

obligations to the company i.e. all operating expenses, working capital investment, fixed capital and

payment made to debt holders including interest cost and principle amount.

Importance of Free Cash Flow

The benefit of FCFF and FCFE method over other cash flow method is that free cash flow to firm and

equity can be used directly in discounted cash flow framework to value the company. The other cash

flow measure such as cash flow from operation (CFO), net income (NI), earnings before interest and

taxes (EBIT) and earning before interest, taxes, depreciation and amortization (EBITDA) do not have

similar property as FCFF and FCFE.If we interpret the EBIT and EBITDA both measures are before tax

and cash flows to the debt holder and shareholder must be after tax. Also both these measures do not

consider the reinvestment of cash flows in fixed assets and working capital for long term sustainability

of the company.

In company valuation process valuing company through free cash flow method is more difficult than

dividend discount method(DDM) because in predicting free cash flow the user must integrate the cash

flow from the company’s operations with cash flow from investing and financing activities. The FCFF

is the after tax cash flow available to shareholders and debt holder of the company, the value of the

company is estimated by discounted at weighted average cost of capital(WACC).The value of equity is

estimated directly by discounting FCFE at the cost of equity(Key).

Uses of Free Cash Flow

Free cash flow either FCFF or FCFE is likely to use:-

When the company does not pay dividend or paid, but the dividend payment is significantly differ

from company’s paying capacity.

When free cash flow of the company is aligned with the profitability of the company within a

reasonable period of forecast.

When company is carrying huge borrowings also known as levered company with negative FCFE

in this case, FCFF will be the best alternative to estimate equity value. In this scenario discount

FCFF to find the present value of operating assets and add excess cash and marketable securities

and any other significant non operating assets to estimate the value of total firm then deduct the

total market value of borrowings to estimate the intrinsic value of equity.

When historical data are used to predict the free cash flow growth rates but the capital structure

of the company is highly fluctuating. In this scenario estimates should be based on FCFF rather

than FCFE.





If the investor takes a control perspective.

OBJECTIVE OF THE STUDY

Following are the objectives of study:-

(i) To analyze the concept of free cash flow.

(ii) To examine the firm valuation through free cash flow technique of National Thermal power

Corporation Limited and Steel Authority India Ltd.

LIMITATION OF THE STUDY

Following are the limitations of the study:-

This study is based on secondary data and its reliability depends on its audit report.

Data are grouped and sub grouped as per the requirement of the study.

It has covered limited time period from 2005 to 2015.

Non-availability of sufficient data and literature.

RESEARCH METHODOLOGY

The nature of study is micro and its type is descriptive and exploratory, the data used in the study is

secondary. To evaluate the financial performance of National Thermal Power Corporation Limited

(NTPC) data are taken form company annual report, BSE website, newspaper, analyst’s reports

company press release, prospectus.Time period of the study covers 10 years i.e. from 2005 to 2015.

The present study has used free cash flow model which is based on the principle that the future cash

flow of a company should be free to be distributed among the debt holders and share holders. Broadly

speaking, Free Cash Flow (FCF) is the cash flow available to the company’s suppliers of total capital.

The following formula is used for the model.

Free Cash Flow to the Firm

FCFF = NOPLAT

+ Depreciation*tax rate

+/- fixed capital investment

+/-Working capital investment

+/- Changes in deferred Taxes

+/- Post tax non-operating cash flows





________________________________

Free Cash Flow to Firm

______________________________________

Free Cash Flow to Equity

FCFE= FCFF

- Interest (1-t)

+ Net Borrowing (from long term perspective)

____________________________________

Free Cash Flow to Equity

_______________________________________

Where,

FCFF = Free cash flow to firm

NOPLAT = Non operating profit less adjusted tax

= EBIDTA*(1-t) OR EBIT*(1-t) + non cash expenses

FCFE = Free cash flow to equity

t = tax rate

Appropriate discount rate:

In the case of FCFF, for calculating the present value, the appropriate discount rate is WACC (weighted

average cost of capital)

WACC= (E/V)*Ke+ (D/V)*Ke*(1-t)

Where,

E= equity

V= value of the firm (total market value of equity + total market value of debt)

D= total debt component

Ke= cost of equity

Kd= cost of debt

t= tax rate

In the case of FCFE, for calculating the present value, the appropriate discount rate is Ke (Cost of

equity).The Ke is calculated by using Capital asset pricing method (CAPM)

Ke= Rf + β (Rm-Rf)

Where,





Ke=Cost of equity

β=Beta

Rm=Market return

Rf= Risk free rate

REVIEW OF LITERATURE

Sorensen and Williamson (1985) A simple study of the Dividend Discount model (DDM) was

conducted on150 stocks from the S&P 400 in December 1980. They use the difference between the

market price and the intrinsic value obtained from the model to form five portfolios based upon the

degree of under- and overvaluation. They make fairly broad assumptions by testing the dividend

discount model: (a) the average of the earnings per share between 1976 and 1980 is used as the

sustainable earnings per share; (b) the cost of equity is estimated using

the CAPM, (c) the extraordinary growth period is assumed to be five years for all stocks, (d) the stable

growth rate is assumed to be 8% for all stocks and (e) the payout ratio is assumed to be 45% for all

stocks. They conclude that model performance improves as model sophistication increases.

Haugen (1997) In another study, Haugen (1997) reports on the results of a fund that used the DDM to

analyze 250 large capitalization US firms from 1979 to 1991 and to classify them into five quintiles.

The valuation was done by six analysts who estimated an extraordinary growth rate for the initial high

growth phase, the length of the high growth phase and a transitional phase for each of the firms. They

find that the undervalued portfolio earned significantly higher returns (22.2% p.a.) than the

overvalued portfolio (13.75% p.a.) and the S&P 500 (16.8% p.a.).

Skantz and Marcheini (1992) use a DCF model to value liquidating firms where the cash flows and

growth patterns are known. They conclude that the market appears to value stocks by discounting

expected free cash flows using a risk-adjusted required rate of return. The uniqueness of their sample

however makes a generalization to going concern companies difficult.

Frankel and Lee (1998) test the residual income model of Ohlson (1995) operationalized with analysts’

earnings forecasts. They find that the model predicts abnormal returns over one-, two, and three-year

holding periods. Specifically, a portfolio constructed by taking a long position in the most undervalued

quintile of firms and a short position in firms in the most overvalued quintile produces cumulative

returns of 3.1%, 15.2%, and 30.6%, over one,two,and three-year holding periods.

Sabal (2007) states that WACC-based methods are more adequate in a perpetuity situation with a

fixed debt ratio, arguing that in APV there is still debate on which discount rates to use when valuing

tax shields, while the WACC method is supposed to “automatically correct for the discount rate

applicable to the tax shield”.

Michel and Oded (2007) also show the equivalence between the Adjusted Present Value (APV), Capital

Cash Flow (CCF), FCFE and FCFF (or WACC) methods. However, they do so basing themselves on the

assumption that there are no leverage costs, that the Book Value of Debt (N) equals its Market Value

(D) and that the firm maintains a fixed Debt to Enterprise Value ratio.





Luehrman (1997) generally points to the same limitations, emphasizing WACC’s poor adequacy in the

real world given the extensive nature of the required adjustments, as well as the poor fit for cross-

border valuation. He further adds (1997b) that APV is less error prone and able to unbundle value

components, considering WACC to be obsolete; however, even if he stresses that no consensus exists

on how to discount tax shields, he opts for the cost of debt plus a fudge factor, a method that

Fernández (2006a) claims to provide inconsistent results (if, for example, in perpetuity, Kd*(1-T) < g).

Cooper and Nyborg (2006) Fernández’ (2004a) initial approach spurred several arguments and

counter-arguments. I’ll mention here the one that seemed to me as most relevant: Cooper and Nyborg

(2004), followed by Fernández (2004b) and Cooper and Nyborg (2006) It is, however, later and in a

separate work that Cooper and Nyborg (2006b) make an overview of other valuation methods. Of

those, they seem to favor two: the Miles-Ezzel (ME) method and what they term as the Extended ME

(that corresponds, indeed, to the Kaplan and Ruback (1995) capital cash flow approach).

ANALYSIS OF FREE CASH FLOW OF NATIONAL THERMAL POWER CORPORATION

COMPANY OVERVIEW

National Thermal Power Corporation Limited (NTPC) got incorporated on 7 November 1975 to

accelerate power development in India, 1975 to cater to the need of growing demand of power in

India.

In power generation, NTPC owned coal plants are 15 with 23895MW capacity and 7 Gas liquid fuel

plants with 3955 MW capacity. While in Joint venture it is having 4 coal & gas plant with 2294MW

capacity. Hence overall it is having 26 power plants with total installed capacity of 30144MW.

BUSINESS MODEL

The understanding NTPC comes from the understanding its business model. Understanding business

model helps me in analyzing the factors that affect the company. It gives a clear picture as to which

factor has huge influence on the top line and bottom line. Further understanding business model helps

me in valuation of NTPC i.e. forecasting financial statement and value the company. There are

different parts of business model of a company and has been discussed in details below.

Product and services offered by company

Offers Power generated to various segments: NTPC offers the power generated to various

segments through SEB’s and Pvt. Utilities to Domestic users, commercial establishments

and various industries.

Consultancy Services in both domestic and overseas

NTPC consultancy service is related to fossil fuel based thermal power, infrastructure

sector plant, combined cycle business plant, cogeneration plant, water supply and

treatment, and environment engineering and management. NTPC formally established its

consultancy wing in 1989 since then NTPC has secured 435 orders from both domestic

and international.

Focusing towards diversified growth





Entered into hydro power plants and other green power projects to generate

electricity apart from its main source of power generation through coal power plant

and oil and gas power plant.

Coal mining business- In a way to create fuel security of 20% of its coal requirement

by 2017 it has entered into coal mining business. Government of India has allotted 7

coal blocks to NTPC.

Power trading- For optimal utilization of its assets it has entered into power trading

business through a JV between NTPC,NHPC,PFC, TCS .It is the second largest trading

company in the country.

Ash business- It also sells ash generated during power production to Cement,

Asbestos – Cement products & Concrete manufacturing industries, Land

development, Road & Embankments, Ash Dyke Raising and Building Products such as

bricks/ blocks/tiles, as a soil amender and source of micro –nutrients in agriculture

and backfilling of mine filling.

Target Customers

Target customers of NTPC are domestic users, commercial establishments, industries,

ash utilizing companies like cement, concrete and others.

Distribution channel

Power generated by the company is distributed to its final customers like domestic

users, industries and commercial establishments through state electricity boards

(SEB’s), Power Grid Corporation of India Ltd. and Pvt. Utilities.

Promotion

The aim of company is to provide reliable power, reliable power related products and

services at competitive price, integrating multiple energy sources with innovation and

eco-friendly technique and contribute to society. The company has also adopted

corporate social responsibility scheme like NTPC has actively gone for adoption of the

best international practices on environment, occupational health and safety areas.

Pollution control systems / devices have been installed to control air and water

pollution like- Electrostatic precipitators, Flux gas stacks, Low –NOX burners, Ash

Water Recycling System , Dry Ash Extraction System (DAES) , Liquid Waste Treatment

Plants & Management System etc

Environmental Institutional set up additional measures taken by NTPC in the area of

Environment Management are: Environment Management during Operation Phase,

up gradation & Retrofitting of Pollution Control Systems, Resources Conservation,

Waste Management, Municipal Waste Management, Hazardous Waste Management

etc.

Revenue streams:

The revenues generated for the company are from the sale of power generated,

consultancy services and ash sales to the companies like cement and concrete and

others. Consultancy services provided by company related to infrastructure sector

business such as Fossil fuel based thermal power plants , Combined cycle power plants

, Cogeneration plants , Water supply and treatment ,Environment engineering and

management etc.

Core capabilities





Company is capable to produce power through coal plants, thermal plants and hydro

power projects.

Value configuration

For power generation, company is using gas, coal, steam and oil. Now it is also going

to use nuclear technology as it is cost effective. For development of new technology

NETRA subsidiary of NTPC has undertaken many technology development projects

like Robotic Crawler for Boiler Water Wall Inspection, Artificial Intelligence Power

Plant Advisory System, Multi composition Ammonia Liquor Absorption Engine, Flue

Gas Heat Recovery System, CFD Modeling of Boiler, Ammonia based Flue Gas

Conditioning etc.

Partner network

Partners network of the company are Equipment manufacturing companies like BHEL

and Bharat forge, Fuel supplier like Coal India Ltd.

Cost structure

Under the cost structure of the company, as the company is in the power generation

as its core business it is heavily dependent on the raw material like coal, gas etc. which

constitute around 60% of sale and purchase of equipments. The company is also

operating at a large scale so employees cost is also a major factor of cost structure of

a company.

Historical Performance of Free Cash Flow to Firm (FCFF)

Interpretation:-Table 1, shows the historical performance of FCFF of NTPC.The free cash flow of NTPC

in the initial year was increasing and later on it decreases and shows negative free cash flows which

indicate that company has cash flows problems. In the year 2005 the FCFF was Rs 12361.5 million

increases to Rs 43660.2 million and keeps on increasing in 2007, then decreases to Rs 68433.2 million,

again increases to Rs 75619.9 million. In the year 2014 and 2015 the FCFF of NTPC was negative to the

tune of Rs 31201.9 million and Rs 24610.9 million respectively. In the year 2014 and 2015 the company

Particular 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Revenue 225650 261429 326317 370501 441261 482213 583598 620536 656740 720190 732461

EBIT 41114 43708 80178 90854 102357 116691 133110 112593 137173 136224 111740

% of Revenues 18.22% 16.72% 24.57% 24.52% 23.20% 24.20% 22.81% 18.14% 20.89% 18.92% 15.26%

Depreciation 19584 20477 20754 21385 23645 26501 24857 27917 33968 41422 49117

% of Revenues 8.68% 7.83% 6.36% 5.77% 5.36% 5.50% 4.26% 4.50% 5.17% 5.75% 6.71%

EBITDA 60698 64185 100932 112239 126002 143191 157967 140510 171141 177646 160856

% of Revenues 26.90% 24.55% 30.93% 30.29% 28.55% 29.69% 27.07% 22.64% 26.06% 24.67% 21.96%

NOPLAT 57990 62030 77786 81154 110410 114814 119333 105144 125649 140214 156955

Depreciation*Tax Rate 874 688 4759 5923 2926 5252 6079 7027 9029 8728 1191

FA Inv -55113 -66389 -78929 -82798 -129116 -102165 -120514 -125236 -166848 -215102 -230731

WC Inv -19869 22107 73443 42697 81352 -399 68957 61583 91491 13735 27324

Post Tax Non-operating cash flows 28479.9 25224.7 21185.8 21457.2 10048 8221.08 6709.02 20790.9 22771.4 21223.1 20649.7

Free Cash Flow To Firm(FCFF) 12361.5 43660.2 98244.9 68433.2 75619.9 25722.9 80564.6 69309 82092.1 -31201.9 -24610.9

Table 1 : Company Valuation Through FCFF of National Thermal Power Corporation

(Rs In Million)





made huge investment in fixed assets was Rs 215102 million and 230731 million. The table 1 also

shows the % of Revenue which was maximum in 2007 and 2008 i.e. 24.57% and 24.52% respectively.

Later on decline to 18.92% and 15.62 in the year 2014 and 2015 respectively.

Forecasted Free Cash Flow to Firm (FCFF)

The forecasted FCFF of NTPC depict in table no 2 and 2.1.The predicted FCFF was calculated after

understanding the business model and historical performance of NTPC.While projecting future FCFF

we have assume the past performance of the company and will continue in the same pace without

any uncontrollable event will happen to company. The predicted FCFF for five year is discounted at

weighted average cost of capital (WACC).For calculating terminal value of NTPC we assume the

expected GDP growth of 7.5% projected by International Monetary Fund (IMF).The terminal value is

calculated at the end of fifth year on the basis of assumption that the company will continue

perpetually. In the fifth year the terminal value is Rs 2036503.2 million and this value is discounted

11.69% and present value of terminal value in the year 2015 is Rs 1171869.90 million. The total value

of the firm in the year 2015 is Rs 1943428 million. From the total value of firm the book value of firm

Rs 825346 million is subtracted and gets fundamental value of equity to the tune of Rs 1118082

million. The number of outstanding share of NTPC is 8256 million as on march 2015.The fundamental

value of equity is divided by outstanding share we get the fundamental value or intrinsic value per

share as on 31st march 2015.

FINDINGS

F

Particular 2016(E) 2017(E) 2018(E) 2019(E) 2020(E)

Revenue 729764 797698 873803 956240 1041843.6

EBIT 157817 172335 189924 205332 220831

% of Revenues 21.63% 21.60% 21.74% 21.47% 21.20%

Depreciation 42659 45028 47875 51671 55942

% of Revenues 5.85% 5.64% 5.48% 5.40% 5.37%

EBITDA 200476 217364 237799 257003 276774

% of Revenues 27.47% 27.25% 27.21% 26.88% 26.57%

NOPLAT 167429 178385 191431 207589 225958

Depreciation*Tax Rate 7032 8075 9335 9935 10271

FA Inv 489929.1 -183195 -195602 -230391 -275805.7

WC Inv -111339 37107.1 84797.69 92015.2 89584.282

Post Tax Non-operating cash flows 27216.98 26620.5 26786.95 28001.2 29304.529

Free Cash Flow To Firm(FCFF) 580267.4 66991.9 116749.1 107149 79312.192

Table 2 : Company Valuation Through FCFF of National Thermal Power Corporation

(Rs In Million)





Following are the findings of the study:-

In the initial year of the study period the company was performing good later on its free cash

flow to firm was decreased. Which indicate the cash flows problems of the NTPC?

The company has made huge investment in fixed assets which indicate that company has

increased its plant capacity by seeing the future demand of electricity.

EBDITA margin of the company is very good maintained on an average of 26.67% which is

good sign

Company has sufficient cash to pay its interest cost and repayment of principle loan amount.

Company has made investment in working capital which is required to manage day to day

operations.

SUGGESTIONS

On the basis of study following are the suggestions:-

Company should diversify its business to other renewable resources to generate

electricity.

Company should decrease its investment in fixed assets.

Company should decrease its overall cost structure.

To finance its capital expenditure company should raised capital through capital

market by issuing right share in the market. Instead borrowing from banks.

CONCLUSIONS

The fundamental value or intrinsic value of the company is Rs 135.59 as on 31st march 2015 and

market price of the company as on 31st march 2015 is Rs147.40.Hence we conclude that the company

is price fairly and have good prospect in future. The company is fundamentally strong. The predicted

FCFF of the company is positive which indicate the company does not have any cash problem in the

future.

Particular 2015 2016(E) 2017(E) 2018(E) 2019(E) 2020(E)

PV of Estimated FC Flows 519550 53706 83801 68863 45639

Terminal Value 2036503

PV of Estimated Perpetuity Flows 1171870

Total Present Value of Firm 1943428

Book value of Debt 825346

Fundamental Value of Equity 1118082

No of Outstanding Shares 8246

Fundamental Value per share (Rs) 135.591

Table 2.2: Company Valution through FCFF (Rs in million)





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http://www.nyu.edu/classes/keefer/waoe/roshanb3.pdf

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http://pages.stern.nyu.edu/~adamodar/

https://www.youtube.com/watch?v=yYBJfvBXkN0

http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/dcfveg.pdf

http://www.iese.edu/research/pdfs/DI-0629-E.pdf

http://ssrn.com/abstract=256987

http://fundersandfounders.com/how-startup-valuation-works/

www.forbes.com/.../small-business-valuation-entrepreneurs-finance-zwill...

https://blog.udemy.com/business-valuation-methods/

http://www.bu.edu/questrom/files/2011/01/UFC_Valuation.pdf

a

http://anale.steconomiceuoradea.ro/volume/2011/n2/083.pdf

http://www.nyu.edu/classes/keefer/waoe/roshanb3.pdf

http://educ.jmu.edu/~drakepp/general/FCF.pdf

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/free-cash-flow-1000

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/free-cash-flow-1000

http://pages.stern.nyu.edu/~adamodar/

https://www.youtube.com/watch?v=yYBJfvBXkN0

http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/dcfveg.pdf

http://www.iese.edu/research/pdfs/DI-0629-E.pdf

http://ssrn.com/abstract=256987

http://fundersandfounders.com/how-startup-valuation-works/

http://www.forbes.com/.../small-business-valuation-entrepreneurs-finance-zwill

https://blog.udemy.com/business-valuation-methods/

http://www.bu.edu/questrom/files/2011/01/UFC_Valuation.pdf

Documents

Company Valuation using free cash flow technique: A case