DISCOUNTED CASH FLOW VALUATION
Shashank Santhosh Rajeshwari Simran
Discounted Cash Flow Valuation
What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows 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.
Discounted Cash Flow Valuation
Information Needed: To use discounted cash flow valuation, you need
to estimate the life of the asset to estimate the cash flows 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.
Discounted Cash Flow (DCF)
If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Advantages of DCF Valuation
Since DCF valuation, done right, is based upon an assets fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an 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.
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 noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.
Disadvantages of DCF valuation
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 in that sector equity portfolio managers, who have to be fully (or close to fully) invested in equities
When DCF Valuation works best
This approach is easiest to use for assets (firms) whose
Cash flows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available.
It works best for investors who either
have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to true value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm
How will we do DCF valuation?
A simple framework involving the estimation of only a few key inputs
Earnings or dividends Growth ROE or ROC Retention ratio Cash flow Cost of capital
How will we do DCF valuation?
Key equation
g = ROE*RR Why is this key?
Allows us to pass growth in earnings to growth in cash flow
Free cash flow = earnings * (1-RR)
How will we do DCF valuation?
Key assumptions
Growth in earnings should translate into growth in cash flow
Fundamental growth equation holds (more or less) Is this true when examining dividends?
All cash flow will eventually be given back to shareholders
Dividends, share repurchases, higher ROE, etc.
Good firms tend to do good things with free cash flows
FCFE Valuation
Present value of free cash flow to equity
Find present value of the free cash flow available to stock holders after all payments to other capital suppliers and after providing for continued investment in the firm FCFE = net income + depreciation capital expenditures change in net working capital principal debt repayments + new debt issues
FCFF Valuation
Present value of operating free cash flow
FCFF = EBIT( 1 T ) + depreciation capital expenditures change in net working capital net change in other assets Total firm value (debt + equity)
DISCOUNTED CASHFLOW VALUATION
Discounting the expected cash flow at a risk adjusted discount rate t ! g E (CFt ) Value of Assets ! (1 radj ) t t !1 Discounting a Certainty Equivalent of the cash flow at the risk free rate
CE (CFt ) Value of Asset ! (1 r f ) t t !1
t !g
DETERMINING THE RISK ADJUSTED DISCOUNT RATE
RiskandReturn Models (CAPM)
Expected Return = rf + F(rm rf),
whereby (rm rf) is the equity risk premium Calculation of F :
Historical regression Fby regressing its ROI against return on the market index Bottom-up F, by looking at the betas of other public traded companies
Example on Google :
10 year Treasury Bond is 4.25% Bottom-up beta for internet companies is 2.25 Risk premium is 4.09% Expected return on Google stocks = 4.25% + 2.25*4.09%=13.45%
DETERMINING THE RISK ADJUSTED DISCOUNT RATE
Proxy Models
Find variables that characterized high return stocks and regressed them Findings of Fama & French
rj=1.77%-0.11*ln(MVj)+0.35*ln(BVj/MVj) Expected annual return = (1+rj )12 1
Example :
Market Value = usd 500 Book Value = usd 300
rj=1.77%-0.11*ln(500)+0.35*ln(300/500)=0.9076% Expected annual return = (1+0.009076 )12 1=11.45%
DETERMINING CERTAINTY EQUIVALENT CASH FLOWS
Risk-and-Return Models
CE (CFt ) ! (1 rf ) t (1 r )
t
x E (CFt )
Cash Flow Haircuts
Cuts are done based on analysts judgment Risks can be considered twice to this intuitive judgment
HYBRID MODELS
Type of Risks Examples Risk Adjustment in Valuation
Adjust the discount rate for risk Continuous market risk Interest rate risk, where buying protection is inflation risk, exposure difficult or impossible to economic cyclicality Discontinuous market risk, with low likelihood of occurrence but big impact Market risk that is contingent on a specific occurrence Firm-specific risk
Political risk, risk of If insurance exists, include expropriation, terrorism premium as cost and adjust cash risk flow. Otherwise adjust discount rate Commodity price risk Estimate the option premium to hedge against the risk, include as cost and adjust cash flow If investors are diversified, no adjustments needed. If investors are not diversified use the models for market risk
Estimation risk, competitive risk, technology risk
POST VALUATION RISK ADJUSTMENT
Adjusting the value for risk after the valuation for downside as well as upside risk Downside Risk Illiquidity Discount
Common practice to deduct 20 -30 % from value
UPSIDE RISK
Control Premium
Common practice to add 30% for benefit of controlling the company
Synergy Premium
Calculated via consolidated cash flow projection
DANGER OF POST VALUATION ADJUSTMENT Risks can be easily double counted Magnitude of discount/premium is arbitrary By adjusting an estimated value again with discounts/premiums, opens the door for additional biases in the numbers
RELATIVE VALUATION APPROACHES
The value is derived from either a comparable/similar asset or a standardized price using :
Sector comparison Market capitalization or size Ratio based comparisons Statistical controls
CFaR VALUATION
Define all risks that might have an impact on the cash flow Use valuation method for every projected cash flow Cash Flow at Risk (CFaR) Cash flow before risk management vs cash flow after risk management Difference of value is the gain from risk management Value the gain
CFaR VALUATION
PV ( of companys cash flow with hedge plus hedging cost ) --PV ( of companys cash flow without hedge plus bankruptcy cost) === Benefit of risk management
Requirements :
Use operational cash flow excluding interest Calculate projected Cash flow considering probabilities of occurrence Use WACC as discount rate Include risk premium in cost of equity Include transaction cost of hedging Include bankruptcy cost
Thank You
