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