BAV

Unit 3rd

DCF: A discounted cash flow model ("DCF model") is a type of financial model that values a
company by forecasting its' cash flows and discounting the cash flows to arrive at a current,
present value.

In simple words, Discounted Cash Flow or DCF analysis is a process of evaluating the
attractiveness of an investment opportunity in the future at present. As such, discounted cash
flow valuation analysis tries to calculate the value of a company today, based on forecasts of
how much money the company is going to make in the future.

DCF Value-

Present Valuet=0 = Cash Flow t=1 / (1+r)t

Steps-DCF

Step 1: Project the company’s Free Cash Flows: Typically, a target’s FCF is projected out 5 to
10 years in the future.

Step 2: Choose a discount rate

Step 3: Calculate the TV

Step 4: Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net
present value

Step 5: Calculate the equity value by adding debt and subtracting cash from EV (Note: Debt –
Cash is called Net Debt)

Assumption- DCF

1. Free cash flow (FCF) – Cash generated by the assets of the business (tangible and
intangible) available for distribution to all providers of capital. FCF is often referred to
as unlevered free cash flow, as it represents cash flow available to all providers of capital
and is not affected by the capital structure of the business. All cash flows are treated as
though they occur at the end of the year.

2. DCF methods treat cash flows associated with investment projects as though they were
known with certainty.

3. All cash inflows are reinvested in other projects that earn monies for the company.

4. DCF analysis assumes a perfect capital market.

 5. Terminal value (TV) – Value at the end of the FCF projection period is calculated.

6. Discount rate and growth rate – The rate used to discount projected FCFs and terminal
value to their present values. This is also called WACC. The growth rate is also known.
This is the expected rate of growth in earnings.

Topic: Value Drivers-DCF

Value Dricers: Value drivers are anything that can be added to a product or service that will
increase its value to consumers.

Valuation drivers refer to factors that increase the value of a business in the event of a sale
opportunity. Business owners need to consider essential factors to increase cash flows, as well as
reduce risk, thus enhancing the overall value of the company. They need to start monitoring their
company’s value a number of years before they consider an exit.

Any DCF analysis, however, is only as accurate as the assumptions and forecasts it relies on.
Errors in estimating key value drivers can lead to a very distorted picture of a company´s fair
price. Depending on the determination of the key value drivers, the enterprise value for the same
company can differ greatly. Therefore, every DCF analysis has to focus on a careful
determination and justification of those important parameters.

Since the cashflows usually have the strongest influence on the enterprise value, the projection of
the free cashflows is the decisive aspect of every DCF analysis. The development of the
cashflows depend on various value drivers such as sales growth, profit margin, investments in
fixed assets (CAPEX) and investments in working capital. These value drivers will be discussed
below.

1. Sales

Logically, if all other value drivers remain the same, higher sales lead to higher cash flows and
thus to a higher enterprise value. However, the assumption that other factors will remain
unchanged with higher sales is unrealistic and untenable. For example, an increase in sales
usually also entails additional investments in working capital. If the company encounters its
production capacities at certain sales levels, investments in fixed assets must also be taken into
account. The effects of the change in sales can therefore not always be clearly determined at first
glance.

2. Profit Margin

In contrast to an increase in turnover, a reduction in costs always has a value-increasing effect. If

the company succeeds in reducing costs (ceteris paribus assumption), the EBIT margin and thus
also the free cashflows and the enterprise value will increase.

3. Working Capital and CAPEX

Even if sales remain unchanged, there may be changes in working capital. Thus for example the
payment modalities of the customers or also the own payment modalities can change. Higher
payment terms of the customers lead to an increase in trade receivables and thus to an increase in
the working capital requirements. The opposite effect is caused by greater utilization of the
company’s own payment terms.

Investments in fixed assets (CAPEX) can largely be derived from the schedule of fixed assets. If
replacement investments in fixed assets were not made in the past, they must be made sooner or
later. In this case the future investments in fixed assets increase in comparison with those in the
closer past, even if the conversion remains constant. A further reason for increased investments
can be technical innovations of the own machinery. All these factors must be taken into account
when forecasting capital expenditures.

Cost of Capital – Discount factor

The effect of the costs of capital on the enterprise value is immediately apparent. If the return
requirements for debt and equity, and thus the discount factor increase, the cashflows will be
discounted with a higher factor which results in a lower enterprise value. Mathematically, this
relationship is clear because the present value of the cash flows is directly dependent on the level
of the discount factor and thus on the cost of capital.

The discount factor is influenced by the following parameters (if WACC approach is used):

(A) Cost of debt

If the interest rate on borrowed capital increases, higher cash flows must be made available to the
lenders. This results in a reduction in the cash flows available to the equity providers and thus
also in a reduction in the equity value of the company.

(B) Cost of equity

If the return requirements of equity investors increases, the enterprise value decreases. In a DCF
analysis, the cost of equity is usually calculated using the Capital Asset Pricing Model (CAPM).
The amount of the cost of equity depends on the factors of the risk-free interest rate, the market
risk premium and the beta factor.

4. Growth rate of the Terminal Value

The growth rate of the cashflow in the Terminal Value reflects the growth of the cashflow at the
end of the detailed forecasting period. This growth rate is intended to reflect corporate growth to
infinity. It therefore makes sense to use a variable such as general economic growth as the
growth rate for the company. In practice, growth rates between 0 and 5% are used, whereby 5%
is the upper limit and is only used for companies in extremely dynamic industries. An increase in
the growth rate from 1% to 5%, for example, results in an enormous increase in the Terminal
Value and thus also in the enterprise value.

Hence, The analysis of the value drivers not only serves to sensitize the user to the most
important parameters of a DCF analysis, but is also helpful in decision-making. Whether an
acquisition or sale is the right decision depends on the price of the company. In the DCF
analysis, however, this fair price is determined on the basis of forecasted figures that are subject
to uncertainty. Therefore, when determining an enterprise value, different scenarios should
always be considered that reflect this uncertainty. It is therefore advisable to analyze the
enterprse value with multiple variants of the key value drivers.

Topic: Relative Valuation Model

A relative valuation model is a business valuation method that compares a firm's value to that of
its competitors to determine the firm's financial worth.

A relative valuation model is a business valuation method that compares a company's value to
that of its competitors or industry peers to assess the firm's financial worth. Relative valuation
models are an alternative to absolute value models, which try to determine a company's intrinsic
worth based on its estimated future free cash flows discounted to their present value without any
reference to another company or industry average. Like absolute value models, investors may
use relative valuation models when determining whether a company's stock is a good buy.

A relative valuation model can be used to assess the value of a company's stock price compared
to other companies or an industry average.

Methods of calculating Relative value:

1. Price to Earning Ration (P/E Ratio)-

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is
calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's
share price as a multiple of its earnings. A company with a high P/E ratio is trading at a higher
price per dollar of earnings than its peers and is considered overvalued. Likewise, a company
with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued.
This framework can be carried out with any multiple of price to gauge relative market value.
Therefore, if the average P/E for an industry is 10x and a particular company in that industry is
trading at 5x earnings, it is relatively undervalued to its peers.

In addition to providing a gauge for relative value, the P/E ratio allows analysts to back into the
price that a stock should be trading at based on its peers. For example, if the average P/E for the
specialty retail industry is 20x, it means the average price of stock from a company in the
industry trades at 20 times its EPS.
Assume Company A trades for $50 in the market and has an EPS of $2. The P/E ratio is
calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of 20x,
which means Company A is overvalued. If Company A were trading at 20 times its EPS, the
industry average, it would be trading at a price of $40, which is the relative value. In other
words, based on the industry average, Company A is trading at a price that is $10 higher than it
should be, representing an opportunity to sell.

Application of Valuation:

Topic: Valuation Multiples

1. PE Ratio

2. EV/EBITDA (1 & 2 are called Earning Multiples)

3. EV/Sales (is called Revenue Multiple)

Price/Book Value (is called Book Value Multiple) • Book Value is the Investment (Net Worth)
that equity shareholders have put in & earned in Company .

The book value is referred to as the net asset value of a company. It is calculated as total assets
minus intangible assets (patents, goodwill) and liabilities.

• P/B ratio = (Market price per share/ book value per share)
As a thumb rule, companies with lower P/B ratio is undervalued compared to the companies with
higher P/B ratio. The P/BV ratio is compared only with the companies in the same industry.

The Four Basic Steps-

first step is to ensure that the multiple is defined consistently and that it is measured uniformly
across the firms being compared.

The second step is to be aware of the cross sectional distribution of the multiple, not only across
firms in the sector being analyzed but also across the entire market.

The third step is to analyze the multiple and understand not only what fundamentals determine
the multiple but also how changes in these fundamentals translate into changes in the multiple.

The final step is finding the right firms to use for comparison, and controlling for differences that
may persist across these firms.

Topic: Advantage of Relative valuation

Usefulness: Valuation is about judgment, and multiples provide a framework for making value
judgments. When used properly, multiples are robust tools that can provide useful information
about relative value.

Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user-
friendly method of assessing value. Multiples can help the user avoid the potentially misleading
precision of other, more 'precise' approaches such as discounted cash flow valuation or EVA,
which can create a false sense of comfort.

Relevance: Multiples focus on the key statistics that other investors use. Since investors in
aggregate move markets, the most commonly used statistics and multiples will have the most
impact.

Disadvantage of Relative Valuation:

No valuation technique can be perfect. There are few disadvantage/ limitations of relative
valuations which are discussed below:

The relative valuation approach does not give an exact result (unlike discounted cash flow) as
this approach is based on the comparison.

It’s assumed that the market has valued the companies correctly. If all the companies in the
Industry are overvalued, then the relative valuation approach might give a misleading result for
the company which you are investigating.

Static: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture
the dynamic and ever-evolving nature of business and competition.
Dependence on correctly valued peers: The use of multiples only reveals patterns in relative
values, not absolute values such as those obtained from discounted cash flow valuations. If the
peer group as a whole is incorrectly valued (such as may happen during a stock market "bubble")
then the resulting multiples will also be misvalued.

Difficulties in comparisons: Multiples are primarily used to make comparisons of relative value.
But comparing multiples is an exacting art form, because there are so many reasons that
multiples can differ, not all of which relate to true differences in value. For example, different
accounting policies can result in diverging multiples for otherwise identical operating businesses.

Short-term: Multiples are based on historic data or near-term forecasts. Valuations based on
multiples will therefore fail to capture differences in projected performance over the longer term,
and will have difficulty correctly valuing cyclical industries unless somewhat subjective
normalization adjustments are made.

Important note:

Note: 1. Ensure that both the denominator and numerator represent same group.

2. PE, Book Value, Mcap/Sales Multiples result in Equity Value (these are used for Equity
Value)

3. EBIT, EBITDA, EV / Sales Multiple result in Enterprise Value (these are used for Enterprise
Value)

Impact on Different Stakeholders in terms of Business Valuation

In business, a stakeholder is any individual, group, or party that has an interest in an organization
and the outcomes of its actions. Common examples of stakeholders include employees,
customers, shareholders, suppliers, communities, and governments. Different stakeholders have
different interests, and companies often face tradeoffs when trying to please all of them.
Impact on Different Stakeholders

The objective of any management today is to maximize corporate value and shareholder wealth.
This is considered their most important task. A company is considered valuable not for its past
performance, but for what it is and its ability to create value to its various stakeholders in future.

The priorities of different stakeholders in terms of business valuation need to be recognized

under three circumstances. They are given below:

Liquidation: While the major and important requirements may governed by the relevant
provisions of Company Law, the management may still be able to influence stakeholder
priorities by negotiating with the various groups, especially in a voluntary liquidation.

2nd Refinancing: There are occasions when companies need to obtain new financing or re-finance
existing debt. The company has to then take into account the views of managers, shareholders,
long term lenders and creditors.

3rd Mergers and Acquisitions: Other than the bidder and the bidee, numerous stakeholders, such
as employees, suppliers, customers, government and local community, will be involved in the
process. For instance, recall the recent acquisition of Tata Motors of Ford’s Jaguar and Land
Rover (JLR) in UK. The Tatas had to engage the with the employees of JLR and provide with
adequate assurances as an essential step in the acquisition process.
Others points are:

Relational capital comprises not only customer relations but also the organisation’s external
relationships with its network of suppliers, as well as its network of strategic partners and
stakeholders. The value of such assets is primarily influenced by the firm’s reputation. In
measuring relational capital, the challenge remains in quantifying the strength and loyalty of
customer satisfaction, longevity, and price sensitivity.

Resolve disputes among stakeholders/litigation: Divorce, bankruptcy, breach of contract,

dissenting shareholder and minority oppression cases, economic damages computations,
ownership disputes, and other cases.

1. Customers

Many would argue that businesses exist to serve their customers. Customers are actually
stakeholders of a business in that they are impacted by the quality of service and its value. For
example, passengers traveling on an airplane literally have their lives in the company’s hands
while flying with the airline.

2 Employees: Employees have a direct stake in the company in that they earn an income to
support themselves, as well as other benefits (both monetary and non-monetary). Depending on
the nature of the business, employees may also have a health and safety interest (for example,
transportation, mining, oil and gas, construction, etc.).

3 Investors: Investors include both shareholders and debtholders. Shareholders invest capital in
the business and expect to earn a certain rate of return on that capital. Investors are commonly
concerned with the concept of shareholder value. Lumped in with this group are all other
providers of capital, such as lenders and different classes of shareholders.

4 Suppliers and Vendors: Suppliers and vendors sell goods and/or services to the business and
rely on it for revenue generation and on-going business. In many industries, the suppliers also
have their health and safety on the line, as they may be directly involved in the company’s
operations.

5 Communities: Communities are major stakeholders in large businesses. They are impacted by
a wide range of things, including job creation, economic development, health, and safety. When
a big company enters or exits a small community, they will immediately feel the impact on
employment, incomes, and spending in the area. In some industries, there is a potential health
impact, as companies may alter the environment.

6 Governments: Governments can also be considered a major stakeholder in a business as they

collect taxes from the company (corporate income), as well as from all the people it employs
(payroll taxes) and other spending the company incurs (goods and services taxes). Governments
benefit from the overall Gross Domestic Product (GDP) that companies contribute to.