Valuation Basics

Chapter 3
DISCOUNTED CASH FLOW VALUATION

CHAPTER CONTENTS
1. Definition and description of DCF analysis
2. Assumptions in DCF Model
3. Importance of DCF approach
4. Advantages and Limitations of DCF approach
5. Application of DCF Valuation
6. Value drivers
7. Steps in DCF Valuation
“The value of a business is the future expected cash fl ows discounted at a rate that reflects the risk of the
cash flows”.
- Copeland, Koller and Murrin McKinsey & Co., Valuation Measuring and Managing the Value of
Companies. 2nd Edition, 1994.

3.1 What is DCF?

3.1.2 In Discounted Cash Flow (DCF) valuation, the value of an asset is the present value of the expected
cash flows on the asset.
3.1.3 The basic premise in DCF is that every asset has an intrinsic value that can be estimated, based
upon its characteristics in terms of cash flows, growth and risk.
3.1.4 Though the DCF Valuation is one of the three approaches to Valuation, it is essential to understand
the fundamentals of this approach, as the DCF method finds application in the use of the other two
approaches also. The DCF model is the most widely used standalone valuation model.

3.2 Discounted Cash Flow (DCF) Analysis:

3.2.1 To use DCF valuation, we need to estimate the following:

the life of the asset
the cash flows during the life of the asset
the discount rate to apply to these cash flows to get present value
The Present Value of an asset is arrived at by determining the present values of all expected future
cash flows from the use of the asset. Mathematically,
i=n

Value of an asset =  [(CFi / (1+r)i]

i=1
That is:
CF1 CF2 CFn
Value = + + …+
(1+ r) 1
(1+ r) 2
(1+ r)n
 Business Valuation Management

where
CFi = Expected Future Net Cash Flow during period i
n = Life of the asset
r = rate of discount
The expected future net cash flow is defined as after-tax cash flow from operations on an invested
capital basis (excluding the impact of debt service) less the sum of net changes in working capital
and new investments in capital assets.
The discount rate should reflect the riskiness of the estimated cash flows. The rate will be higher
for high risk projects as compared to lower rates for safe or less risky investments. The Weighted
Average Cost of Capital (WACC) is used as the discount rate. The cost of capital with which the
cash flows are discounted should reflect the risk inherent in the future cash flows.
The WACC is calculated using the following formula:
WACC = [(E/(D+E) x CE] + [(D/(D+E) x C D x (1-T)]
where E is the market value of equity, D is the market value of debt, C E is the cost of equity, CD is
the cost of debt and T is the tax rate.
The first step in determining WACC is the assessment of capital structure, i.e., how a company has
financed its operations.
It can thus be seen that the company’s net cash flows are projected for a number of years and then
discounted to present value using the WACC. The expected cash flows earned beyond the projec-
tion period are capitalized into a terminal value and added to the value of the projected cash flows
for a total value indication.

3.3 Assumptions of the DCF Model:

3.3.1 The DCF model relies upon cash flow assumptions such as revenue growth rates, operating mar-
gins, working capital needs and new investments in fixed assets for purposes of estimating future
cash flows. After establishing the current value, the DCF model can be used to measure the value-
creation impact of various assumption changes, and the sensitivity tested.

3.4 Importance of DCF:

3.4.1 Business valuation is normally done to evaluate the future earning potential of a business, and
involves the study of many aspects of a business, including anticipated revenues and expenses. As
the cash flows extend over time in future, the DCF model can be a helpful tool, as the DCF analysis
for a business valuation requires the analyst to consider two important components of:
a. projection of revenues and expenses of the foreseeable future, and,
b. determination of the discount rate to be used.
3.4.2 Projecting the expected revenues and expenses of a business requires domain expertise in the busi-
ness being valued. For example, a DCF analysis for a telecom company requires knowledge of the
technologies involved, their life cycle, cost advantages and so on. Similarly, a DCF analysis of a pro-
posed mine requires the expertise of geologists to ascertain the quality and quantity of deposits.
 Valuation Basics

3.4.3 Selecting the discount rate requires consideration of two components:

a. the cost of capital, and
b. the risk premium associated with the stream of projected net revenues.
3.4.4 The cost of capital is the cost of funds collected for financing a project or purchasing an asset.
Capital is a productive asset that commands a rate of return. When a business purchase is financed
by debt, the cost of capital simply equals the interest cost of the debt. When it is financed by the
owner’s equity, the relevant cost of capital would be the “opportunity cost” of the capital, i.e., the
net income that the same capital would generate if committed to another attractive alternative.
3.4.5 The choice of discount rate must consider not only the owner’s cost of capital, but also the risk of
the business investment.

3.5 Advantages of DCF Valuation:

a. As DCF valuation is based upon an asset’s fundamentals, it should be less exposed to market
moods and perceptions.
b. DCF valuation is the right way to think about what an investor would get when buying an
asset.
c. DCF valuation forces an investor to think about the underlying characteristics of the firm, and
understand its business.

3.6 Limitations of DCF Valuation:

a. Since DCF valuation is an attempt to estimate intrinsic value, it requires far more inputs and
information than other valuation approaches.
b. The inputs and information are difficult to estimate, and can also be manipulated by a smart
analyst to provide the desired conclusion.
c. It is possible in a DCF valuation model to find every stock in a market to be over valued.
d. The DCF valuation has certain limitations when applied to firms in distress; firms in cyclical
business; firms with unutilized assets, patents; firms in the process of reorganizing or involved
in acquisition, and private firms.

3.7 Application of DCF Valuation:

3.7.1 DCF valuation approach is the easiest to use for assets or firms with the following characteristics:
cash flows are currently positive
the cash flows 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.
3.7.2 DCF approach is also attractive for investors who have a long time horizon, allowing the market
time to correct its valuation mistakes and for price to revert to “true” value, or those who are
capable of providing the needed thrust as in the case of an acquirer of a business.
 Business Valuation Management

3.8 Value Drivers:

3.8.1 In business valuation, it is important to understand the value creation process in a company, and
this warrants an understanding of the hundreds of value-drivers and their effect on the company’s
future cash flow.
3.8.2 Value drivers include Financial value drivers such as operating margins and return on invested
capital, and operational, non-financial value drivers. While financial drivers are generic, opera-
tional value drivers differ from company to company and from industry to industry.
3.8.3 According to David Frykman and Jakob Tolleryd, the key value drivers can be divided into three
distinct areas:
1. The company’s internal resources and its intellectual capital (such as brand strength, innova-
tion power, management and board motivation and past performance, and person-independ-
ent knowledge)
2. The company’s external environment and its industry structure (sector growth, relative mar-
ket share and barriers to entry)
3. The company’s strategy, the way the company chooses to exploit its key value drivers.

3.9 Steps in DCF Valuation:

3.9.1 The steps in valuing a company using DCF are given below:
1. Determine the time horizon for specific forecasts:
Consider economic and business cycles, positive and negative growth.
2. Forecast operating cash flows:
Determine value drivers, estimate historic, current and future ratios, decide on cash/invest-
ment policy.
3. Determine residual value:
Decide on residual value methodology, estimate growth rate in perpetuity.
4. Estimate WACC:
Estimate cost of equity and debt, the debt-equity ratio.
5. Discount cash flows:
Determine enterprise value and equity value, conduct sensitivity analysis.s
6. Prepare related financial statements.
 Business Valuation Management

Illustrations on Valuation

 DCF Valuation

You are evaluating a new project. the Project requires an investment of 4000 now and is expected to
product the following cash flow:
Period Cash flow
1 1500.00
2 2000.00
3 1500.00
4 1200.00
Cost of capital 15%
Determine the Net Present Value and Internal rate of return
Net present value is the total of discounted future value of estimated cashflows from the project, discounted
at the appropriate cost of capital, minus the initial investment. The method used is DCF approach.

Time 0 1 2 3 4
Cash flow. -4000 1500 2000 1500 1200
Cost of capital 0.15
Present value 4000/(1+.15)° 1500/(1+.15)1 2000/(1+.15)² 1500/(1+.15)³ 1200/(1+.15)4
Net Present Value $489.01

 Earnings Multiplier

R Ltd. is having an issued and subscribed capital of 50,000 equity shares of Rs. 100 each fully paid up.
The company’s after tax profits for the year 2008-09 amounting to Rs. 30 lakhs. The average present stock
exchange price of the company’s share is Rs. 190. The Price/Earning ratio of the four listed companies to
be used for calculation, their type of business seems to be similar to R Ltd. are:

Company 2007 2008 2009

A Ltd. 5.7 6.3 7.1
B Ltd. 6.5 5.9 6.8
C Ltd. 7.4 6.8 7.0
D Ltd. 5.0 5.9 6.1
Calculate the valuation of business and per share based on average P/E ratio of the industry.
 Valuation Basics

Solution:
Calculation of P/E ratio of four listed companies

Company 2007 2008 2009 Company Average

A Ltd. 5.7 6.3 7.1 6.37
B Ltd. 6.5 5.9 6.8 6.40
C Ltd. 7.4 6.8 7.0 7.07
D Ltd. 5.0 5.9 6.1 5.67
Total = 25.51

25.51
Average P/E ratio = = 6.38
4
Profit after tax Rs. 28,00,000
Earnings per share = = = Rs. 56.00
No. of Equity Shares 50,000
Market price per share Rs. 190
P/E ratio of R Ltd. = = = 3.39
Earnings per Share Rs. 56
Value of Share = Earnings per Share × Average P/E ratio
= Rs. 56.00 × 6.38 = Rs. 357.28
Value of Business = Total Earnings × Average P/E ratio
= Rs. 30,00,000 × 6.38 = Rs. 1,91,40,000 lakhs.
 Market Capitalization

Particulars X Ltd. Y Ltd.

No. of Equity shares 10,00,000 6,00,000
Market price per share (Rs.) 30 18
Market Capitalisation (Rs.) 3,00,00,000 1,08,00,000