This action might not be possible to undo. Are you sure you want to continue?

K.VISWANATHAN

4/10/2011

1

**The Key Inputs in DCF Valuation
**

Discount Rate Cost of Equity, in valuing equity Cost of Capital, in valuing the firm Cash Flows Cash Flows to Equity Cash Flows to Firm Growth (to get future cash flows) Growth in Equity Earnings Growth in Firm Earnings (Operating Income)

4/10/2011 2

I. Discount Rate

4/10/2011

3

**Estimating Inputs: Discount Rates
**

Critical ingredient in discounted cash flow valuation. Errors in estimating the discount rate or mismatching cash flows and discount rates can lead to serious errors in valuation. At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cash flow being discounted. Equity versus Firm: If the cash flows being discounted are cash flows to equity, the appropriate discount rate is the cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal

4/10/2011 4

on the other hand. A risk and return model. if the objective is to find out if an asset is correctly valued. There are two approaches to estimating the cost of equity. It cannot be used in valuation.Cost of Equity The cost of equity is the rate of return that investors require to make an equity investment in a firm. a risk and return model The dividend growth model (which specifies the cost of equity to be the sum of the dividend yield and the expected growth in earnings) is based upon the premise that the current price is equal to the value. a dividend-growth model. tries to answer two questions: How do you measure risk? How do you translate this risk measure into a risk premium? 4/10/2011 5 .

only market risk will be rewarded and priced 4/10/2011 6 . Thus. 2. Risk averages out across investments in portfolio Market Risk Risk that affects all investments (Market Risk) Cannot be diversified away since it affects most assets The marginal investor is assumed to hold a diversified portfolio.Risk and Return Models Step 1 : Defining Risk : The risk in an investment can be measured by the variance in actual returns around an expected return Step 2: Differentiating between Rewarded and Unrewarded Risk Specific Risk Risk that is specific to investment (Firm Specific) Can be diversified away in a diversified portfolio . 1. Each investment is a small proportion of portfolio.

Everyone will hold this market portfolio Market Risk = Risk added by any investment to the market portfolio: The APM If there are no arbitrage opportunities then the market risk of any asset must be captured by betas relative to factors that affect all investments. Market Risk = Risk exposures of any asset to macro economic factors. differences in returns across long periods must be due to market risk differences. Looking for variables correlated with returns should then give us proxies for this risk. Market Risk = Captured by the Proxy Variable(s) Equation relating returns to proxy variables (from a Regression) 7 Beta of asset relative to Betas of asset Market portfolio (from a relative to regression) unspecified market factors (from a factor analysis) 4/10/2011 Betas of assets relative to specified macro economic factors (from a Regression) .Risk and Return Models Step 3: Market Risk The CAPM If there is 1.factor Models Since market risk affects most or all investments. Proxy Models In an efficient market. it must come from macro economic factors. no private information 2. no transactions cost the optimal diversified portfolio includes every traded asset. Market Risk = Risk exposures of any asset to market factors Multi.

. Above Average risk investment b < 1 .. Average risk investment > 1 .Beta s Properties Betas are standardized around one... Below Average risk investment = 0 ... Riskless investment The average beta across all investments is one 4/10/2011 8 . If = 1 ...

price/book value) seem to explain differences in returns better.Firm may have changed during the 'estimation' period' 3.If the model is right.Limitations of the CAPM 1. The model makes unrealistic assumptions 2. The reality is that the relationship between betas and returns is weak Other variables (size. The model does not work well . The parameters of the model cannot be estimated precisely . 4/10/2011 9 .Definition of a market index . there should be a linear relationship between returns and betas the only variable that should explain returns is betas 4.

two conditions have to be met There has to be no default risk. however. There can be no uncertainty about reinvestment rates. Note. since it has no default risk The Risk Free Rate: On a risk free asset. which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed. For an investment to be risk free. to have an actual return be equal to the expected return. which generally implies that the security has to be issued by the government.Bill). i. 4/10/2011 10 .e. there is no variance around the expected return. the actual return is equal to the expected return. Risk free Rate in Valuation The correct risk free rate to use in a risk and return model is a short-term Government Security rate (eg.Inputs required to use the CAPM (a) the current risk-free rate (b) the expected return on the market index and (c) the beta of the asset being analyzed. that not all governments can be viewed as default free. Therefore.. since it has no default risk or price risk a long-term Government Security rate. T.

the present value effect of using time varying risk free rates is small enough that it may not be worth it.the 1 year zero coupon rate for the cash flow in year 2. Theoretically. this translates into using different risk free rates for each cash flow .Risk free Rate in Practice The risk free rate is the rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed.. Practically speaking.. if there is substantial uncertainty about expected cash flows. 4/10/2011 11 . the 2-year zero coupon rate for the cash flow in year 2 .

For short term analysis.The Bottom Line on Risk free Rates Using a long term government rate (even on a coupon bond) as the risk free rate on all of the cash flows in a long term analysis will yield a close approximation of the true value. approximately. If the analysis is being done in real terms (rather than nominal terms) use a real risk free rate. which can be obtained in one of two ways from an inflation-indexed government bond. it is entirely appropriate to use a short term government security rate as the risk free rate. 4/10/2011 12 . to the long term real growth rate of the economy in which the valuation is being done. if one exists set equal.

to the long term real growth rate of the economy in which the valuation is being done. For short term analysis. approximately. 4/10/2011 13 .The Bottom Line on Risk free Rates Using a long term government rate (even on a coupon bond) as the risk free rate on all of the cash flows in a long term analysis will yield a close approximation of the true value. it is entirely appropriate to use a short term government security rate as the risk free rate. If the analysis is being done in real terms (rather than nominal terms) use a real risk free rate. which can be obtained in one of two ways from an inflation-indexed government bond. if one exists set equal.

this premium should be greater than zero increase with the risk aversion of the investors in that market increase with the riskiness of the average risk investment 4/10/2011 14 . As a general proposition. relative to the risk free rate.Measurement of Risk Premium The risk premium is the premium that investors demand for investing in an average risk investment.

the risk premium would be a weighted average of the risk premiums demanded by each and every investor. you would expect the equilibrium premium to increase. 15 .Risk Aversion & Risk Premium If this were the capital market line.. Estimating Risk Premiums in Practice We may survey investors on their desired risk premiums and use the average premium from these surveys. Thus. Warren Buffet s risk aversion counts more towards determining the equilibrium premium than yours and mine. We may assume that the actual premium delivered over long time periods is equal to the expected premium . As investors become more risk averse. use historical data 4/10/2011 We may estimate the implied premium in today s asset prices.i.e. The weights will be determined by the magnitude of wealth that each investor has.

even the longest surveys do not go beyond one year 4/10/2011 16 . In practice. The limitations of this approach are: there are no constraints on reasonability (the survey could produce negative risk premiums or risk premiums of 50%) they are extremely volatile they tend to be short term. this translates into surveys of money managers expectations of expected returns on stocks over the next year. However. you can survey a few investors (especially the larger investors) and use these results.The Survey Approach Surveying all investors in a market place is impractical.

Present etc. 1965. (The risk aversion may change from year to year. but it reverts back to historical averages) it assumes that the riskiness of the risky portfolio (stock index) 4/10/2011 17 has not changed in a systematic way across time. this approach does the following it defines a time period for the estimation (1945-Present. The Historical Premium Approach . This is the default approach used by most to arrive at the premium to use in the model In most cases.) it calculates average returns on a stock index during the period it calculates average returns on a riskless security over the period it calculates the difference between the two and uses it as a premium looking forward The limitations of this approach are: it assumes that the risk aversion of investors has not changed in a systematic way across time.

the dividends on the index and expected growth rate will yield a implied expected return on stocks. Subtracting out the risk free rate will yield the implied premium. For instance. if stock prices are determined by the simple Gordon Growth Model: Value = Expected Dividends next year/ (Required Returns on Stocks .Expected Growth Rate) Plugging in the current level of the index.Implied Equity Premiums If we use a basic discounted cash flow model. The problems with this approach are: the discounted cash flow model used to value the stock index has to be the right one. we can estimate the implied risk premium from the current level of stock prices. the inputs on dividends and expected growth have to be correct it implicitly assumes that the market is currently correctly valued 4/10/2011 18 .

4/10/2011 19 . and measures the riskiness of the stock.Estimating Beta The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm)-Rj = a + b Rm where a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock.

Measuring Cost of Capital It will depend upon: (a) the components of financing: Debt. Equity or Preferred stock (b) the cost of each component In summary. WACC = ke (E/(D+E)) + kd (D/(D+E)) 4/10/2011 20 . the cost of capital is the cost of each component weighted by its relative market value.

It will depend upon three components(a) The general level of interest rates (b) The default premium (c) The firm's tax rate 4/10/2011 21 .The Cost of Debt The cost of debt is the market interest rate that the firm has to pay on its borrowing.

. The cost of debt is the rate at which the company can borrow at today corrected for the tax benefit it gets for interest payments.What the cost of debt is and is not.Tax rate) The cost of debt is not the interest rate at which the company obtained the debt it has on its books. 4/10/2011 22 . Cost of debt = kd = Interest Rate on Debt (1 .

If the firm is not rated. use the interest rate on the borrowing or estimate a synthetic rating for the company. use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. and use the synthetic rating to arrive at a default spread and a cost of debt The cost of debt has to be estimated in the same currency 4/10/2011 as the cost of equity and the cash flows in the valuation. If the firm is rated. 23 . and the bonds are traded. the yield to maturity on a long-term.Estimating the Cost of Debt If the firm has bonds outstanding. and it has recently borrowed long term from a bank. straight (no special features) bond can be used as the interest rate.

Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses 4/10/2011 24 . In its simplest form.

There are two solutions: Assume book value of debt is equal to market value Estimate the market value of debt from the book value 4/10/2011 25 .Estimating Market Value Weights Market Value of Equity should include the following Market Value of Shares outstanding Market Value of Warrants outstanding Market Value of Conversion Option in Convertible Bonds Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt.

Mechanics of Cost of Capital Estimation 1. Calculate the effect on Firm Value and Stock Price. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. Estimate the Cost of Capital at different levels of debt 4. 2. 3. Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Cost of Equity will increase. 4/10/2011 26 .

Estimating Cash Flows 4/10/2011 27 .II.

it will cover some of these expenditures. Increasing working capital needs are also investments for future growth If looking at cash flows to equity. look at earnings after interest expenses -i.Steps in Cash Flow Estimation Estimate the current earnings of the firm If looking at cash flows to equity.e. look at operating earnings after taxes Consider how much the firm invested to create future growth If the investment is not expensed.debt repaid) 4/10/2011 28 . To the extent that depreciation provides a cash flow. net income If looking at cash flows to the firm. it will be categorized as capital expenditures. consider the cash flows from net debt issues (debt issued .

Earnings Checks When estimating cash flows. we invariably start with accounting earnings. it may be necessary to normalize the earnings. it is worth considering the following questions: Are basic accounting standards being adhered to in the calculation of the earnings? Are the base year earnings skewed by extraordinary items profits or losses? (Look at earnings prior to extraordinary items) Are the base year earnings affected by any accounting rule changes made during the period? (Changes in inventory or depreciation methods can have a material effect on earnings) Are the base year earnings abnormally low or high? (If so. To the extent that we start with accounting earnings in a base year.) How much of the accounting expenses are operating expenses and how much are really expenses to create future growth? 4/10/2011 29 .

Revenues . Revenues. Equity Invested-Return on equity= Net Income 4/10/2011 30 . Revenues . Capital Invested.Operating Margin= Operating Income 3.Net Margin= Net Income 3.taxes = Net Income 2.Operating Expenses = Taxable Income.Three Ways to Think About Earnings 1.Pre-Tax ROC= Operating Income Capital Invested = Book Value of Debt + Book Value of Equity Pre-tax ROC = EBIT / (Book Value of Debt + Book Value of Equity) The equity shortcuts would be as follows: 1. Revenues -Operating Expenses= Operating Income 2. Taxable Income.

using a model that focuses only on dividends will under state the true value of the equity in a firm. 4/10/2011 31 . the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock.Dividends and Cash Flows to Equity In the strictest sense. Actual dividends. however. are set by the managers of the firm and may be much lower than the potential dividends (that could have been paid out) managers are conservative and try to smooth out dividends managers like to hold on to cash to meet unforeseen future contingencies and investment opportunities When actual dividends are less than potential dividends.

new debt issues) The common categorization of capital expenditures into discretionary and non-discretionary loses its basis when there is future growth built into the valuation. where earnings are discounted back to the present. This cannot be true for several reasons: Earnings are not cash flows. a firm that paid its earnings out as dividends would not be investing in new assets and thus could not grow Valuation models. will over estimate the value of the equity in the firm The potential dividends of a firm are the cash flows left over after the firm has made any investments it needs to make to create future growth and net debt repayments (debt repayments . 4/10/2011 32 .Measuring Potential Dividends Some analysts assume that the earnings of a firm represent its potential dividends. since there are both non-cash revenues and expenses in the earnings calculation Even if earnings were cash flows.

There are anomalies in the way in which this principle is applied. Research and development expenses are treated as operating expenses. Operating expenses are netted against revenues to arrive at operating income. operating expenses are expenses that create earnings only in the current period. This depreciation and amortization expense is a noncash charge when it does occur. are depreciated or amortized over their estimated life. The net cash flow from capital expenditures can be then be written as: Net Capital Expenditures = Capital Expenditures .Depreciation 4/10/2011 33 . Capital expenditures. .Measuring Investment Expenditures Accounting rules categorize expenses into operating and capital expenses. while not shown as operating expenses in the period in which they are made. when they are in fact designed to create products in future periods. In theory. whereas capital expenses are those that will create earnings over future periods as well.

short term debt and debt due within the next year) A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) Any investment in this measure of working capital ties up cash. the working capital is the difference between current assets (inventory. it is important to forecast the effects of such growth on working capital needs.The Working Capital Effect In accounting terms. 4/10/2011 34 . cash and accounts receivable) and current liabilities (accounts payables. When forecasting future growth. Therefore any increases (decreases) in working capital will reduce (increase) cash flows in that period. and building these effects into the cash flows.

Capital Expenditures .Preferred Dividends .Estimating Cash Flows: FCFE Cash flows to Equity for a Levered Firm Net Income + Depreciation & Amortization = Cash flows from Operations to Equity Investors .Principal Repayments + Proceeds from New Debt Issues = Free Cash flow to Equity 4/10/2011 35 .Working Capital Needs (Changes in Non-cash Working Capital) .

Estimating Growth 4/10/2011 36 .III.

Look at fundamentals Ultimately. all growth in earnings can be traced to two fundamentals . It is useful to know what their estimates are. and what returns these projects are making for the firm. 4/10/2011 37 .how much the firm is investing in new projects.Ways of Estimating Growth in Earnings Look at the past The historical growth in earnings per share is usually a good starting point for growth estimation Look at what others are estimating Analysts estimate growth in earnings per share for many firms.

I. the following factors have to be considered how to deal with negative earnings the effect of changing size 4/10/2011 38 . Historical Growth in EPS Historical growth rates can be estimated in different ways Arithmetic versus Geometric Averages Simple versus Regression Models Historical growth rates can be sensitive to the period used in the estimation In using historical growth rates.

Most of this time. is spent forecasting earnings per share in the next earnings report While many analysts forecast expected growth in earnings per share over the next 5 years. the analysis and information (generally) that goes into this estimate is far more limited. a significant proportion of an analyst s time (outside of selling) is spent forecasting earnings per share. 4/10/2011 39 .II. in turn. Analyst Forecasts of Growth While the job of an analyst is to find under and over valued stocks in the sectors that they follow.

Fundamental Growth Rates (1) Investment in existing project=Rs.III. 132 (3) Investment in existing project=Rs. 1000 X change in the ROI from current period to next period (say 0%) + Investment in new project = Rs. 1000 X Next period s return on investment ( say 12%) + Investment in new project = Rs. 12 4/10/2011 40 . 100 X Return on investment of new project ( Say 12%) = Next Period s earnings = Rs. 100 X Return on investment of new project ( Say 12%) = Change in earnings = Rs. 120 (2) Investment in existing project=Rs. 1000 X Current return on investment on projects ( say 12%) = Current earnings Rs.

the expected growth rate will be 4/10/2011 41 .Growth Rate Derivations Reinvestment Rate x Return on investment = Growth rate in earnings 83.33 % X 12% = 10 % If the ROI increases from 12% to 13%.

IV. Growth Patterns 4/10/2011 42 .

4/10/2011 43 . the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r g) Where.Stable Growth and Terminal Value When a firm s cash flows grow at a constant rate forever. When they do approach stable growth. the valuation formula above can be used to estimate the terminal value of all cash flows beyond. r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. they will all approach stable growth at some point in time. While companies can maintain high growth rates for extended periods.

at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) Stable Growth 2-Stage Growth 3-Stage Growth 4/10/2011 44 . at the end of which the growth rate will drop to the stable growth rate (2-stage) there will be high growth for a period. In general. we can make one of three assumptions: there is no high growth. in which case the firm is already in stable growth there will be high growth for a period. and the pattern of growth during that period.Growth Patterns A key assumption in all discounted cash flow models is the period of high growth.

which. As firms become larger. it becomes much more difficult for them to maintain high growth rates Current growth rate While past growth is not always a reliable indicator of future growth. 45 4/10/2011 . how long they will stay up and how strong they will remain. a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now. Barriers to entry and differential advantages Ultimately. comes from barriers to entry and differential advantages. The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are. Thus. in turn. there is a correlation between current growth and future growth. high growth comes from high project returns.Determinants of Growth Patterns Size of the firm Success usually makes a firm larger.

Model DDM High Growth Firms usually 1. Have high net capex 2. Have high risk 3. Have lower net capex Have average risk Earn ROC closer WACC Have leverage closer to industry average 4/10/2011 46 . Earn high ROC 1. Earn high ROC 4. the firm should be given the characteristics of a stable growth firm. Pay low or no dividends 2. Have high Risk 3. 2.how much it reinvests and how high its project returns are. As growth rates approach stability . Have low leverage Stable growth firms usually 1. 3. Pay high dividends 2.Stable Growth and Fundamentals The growth rate of a firm is driven by its fundamentals . Have average risk FCFE/ FCFF 1. 4.

Discounted Cash Flow Valuation Inputs THANK YOU 4/10/2011 47 .

- Mozal Finance EXCEL Group 15Dec2013
- Risk Managemnet
- frbsf_let_19900413.pdf
- Time Value ,Risk and Return
- The Long Run, In the Short Term _ Macro Strategy Update
- Predictions 2011
- Risk & Return
- Chapter 9.10
- 66457_1980-1984
- Investment Checklist[1]
- Case No. 1 BWFM5013
- WS Chad Cameroon
- Survey on Investment behavior
- Finl Analysis
- Fm Project
- Is Economic Growth Good for Investors
- boeckh
- Financial Stability Report 2014 - Reserve Bank
- Indian Economy
- 10 Things to Look for When Investing
- International Project Appraisal
- FPA Capital - Commentary March 2011
- forrestal_19890111.pdf
- Working capital management
- LFM Commentary April 2010
- Hse Lecture III (May 23, 2011) Basel i and Basel II (1)
- AIRBUS A3XX Ivon Ike Tonny via Irma Ronald
- Economic Recovery Fact or Mirage
- 19571105jec_fedexpenditure_duesenberry
- 11th Five Year Plan
- Discounted_Cash_Flow_Valuation_-Inputs-_PPT

Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

We've moved you to where you read on your other device.

Get the full title to continue

Get the full title to continue reading from where you left off, or restart the preview.

scribd