Valuation 企業評價模型 ( 估

值)
The Income Approach:
Discounted Cash Flow Analysis

林家振
台灣大學管理學院商學研究所
 Overview: The Basic DCF Formula

This turns into:

The fundamental time-value
relationship: CF1
CF0 =
CF0(1 + r) = CF1 (1 + r)
The fundamental DCF
where CF1 is risk-free and relationship.

r = risk-free rate of interest.

But business cash flows are risky.

We must adjust both the numerator
and the denominator of the DCF
formula.

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 Overview: The Generalized DCF Formula

Expected cash flows

General Formula for Future business cash flows, CF,
DCF Valuation of Risky are uncertain, so we discount expected
Business Assets cash flows, E(CF)

E (CF ) t
n
Present Value  
t  0 (1  k )
t

Time value and risk

Timing

We project cash flows in the future, The discount rate k represents the
discount them, and sum them all up equilibrium expected rate of return,
and contains a risk premium

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 Characteristics of a DCF Analysis

 Fundamental valuation elements (cash amount, timing and risk) are explicitly
estimated.

 Based on projections of future revenue, expense, investment and cash flow.

 Value of subject company =

PV of future free cash flows during the term of the projection period plus the terminal
value, discounted to present value by risk-adjusted rate of return (typically, the
weighted average cost of capital).

 Terminal value represents value of business beyond projection period.

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 Overview: Modeling a Business

Steps in a DCF Analysis

 Analyze the industry
 Analyze the subject company
 Forecast cash flows
 Calculate and apply discount rate
 Calculate a residual value
 Adjust the resulting value

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 Steps in a DCF Analysis

STEPS
 Determine relevant horizon for projections
 Explicit projection of cash flow
 Revenue
 Expense
 Capital Expenditures
 Add back depreciation & other non-cash expenses
 Subtract investments in working capital, capital
expenditures.

 Terminal Value
 Discount Rate
EXPLICIT PROJECTION HORIZON
 Shortest - 3 years
 Longest - 20 years or more
 Most - 5 - 10 years

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 Steps in a DCF Analysis

SET EXPLICIT PROJECTION HORIZON

 Start point = valuation date
 End point = ?
 Set terminal horizon at point where the business is plausibly a going concern, operating in a steady state.
 Shortest - 3 years
 Longest - 20 years or more
 Most - 5 - 10 years

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 Formulating Operating Projections

 Critical aspects to consider:

 Economic outlook (at valuation date)
 Industry outlook (ditto)
 Historical results, visible trends
 Strategic plans, competitors’ plans
 Capacity constraints
 Working capital requirements
 Capital expenditure requirements

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 Elements of Industry Analysis (M. Porter)
If you don’t understand the industry, you cannot understand the
subject company, no matter how elegant your numbers are!
1) Ease of Entry
Capital requirements Economies of scale
Distribution channels Brand loyalty
Cost advantages Government policy

2) Rivalry between existing competitors

Number of competitors Relative strength of competitors
Industry growth Product differentiation

3) Pressure from substitutes

Do substitutes have improving price-performance tradeoff with subject industry?
Are substitutes produced by industries earning high profits?

4) Bargaining power of buyers

Volume of purchases Profitability of buyer
Threat of backward integration Products impact on buyer’s business
Percentage of buyer costs that is represented by the product

5) Bargaining power of sellers

Relative size of supplier v. buyer Importance of the buyer to the seller
Switching costs Threat of forward integration
Degree of organization Government policy

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 Criticizing Projections: Beware of…

 Internal Inconsistency
 Strong revenue growth generally requires significant investment
 Start-ups generally have substantial working capital requirements
 Capital expenditures in mature companies tend to exceed depreciation
(never vice versa in perpetuity)
 Physical outputs should reconcile with physical inputs

 Nature of Cost Structure

 Position on supply curve: high- or low-cost producer?
 Fixed vs variable
 One time or extraordinary

 Inconsistency with historical results: “Hockey Stick” projections

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 Hockey Stick Projections

Historical & Projected Financial Results

60

50
historical projected

40

Revenue (millions) 30

20

10

0
Year 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Year

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 Normalization of Historical Financials

 Recent earnings performance generally provides a “base” for

the projections
 Adjustments can be made for:
 Accounting method (LIFO vs. FIFO)
 An excess/deficiency of net working capital
 The existence of non-operating assets
 Under-utilized productive capacity
 The existence of non-recurring items
 Excess executive compensation
 Other reasons

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 Levered vs. Debt-free Analysis

 For purposes of business valuation, cash flows are typically analyzed

on an enterprise, or debt-free basis.
 Calculate cash flows as if the company had no debt
 Projected interest expense is set at zero
 Projected taxes aren’t shielded by interest expense
 Cost of debt in discount rate (WACC) is computed on an “after-tax”
basis
 Alternatives:
 Adjusted Present Value (APV) approach: also uses debt-free cash
flows, but does not use WACC
 Discount equity (levered) cash flows at levered discount rate (the
cost of levered equity).

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 Matching Value with Income Stream

Discounting debt- Debt

free cash flows
using the WACC MVIC
gives the value of
the Enterprise (or (Business = Discounting levered
(after-interest expense)
MVIC) Enterprise cash flows by the cost
Value) of equity gives the
Equity value of Equity

Debt-free cash flows are also known as: Levered cash flows are also known as
Asset cash flows, enterprise cash flows equity cash flows

unlevered cash flows, free cash flows

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 Most CVC Engagements Utilize
Debt-free Analysis (Enterprise Value)

 Important point:
 When using a debt-free DCF approach (i.e. almost all the time),
remember that the present value of cash flows gives an
indicated value of the enterprise, or Total Capital or MVIC or
Business Enterprise Value.
 If you then want to determine the Market Value of Equity…
...you must subtract the PV of the subject company’s
debt.
 If you apply an unlevered discount rate (such as WACC) to
levered (equity) cash flows you will make egregious errors.
Similarly for applying a levered discount rate (cost of equity) to
debt-free cash flows.

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 Significant Variables in DCF Models:
“Value Drivers”

 A few critical economic variables can significantly affect value:

 Growth rates
 Operating margins
 Tax rates
 Discount rates
 Working capital requirements
 Capital expenditures
 Residual calculations

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Calculation of Debt-free Available Cash Flow
(also called Free Cash Flow)

 Revenue
- Operating Expenses (cash basis)
 EBIT
 - Taxes
 = Debt-Free Net Income
 + Depreciation, Amortization and Deferred Charges
 - /+ Change in Net Working Capital
 - Capital Expenditures
 = Available Cash Flow (Free Cash Flow)

 Note that projections are usually expressed in nominal, rather than real, terms.
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 Determination of Free Cash Flow

EBIT
 Represents the pretax income the company would have earned if it had no debt
 Generally computed as Revenues less COGS and SGA expenses.
 Often equal to the line "Operating Income" on the company's income statement.

Taxes on EBIT
 Represent income taxes attributable to EBIT on an unlevered basis
 Taxes should be stated on a cash basis (I.e., use tax depreciation & amortization)
 Resulting amount is debt-free (unlevered) net income, also referred to as Earnings Before Interest and
After Taxes ("EBIAT") or Net Operating Profit less Adjusted Taxes ("NOPLAT") or “EBIT after tax”

Non-Cash Addbacks
 Depreciation and Amortization (subtracted in computing EBIT)
 Other non-cash charges

Add/Subtract Change in Net Working Capital

 Represents the difference between a company's short term operating assets (accounts receivable and
inventories) and short term liabilities (accounts payable, accrued expenses)
 Does not include non-operating assets, excess marketable securities, or interest bearing liabilities
(short-term debt and current portion of long term debt)

Subtract Capital Expenditures

 On new and replacement property, plant and equipment
 Must be consistent with projections for depreciation

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 Present Value Factors

Present Value Factors perform the necessary discounting. They

can be calculated two ways.

1) PVF = 1/(1 + k)t (End-of-year convention)

2) PVF = 1/(1 + k) (t‑0.5) (Mid-year convention)

where k = discount rate
t = years from valuation date until end of
the particular year for which
discounting is being performed.
CVC typically uses the mid-year convention.

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 The Mid-period Discounting Convention

The mid-period discounting convention is appropriate when cash

flows are distributed evenly throughout the year.

Midpoint of remainder of Middle of Fiscal

2020 (11/15/20) Year 2021 (6/30/01)

9/30/20 12/31/20 12/31/21

For 2020 cash flows: t = 0.125: PVF = 1/(1+k)0.125

(t is half of the three months remaining in the year)

For FY 2021 cash flows:

t = 0.75: PVF = 1/(1+k)0.75

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 Sample Discounted Cash Flow Model

End of End of End of End of End of

Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $100 $125 150 165 173
% Growth N/A 25% 20% 10% 5%
Expense (85) (105) (126) (138) (144)
% of Revenue 85.0% 84.5% 84.0% 83.5% 83.0%
EBIT (using tax depreciation) 15 20 24 27 29
Tax (@ 40%) (6) (8) (10) (11) (12)
Debt-Free Net Income 9 12 14 16 17

Depreciation 10 14 12 8 7
Capital Expenditure (15) (12) (8) (8) (8)
Change in Working Capital (6) (5) (5) (3) (2)

Debt-Free Cash Flow (2) 9 13 13 14

Present Value Factor (k=15%)* 0.932 0.811 .705 .613 .533

PV of DFCF (1.9) 7.3 9.2 8.0 7.5

Sum of PV (Years 1-5) = $30

* PV Factor calculated as 1/(1+k) (year-0.5)

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 Estimation of Terminal Value

 Terminal value is also known as “residual value.”

 Represents value of the cash flows occurring after the explicit
projection period, i.e., beyond the terminal horizon.
 Capitalization of cash flow as a growing perpetuity (a.k.a. perpetuity
growth formula, Gordon growth model, etc.)
 Commonly expressed as: FCFt+1
Where: TVt =
k-g
FCFt+1 = “Normalized” Free cash flow in year t+1
g = assumed constant growth rate in
perpetuity k = discount rate (generally
WACC)
 The terminal value TVt still must be discounted back to present
value from the mid-point of the last year in the explicit projection
period (i.e., it receives the same factor as the final year’s cash flow).

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 Perpetuity growth model: FCF t+1
k-g

What is the appropriate numerator?

 “Normalized” residual annual free cash flow:
 Sales grow from the last projection period by the assumed
residual growth rate
 Operating margins are set at “normal” levels
 Capital expenditures should be adequate to sustain growth
 Net Working Capital investment should be adequate to
support sales growth
 Depreciation must have a sustainable relation with CAPX
 In effect, we are modeling a steady state with constant growth in
perpetuity.

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 Perpetuity growth model: FCF t+1
k-g

What is the appropriate denominator?

 The discount rate must reflect the riskiness of the cash flows in
the numerator.
 If WACC is used as the discount rate, it must incorporate the
steady-state capital structure and tax rate.
 The growth rate g may be negative (perpetual shrinkage).
 Note, though, that if g  k the expression yields nonsense.
 Check g for reasonableness by comparing to hard benchmarks:
 nominal GDP growth
 projected nominal growth for the industry
 the risk-free rate

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 Perpetuity Growth Model (cont.)

 If in the last year of the explicit forecast period…

 growth is the same as the assumed perpetual growth in the residual
period
 capital expenditures are adequate to sustain the assumed perpetual
growth rate
 working capital investment is adequate to sustain the assumed
perpetual growth rate
 …then the Perpetuity Growth Formula can be restated as...

FCFt (1+g)
k-g
where:
FCFt = Free cash flow in the last year of the explicit projection period
g = assumed growth in perpetuity
k = discount rate (WACC)

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 Normalizing Residual Cash Flows

 If in the last year of the explicit forecast period…

 Net Fixed Assets have a sustainable relation to sales
 Net Working Capital has a normal relation to sales

 …then the formula can be refined as follows:

 EBIT(1-t)(1+g) - g(NFA + NWC)

k-g where:

NFA = Net fixed assets in the last year of the projection period
NWC = Net working capital in the last year of the projection
period
 EBIT = EBIT in last year of the projection period

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 Growth as a Value Driver

Value = FCF / (k-g)

How does growth affect value (mathematically)?

 Higher growth means a lower denominator (k-g)
 Higher growth means a lower numerator (FCF) due to
higher required capital expenditures
 So does value go up or down with higher growth?
 Higher growth adds to value so long as the future capital
expenditures earn rates of return that are higher than the
required rate of return on the investments. In other words,
future CAPX has NPV>0.

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 McKinsey’s Value-Driver Model

(See Copeland et al., Valuation, Appendix A)

Value equals...
NOPAT(1-g/r)
k-g
where:
NOPAT = “normal operating profit after taxes”
= EBIT less cash taxes
r = expected rate of return on new investment

If k = r … then Terminal Value = NOPAT

k
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 PwC Value Driver Model

A restatement of the Value Driver Model. Value equals...

NFCF [1 - (g-inflation) / (r-inflation)]

k-g where:

NFCF = “normalized” free cash flow (with CAPX and

NWC investment to sustain growth at the
rate of inflation)
inflation = expected rate of inflation in perpetuity

If k = r … then Terminal Value = NFCF / (k-inflation)

i.e. Perpetuity Growth Model with growth = inflation

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 Depreciation in the Steady State

 A common assumption is to set depreciation equal to capital

expenditures in the residual period. This is often reasonable though not
precisely accurate. It is dangerous in high-inflation environments.

 If capital expenditures grow over time (even if only due to inflation) then
depreciation should be less than capital expenditures in a steady state.
Depreciation = w * Capital Expenditures
where w = the steady state ratio of tax depreciation to capital spending.
With straight-line tax depreciation: w = [1‑(1/(1+ g) n)]/gn
where g is the growth rate and n is the original tax life of fixed assets.
With MACRS depreciation and multiple asset lives, the relationship is
more complicated but can be calculated with a spreadsheet.

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 Are Your Results Reasonable?

One can check reasonableness of DCF value by analyzing

implied multiples of earnings (EBIT, EBITDA, NI, etc.)

Ace Plumbing Inc. 6 x EBIT

Best Pipe Co. 9 x EBIT
Chicago Plumbing Supplies 7 x EBIT
DCF value of Dad’s Plumbing Co. 30 x EBIT

… you have some explaining to do!

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 Applicability of the DCF Approach

 Use when credible financial projections are available or can be formulated...

 When future performance is more indicative of value than past/present results...

 For specialized business with few (if any) publicly traded comparables…

 For start-up or turnaround operations (but pay attention to financing

requirements implied by projections).

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 Limitations of DCF Analysis

 The analysis is only as good as the projections ("Garbage In - Garbage Out"). Management
is sometimes invested in biased projections.

 Requires substantial information.

 Performs poorly (relative to certain other techniques) when applied to businesses with lots
of real options (e.g. biotech R&D).

 Tendency to start "believing" the model, especially when clients seek to integrate
projections with budgets.

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 Special Considerations in Applying DCF

FIRMS IN FINANCIAL DISTRESS

 Value the firm rather than the equity. Firms get into distress often because
they have too much debt. Equity may represent option value.

 Use liquidation value if the distress is terminal. Both the market and the
income approach are conditioned on a "going concern" value

FIRMS WITH PRODUCT OPTIONS

 Some assets (patent, copyright, product concept), which are valuable, but
are not expected to produce cash flows currently or in the near future.
Solutions:

value product options separately and add to DCF value

use a higher growth rate (can be treacherous in perpetuity).

use an option-pricing model

consult market approach indications of value

Source: Damodaran, Aswath "Security Analysis for Investment and Corporate Finance"
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 Multiple scenarios in DCF Analysis

 Sometimes use multiple explicit scenarios, e.g….

 High case (25% probability)
 Base case (50% probability)
 Low case (25% probability)
But note that cash flows and discount rates must be carefully
conditioned on the scenario.
 Simulation methods
 Thousands of scenarios generated by randomization of key value
drivers
 Crystal Ball, @RISK are commercial simulation packages
 DPL (a product of CVC’s ADA practice) employs decision trees.

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 Sophisticated Sensitivity Analysis:
Business Case Revenue Review (BCR2)

 Led by revenue forecasting experts in the ADA practice

 Provides a comprehensive review of the assumptions, models, and
logic underlying the revenue forecast
 Provides a risk profile, not just a point estimate
 Explores forecasting issues likely to be relevant to that market, with
the intent to identify missing/hidden assumptions
 Compares forecasts to comparables or benchmarks (when available)
 Examines future scenarios, brainstorms strategic alternatives, and
identifies key uncertainties that could significantly affect the revenue
stream
 Conducts interviews to validate assumptions and quantify
uncertainties

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 BCR2: Quantifying Revenue Uncertainty

2000
1800
1600
1400
Revenue

1200
1000
800
600
400
200
0
2002
2003

2004
2005
2006

2007
2008

2009
2010

2011
2012

2013
2014
2015

2016
2017
10th percentile 50th percentile 90th percentile

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 BCR2:
Risk Profile and Expected Value

100%

90%
P
r 80%

o
70%
b
a
60%
b
i
50%
l
i 40% There is approximately Expected Value
t a 13% chance that the $37,500,000
y 30%
value is below $0

20%

10%

0%
-$60,000 -$40,000 -$20,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

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