Cash Flow Method

Overview of DCF

Issues in DCF

CA. Pinkesh Billimoria

17th September 2011

Table of contents

Objective

Valuation in General

Valuation Approach & Methodologies

Discounted Cash Flow (DCF) – Demystified

Wrap Up

2 DCF

Objective

3

Objective

Discussing and understanding the

technique of Discounted Cash Flow

Valuations.

Practical Insight from an operational

perspective of the key issues & factors

that one could consider for the

DCF.

4

Valuation in General

5

Valuation – Principles

6 DCF

Extent of

control

Timing Basis

Context

Principles

Value different

from Price

What is being valued

Why it is being valued

Secure definition of “value” Valuation is relative to

a specific point in time

Going concern vis-à-vis

liquidation

Premium for control,

efficiency and synergy

Valuation – Principles

Valuation is not just a science, but an

art. Though quantitative in nature, the

valuation methods require inputs that

are based on subjective judgment.

Hence, any preconception or bias of

the analyst is reflected in the value.

Value of any asset will depend on the

earnings / cashflows that it is expected

to generate in the future – forward

looking

7 DCF

Valuation is not just a

SCIENCE, but an ART

Value not a precise estimate, always in a range

Valuation Approach &

Methodologies

8

Valuation Approach & Methodologies

9 DCF

Asset based

valuation

Net Asset (book) value

Net Asset Value -

Adjusted

Market multiples

Recent market

transactions

Market based

valuation

Valuation

methods

Discounted Cash flow

Capitalisation of earnings

Earnings based

valuation

Net Asset Value -

Replacement

Liquidation value

Market price

More than one right

way to value

Approaches are not

exclusive; but

complement

each other

Discounted Cash Flow

Methodology

- Demystified

10

Income Approach – Discounted Cash Flow (DCF)

The DCF Method is based on the premise that the value of the

business / enterprise / asset is the present value of the future

economic benefits / income (i.e) cash flows to be derived by the

owners of the business. This method analyses discretely three

factors which directly determine value

The amount of cash expected to be generated;

The timing of the cash flow; and

The riskiness of the projected cash flows

This method entails review of the projections - analysis of

revenues, expenses, working capital investments, capital

expenditures and asset efficiency, capital structure

11 DCF

DCF – Usage Rationale

DCF Methodology is the most scientific method and one of the

most rigorous approaches for the valuation of a business

Value of any asset / business will depend on the earnings / cash

flows that it is expected to generate in the future.

Investors assign value based on the cash flow they expect to

receive in the future in the form of .

Dividends / Distributions

Proceeds on Sale / Liquidation proceeds of Investments

In this technique the projected free cash flows from business

operations are discounted back to the present value at the

investors rate of return expectation and the sum of such

discounted free cash flows is the value of the business / equity /

asset. 12

DCF

DCF Methodology – Imperative Usage

Merger & Acquisition Transactions

Strategic Implications – Control Valuations

Valuation for Synergy Benefits available to the specific purchaser

Start up Ventures – Fledglings.

Companies / Businesses with Negative earnings.

Companies / Businesses engaged in extractive industries – depleting

assets with limited life – Mines.

Companies / Businesses with PPAs, BOOT / BOT Agreements

Unique Business Models – Absence of Listed Comparable Companies

Intangibles such as Brand / Trademarks / Customer contracts etc.

Valuation of Companies undergoing financial reengineering / debt

restructuring – Post money valuations.

Liquidation cases – phased out disposal of assets

13 DCF

DCF Valuation – the key terms

14 DCF

• Valuation Date

• Projections & Free Cash

Flows

• Free Cash Flows to

the Firm (FCFF)

• Free Cash Flows to

Equity (FCFE)

• Discrete Period

• Terminal Period

• Terminal Value /

Continuity Value

• Terminal Growth Rate

• Discount Rate

• Sensitivities / Scenarios

• Cash Accrual Timing Factor

– Present Value Factor

• Exit Multiples

Key terms

DCF – Valuation & Cash Flow Approaches

15 DCF

Enterprise Value

Equity Value

Value of Business

Value of Equity

Free Cash Flows to the

Firm (FCFF)

• Most Commonly used

• Discount rate –

Weighted Average Cost

of Capital`

Free Cash Flows to

Equity (FCFE)

• Less Commonly used

• Relevant for Financing

Companies, Complex

capital structures

• Discount rate – Cost of

Equity

Equity Value

Free Cash Flows – FCFF

16 DCF

= PAT (Profit after Tax)

PLUS

NON-CASH ITEMS

(DEPRECIATION, AMORTIZATION,

DEFERRED TAX ENTRIES)

INVESTMENT IN

INCREMENTAL WORKING CAPITAL

CAPITAL ASSETS & INVESTMENTS

MINUS

FREE CASH FLOWS TO THE FIRM

Overcoming the impact of capital structure on the

business value

INTEREST *(1-Tax Rate)

PLUS

DCF – Value & Components

17 DCF

VALUATION DATE

DISCRETE PERIOD TERMINAL PERIOD

Represents the Present Value

of all free cash flows beyond

the forecast period

Years one through ..n TERMINAL VALUE

Present value of free cash flows

calculated based on the Projections

for the discrete period by using an

appropriate Discount Rate.

Terminal value of the Terminal

period based on

• the market,

• Asset, or

• Income approach

Operating Business / Enterprise Value = PV (Discrete Period) +

Terminal Value

Free Cash Flows – a few pointers

18 DCF

• Projections primarily belong to the Management, should be corroborated with past data / industry data / research reports.

• Exclusion of non recurring items of income and expenditure relevant from a Terminal Value Calculation.

• Nominal / real

• Accounting GAAP consistency – past and projected

• Interest / investment income on surplus funds should be excluded from the profits to be considered for cash flows as the investments will generally be separately considered in the valuation.

Pointers

The Valuers Questions & Counter

19 DCF

THE VALUER’S COUNTER

Discuss issues to make necessary adjustments in order to make projections

more reasonable.

Different scenarios are built up to study the sensitivity and changes in income

& expense & profitability.

Forecasting

Free Cash

Flows – The

Valuers

Questions

Whether the assumptions consider realistic growth of the

industry and the company’s market share?

Whether the company intends to venture into new lines of

businesses?

Whether the company plans to expand its existing

infrastructure?

Are the assumptions sketched: Reasonable?

Comparable in relation with the past trend of the company / industry / peer group?

Whether growth in different heads of expenses is

reasonable and correlated to the growth in revenues /

operations where applicable?

Discrete Period – a few pointers

Discrete Period –

usually several

years since the

Valuation Date

20 DCF

Pointers

Length of discrete period – determining

factors

Steady state performance

Generally covers a business cycle of 3 to 5 years

Project businesses / agreement based business -

the entire period of the life of the project /

agreement.

Depleting resources (Mines) – the entire period

of the life of the resources available for

extraction.

Commodity cycle – 5 to 7 years – discreet period

should cover the entire average length of the

commodity cycle.

Terminal Period

Businesses potentially have an infinite life. The value of a

Business is the present value of

cash flows forever

Since we cannot estimate cash flows forever, we estimate cash flows for the

discrete period and then estimate a

terminal value, to capture the value at

the end of the discrete period

The period beginning at the

end of the discrete period

and continuing to infinity is the

terminal period

Once the business reaches a steady state – determines the

beginning of the terminal period

21 DCF

Business / Company

grows at a constant rate

Reinvests a constant

proportion of its

operating profits into

business

Earns a constant return

on it base level of

invested capital

DCF

Terminal Value

22

Asset

Ap

pro

ach

Income

Approach

Growth

Inco

me

Ap

pro

ach

Co

nverg

en

ce

Market Approach

T V

- Capitalization of earnings

(exit multiple)

- Assets – Regulated asset /

net tangible asset base.

- General Industry Rules of

Thumb (% of AUM)

‒ Liquidation / realization of

assets – based on

forecast balance sheet.

‒ Generally more useful

when assets are

separable and

marketable / more liquid

in nature.

‒ Continuing value formula such as

perpetuity formula using the

convergence approach or the growth

model – judgmental call on case to

case basis.

Growth – Capitalisation of the free

cash flows after considering a

terminal growth rate (WACC – g)

Convergence – Steady

state capitalisation of

NOPLAT (Net operating

profit (EBIT) less

adjustments for taxes)

Terminal Growth Rate – Key Considerations

23

Key Considerations

Natural limits (e.g.

demographics, market share)

Product life cycle / market stage

GDP growth (cannot

exceed long term GDP

growth indefinitely) Capital

expenditure – benefits not

fully captured in the

projections

Optimum Capacity / Potential utilisation

Has the company reached a

steady state.

Discount Rate – Definition

24 DCF

In the context of a business valuation, the discount rate is the rate of

return that would be required by an investor to purchase the stream

of expected benefits (e.g. future cash flows), given the risk of

achieving those benefits

The discount rate is used to determine the amount an investor would

pay today (present value) for the right to receive an anticipated

stream of payments (e.g., cash flows) in the future.

What discount rate is used depends on the type of the “income”

stream

Discount Rate – WACC

25 DCF

Capital Asset Pricing Method

• The main components of the Discount Rate will be

− Cost of Debt (Kd)

− Cost of Equity Capital (Ke)

WACC = [D / (D+E) * Kd * (1-t)] + [E / (D+E) * Ke]

Discount rate to reflect weighted share of Equity

& Debt in the Capital

Discount Rate – Cost of Equity

26 DCF

Ke = Rf + (Rm-Rf) * β + SCRP

Risk

Free

Rate

Beta (β)

Equity

Market

Risk

Premium

Specific

Company

Risk

Premium

(Alpha)

Capital Asset Pricing Method

Discount Rate – A few Pointers

Buyer’s Discount Rate

Seller’s Discount Rate

Normative Discount Rate

27 DCF

Interpretation of Discount Rates

DCF

Enterprise to Equity Value – Final Adjustments

28

Non-

operating

assets

Surplus

Assets

Value

of

EQUITY

Contingent

Liabilities

+

Equity

Dilutants

Non

Convertible

Debt

+

Redeemable

Preference

Capital

Enterprise Value

= Present value of

Free Cash Flows

for the Explicit

Period

+ Terminal Value

+ Post Explicit Tax

Benefits

The DCF model results in the value of a 100% ownership in the business

A range of values can be developed by sensitizing the forecast or the WACC

+ - = -

DCF

The Closing pointers

29

Projections,

Discount Rate

Terminal growth rate

Sensitivity / Scenario Analysis

Reasonableness of the Implied Multiples (historical) & the Exit multiple (terminal value)

Industry benchmarks

Analyst expectations

Relative benchmarks

Valuation Cross

checks

Keeping in mind the various sensitivities and cross checks

Conclusion on Range of Values

– A well accepted practice

DCF

FEMA Valuations – Inbound (FDI)

30

Issue

Transfer

Resident Non-resident

The DCF value so arrived will be

the minimum price at which the

transfer can take place

Resident Non-resident

The DCF value so arrived will be

the maximum price at which the

transfer can take place

Transfer

Non-resident Non-resident

Convertible Instruments –

conversion formula

Transfer

Buyback

Not applicable

Rights

issue

DCF Valuation – Some pitfalls

Garbage IN Garbage OUT

Projections – Management’s biased perception

Risk of Achievability of projections

Discount rate & Terminal value – Subjective matters more based on each

Valuer’s Judgmental call

Not Directly linked to the Market

Generally gives a control value - Subjective discounting for minority value

31

Conclusions

32 DCF

DCF - Disadvantages

• Projections – biased

perception (Subjectivity)

• Achievability of projections

• Discount rate

• Terminal Value

DCF - Advantages

• Considers Cashflow

• Considers Present value

• Considers additional capex,

working capital

• Permits sensitivity /

scenarios

Final recommendation – common sense & reasonableness

33

34

Thank You

This document discusses various methods and process of valuation. The style contained herein is intended to make aware the valuation process in relation to general issues and concerns. The approach might be different in light of specific issues that are in nature different in context and character. Further, the information contained in this document is intended only to provide a perspective on valuation methods and the process followed in relation to such and related engagements. It should be in no way construed to be an opinion or advise of any character and is in no way represented as such. The information provided herein should not be used and reproduced and should be considered privileged and only for the intended recipients.