Download - Discounted Cash Flow

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Discounted Cash Flow

[ 2 ]

Understand the theoretical basis of a DCF

Understand the weighted average cost of capital

Understand the different terminal value approaches:

– Terminal Multiple method

– Perpetuity Growth method

Derive an implied valuation range

Application: Construct a DCF & WACC model

Learning Objectives – DCF Analysis

[ 3 ]

What is a Company ultimately worth?

Cash in the investors’ pockets

[ 4 ]

Two Key Questions of DCF

How much cash?

When investors receive it?

[ 5 ]

What is a DCF Analysis?

Intrinsic value of the company

– Theoretical vs. relative value

Base on unlevered free cash flows (FCFs)

– Independent of capital structure

– Free cash flows available to all capital holders

Value equals the sum of the present values (PV) of:

(1) Unlevered free cash flows &

(2) Projected terminal value

• Estimated value beyond the forecast period

– PV calculated by on a discount rate

• Typically, weighted average cost of capital (WACC)

[ 6 ]

Advantages of a DCF Valuation

Intrinsic value based on projected FCFs

Flexible, adaptable analysis

– How do changes in projections impact value?

• Growth rates

• Operating margins

• Synergies, expansion plans, etc.

Objective calculation (through PV)

Requires scrutiny of key drivers of value

Always obtainable

[ 7 ]

Challenges of a DCF Valuation

Cash flows from forecasts

– Possible bias (run sensitivities)

– Reliability

Subjective valuation

– Based on numerous assumptions

Highly sensitive to changes in:

– FCFs: growth rates & margins assumptions

– Estimated terminal value

– Assumed discount rate (beta, market conditions)

*DCF results should be presented as a RANGE of estimated values not a single estimate!

[ 8 ]

Methodology Steps for a DCF

1. Estimate the Cost of Capital

2. Forecast Free Cash Flows (FCFs)

3. Calculate the Present Values of FCFs

4. Estimate the Terminal Value

5. Derive an Implied Valuation Range

[ 9 ]

Sources for Forecasting Free Cash Flow

Use standalone model projections for DCF and FCF projections

– Alternative cases to assess:

• Upside potential

• Downside risk

• Synergies usually treated as separate analysis

Consider "steady state" forecast horizon

– Cash flows can be "sustained forever" (stable growth)

• Generally viewed NOT to exceed economy's growth rate

[ 10 ]

"Multi-Stage" Projections

Forecast horizon potentially can be in stages

– Concept: Slow growth over time to steady-state

How long does it take to achieve steady state?

– Length varies by industry / situation

• Does the company have a sustainable advantage?

• Growth from single product with protected position?

Generally speaking: As growth nears stable growth, risk and CAPX needs decline

– Closer to industry average?

[ 11 ]

Calculating Free Cash Flow

EBITDA

Less: Depreciation and amortization

= EBIT

Less: Taxes (at the marginal tax rate)

= Tax-Effected EBIT or “NOPAT”

Plus: Depreciation and amortization

+/-: Changes in deferred taxes

Less: Capital expenditures

+/-: Changes in net working capital

+/-: Changes in other non-cash items

= Unlevered Free Cash Flow

Watch your Sources & Uses of Cash!

[ 12 ]

What is the Terminal Value?

Value of the business beyond the projections

– Used due to the impractical nature of extended forecast period (i.e., 20 or 30 years)

Two methods:

1. Exit Multiple

• Assumes the business is worth (or "sold") a multiple of an operating statistic at the end of the projections

2. Perpetuity Growth

• Assumes growth of FCFs at constant rate in perpetuity

Yr 0 Yr N Value - Value - ???

Projections ?

[ 13 ]

Exit Multiple Method

Value the business as a multiple of a relevant operating statistic

– "Worth/sold for 8.0x EBITDA at the end of year N”

Choosing the appropriate Exit Multiple:

– Multiple of EBITDA, EBIT, etc.

– Reasonable multiple from comparables, usually current

• Is the current multiple sustainable?

• Public Comparables: "worth" a multiple at end of Year N

• Acquisition Comparables: "sold" for a multiple at end of Year N

– Do not double count synergies for a potential M&A target if using a separate DCF valuation of synergies

– Be wary of cyclical industries

• Examine ranges and rolling average of EBITDA multiples

– Valued on pre-tax basis (to investors)

[ 14 ]

Perpetuity Growth Method

Assumes the business grows at a constant rate in perpetuity

Consider using "normalized" cash flow in final year

– Sustaining capital investment (i.e., Depreciation ~ CapEx)

– Steady state working capital needs

– Consider no deferred taxes

Perpetuity growth formula:

Where:

FCF = normalized free cash flow in period N

g = nominal perpetual growth rate

r = discount rate or WACC

Terminal Value = FCFn x (1 + g)

(r - g)

[ 15 ]

Which Method to Use - When and Why?

Perpetuity Growth Rate:

– Academically proven approach

Exit Multiple: more often used in practice

– Inherent difficulty in estimating when the company achieves "steady state", perpetual growth rate growth

– Multiples commonly used for valuation

– Major considerations:

• How do you choose the appropriate multiple?

• Introduces relative value with intrinsic value approach

Perpetuity Growth Rate is commonly used by practitioners for:

– Synergies

– Mature industries

[ 16 ]

Equivalent Perpetuity Growth Rate

Helpful reality check to analyze the results calculated by Exit Multiple Method:

Resulting “equivalent g” should be within a reasonable comfort level

Equivalent Perpetuity Growth Rate 1 = [EBITDAN x Multiple x Discount Rate) – FCFN]

[FCFN x EBITDAN X Multiple)]

1 Quick, less complex short-cut approximation: Estimated Perpetuity Growth Rate Discount Rate – [FCFN+1 /(EBITDAN x Multiple)]

[ 17 ]

Equivalent Exit Multiple

Helpful reality check to analyze the results calculated by Perpetuity Growth Rate Method:

Resulting "equivalent multiple" should be within a reasonable comfort level

– Compare with the comparables

Equivalent EBITDA Multiple = FCFN X (1 + g)

EBITDAN (r – g)

[ 18 ]

Calculate the Enterprise Value

PV of Free Cash Flows

(Discounted @ WACC)

Enterprise Value (Firm Value)

PV of Terminal Value

(Discounted @ WACC) +

=

[ 19 ]

Which balance sheet do you? (1) Latest available (2) PV date – projected balance sheet

Typically, use latest available share and option information

– Ideally, consistent timing with balance sheet items

Footnote and use reasonable assumptions

Calculate the Equity Value

Enterprise Value

Debt, Preferred Stock and Min. Interests + – Cash =

Equity Value1

Equity Value

Diluted Shares = Equity Value Per Share

1 For certain companies, it may be appropriate to include equity investments, NOLs or non-operating assets. Such assets not reflected in the cash flows would raise the equity value

[ 20 ]

Terminal Value as % of Enterprise Value

Calculate the PV of the Terminal Value as % of Enterprise Value

Another reality check

– How much of the firm's DCF value is derived from value generated beyond

the projected FCF's?

Comfort level depends on:

• Company and industry

• Situation

• Forecast horizon

[ 21 ]

The Final DCF Analysis

Compare DCF result with current stock price

Derive a reasonable, defensible range

– Range of discount rates

– Range of exit multiples / perpetuity growth rates

Weigh DCF results more heavily when comparables analyses are not as applicable

– No "pure play" public comps or acquisition comps

Common to see various scenarios ("cases")

[ 22 ]

Basis of Mid-Period Convention

Discount back 0.5 years





12/31/20X0 12/31/20X1 12/31/20X2 12/31/20X3 12/31/20X4 12/31/20X5

Key: Periods 1-5 Cash Flows Acquisition occurs on December 31, 20X0

Fiscal year end of December 31

Assumes mid-year cash flows

Discount rate of 10%

Valuation date:

Basis for the “mid-period convention”:

Cash flows are generated more or less continuously

DURING the period, not at the end of the period.

Mid-period convention moves each cash flow from the

END of the period to the MIDDLE of the same period. Q: What is the impact of the valuation?

[ 23 ]

Perpetuity growth method:

– "FCFN" means FCF during period "N" is received at "N - 0.5" with the mid-period

convention

• Continuous flow consistent with other forecasted free cash flow periods

– Discount back "N - 0.5" periods

– Use MID-PERIOD

Exit multiple method:

– Assumption: Business sold or valued at the end of period "N"

– Discount back "N“

– Common to use end-period

Terminal Values & Mid-Period Convention

FCFN X (1 + g)

(r – g) X (1 + r)

Terminal Value for

Perpetuity growth method

EBITDAN X Multiple

(1 + r)N

Terminal Value for

Exit multiple method

[ 24 ]

Equivalent Multiples and Growth Rates

To equate implied multiples and growth rates when using the mid-period

convention, grow the perpetuity growth rate method by 1/2 a period

Equivalent Perpetuity Growth Rate (using mid-period convention) =

((EBITDAN X Multiple X Discount Rate) – FCFN X (1 + r)0.5)

(EBITDAN X + (FCFN X (1 + r)0.5)

EBITDA X Multiple = FCFN X (1+r) 0.5

(r – g)

Equivalent Perpetuity Growth Rate (using mid-period convention) =

FCFN X (1 + g) X (1 + r)0.5)

EBITDAN X + (r - g)

[ 25 ]

What are Synergies?

Financial benefits arising from a merger

3 main areas to consider:

1. Net incremental revenues (net of costs to achieve)

2. Cost savings

3. Merger outlays (severance, additional CapEx)

Sources of synergy projections

– Management

– Research

– Estimates from comparable acquisitions

(e.g., "5.0% of Target sales")

[ 26 ]

How Do You Value Synergies?

DCF valuation of the synergies

– Project the synergy cash flows

– Terminal value via perpetuity growth rate method

Value on an independent basis from the standalone DCF

– Create a "DCF with synergies" value

• Standalone DCF value + synergies DCF value

Do NOT double count the control premium in the standalone DCF terminal value

[ 27 ]

Some Synergy DCF Considerations

1. Progression of the phase in

– Achieving full potential does not happen in one year

2. Percentage realization

– Common to see 50% & 100% realization cases

3. Tax-effect the operating income impact

– At the marginal rate

4. Factor in costs to achieve the synergies

– Cash merger outlays

5. Consider 0% or very low perpetuity growth rate

– Competitive pressures

[ 28 ]

Weighted Average Cost of Capital

Discount rate used to calculate the PV of future cash flows

Required rate of return for both equity and debt investors

Return commensurate with risk of the investment (i.e., target company or project,

not the acquirer in an M&A transaction)

Where:

Ke = cost of equity (from CAPM)

Kd = cost of debt (current cost of borrowing from average yield to maturity)

E = market value of equity

D = market value of debt

T = marginal tax rate

WACC = Ke x E

D+E + Kd x (1 - T) x

D

D+E

Note: Interest expense is tax deductible, so the true cost of borrowing is the after-tax interest expense.

[ 29 ]

Weighted Average Cost of Capital

Discount rate used to calculate the PV of future cash flows

Required rate of return for both equity and debt investors

Return commensurate with risk of the investment (i.e., target company or project,

not the acquirer in an M&A transaction)

Where:

Ke = cost of equity (from CAPM)

Kd = cost of debt (current cost of borrowing from average yield to maturity)


D = market value of debt


WACC = Ke x E

D+E + Kd x (1 - T) x

D

D+E

Note: Interest expense is tax deductible, so the true cost of borrowing is the after-tax interest expense.

[ 30 ]

Issues with the Capital Structure

"E" = market value of equity

– Private company: estimate from comparables

"D" = market value of debt

– Book value used as common, practical proxy

• Market quotes not readily available for all debt

• Price movements usually based on interest rate changes since issuance (and

changes in credit profile)

– Be extremely careful with:

• Recent substantial changes in risk-free rate

• Changes in company's credit profile

[ 31 ]

Issues with the Capital Structure (Cont.)

Adjust debt for operating leases?

– Yes: if material source of financing / capital

Use "net debt" or "total debt?"

– Both are common and generally acceptable

– Be consistent and justify your rationale!

• Are there industry specific approaches?

Other considerations to examine:

– Historical vs. current capital structure

– Possible future financing sources

– Company's vs. industry average capital structure

[ 32 ]

Determining the Cost of Debt

Ideally, observable in market

– Yield to maturity from long-term bond (10 years)

– Normally quoted as “Spread” over risk-free rate

Estimate Kd when no publicly traded debt

– Obtain quote from capital markets

• Based on risk / credit profile

• Quote usually based on "spread" over risk-free benchmark

– Based on comparables

– Examine debt footnote

• Interest rate on recent issuance? Average cost of debt?

Tax effect at the marginal rate

[ 33 ]

Overview of the Cost of Equity

Cost of Equity (Ke) = an investor's expected rate of return including dividends &

capital appreciation

Greater risks require higher expected returns

– Equity investors have a residual claim on assets

– Subordinate claim to debt holders and preferred stockholders

Ke often reflects perceived risk of an investment

– Utilities: low risk, low expected return

– Biotech: high risk, high expected return

Ke difficult to estimate

– Not readily observable in the market

[ 34 ]

Capital Asset Pricing Model (CAPM)

Tool used to estimate required equity returns

– Equity investors expect higher return to taking higher risk

Two types of risk:

1. Systematic risk: market risk

• Unavoidable risk

– Common to all risky securities

• Warrants a “risk premium” above a risk-free rate of return

• Beta measures the amount of an asset’s market risk

2. Unsystematic risk: specific to a company

• Avoidable risk through diversification

• Warrants no “risk premium”

[ 35 ]

CAPM formula:

Risk-free rate (rf)

– Typically, estimated by 10-year US Treasury

Beta (B) - popular sources:

1) Barra's predicted betas (from FactSet)

2) Bloomberg (historical betas)

3) Average calculation from comparable companies

Market risk premium (rm - rf)

– Common source: long-term horizon equity risk premium from Ibbotson Associates' SBBI:

Valuation Edition Yearbook

The CAPM Formula

Ke = rf + [B x (rm – rf)]

Where:

Ke = required return on equity

Rf = risk free rate

B = Beta of the company

Rm – rf = “market risk premium” or the expected return on market minus the risk-free rate

[ 36 ]

Risk – Free Rate: Long-Term Rate

Rate of return on a "riskless" investment

– US Treasury securities best characterizes a "riskless" security

Use the long-term rate that best matches the time frame of most investment or

acquisition decisions

– Extension beyond forecast period accounts for terminal value

In practice, use the market's risk-free benchmark

– Currently, the US Treasury 10 year note

– May want to look at a longer horizon

• 20 year rate derived from 30 year bond with 20 years until maturity

[ 37 ]

What is an Equity Beta?

An equity beta measures a the degree to which a company's equity returns vary

with the return of the overall market

– Beta of 1.0 = risky as overall market

• Expected returns will equal overall market returns

Ideally, beta value should be an expected value;

– Cost of equity is an expected return :

• Barra supplies predicted betas (available via FactSet) ,

– Common to use historical betas

Private company - Use an industry average beta

(a) Beta equals the covariance of the security and the market divided by the variance of the market.

[ 38 ]

Predicted Beta Vs. Historical Beta

Based on a multi-factor forecast model (i.e. Barra

betas)

May be used for dynamic companies

Used is past performance is an effective predictor of

future performance (i.e., the company’s performance is

relatively stable)

Industry Average Beta Vs. Individual Beta

Provides Multiple data points, especially for

companies with:

– Short operational histories

– Limited market exposure

– Restructured operations

– Leverage significantly different than industry

average

Used for well established companies with leverage in a

relative range to the industry average

Adjusted Beta Vs. Unadjusted Beta

Beta of most stocks converges to 1.00 over time

May understate relative volatiility (if beta > 1.00)

Calculated according to strict mathematical definition

May overstate relative volatility (if beta > 1.00)

Issues to Consider Regarding Betas*

[ 39 ]

Unlevering and Relevering Equity Betas

Unlever beta to neutralize impact leverage:

Relever a beta at a targeted capital structure:

– Company's current capital structure

– Industry average capital structure

– Projected capital structure

Where:

BU = unlevered beta (“asset beta”)

BL = levered beta (“equity beta”)


D = market value of debt 1


BU = BL

1 + X (1 - T) D

E

BL = BU

D

E [1 + x (1 - T)]

1 The value of preferred stock and minority interest may be included in the value of debt for purposes of unlevering /relevering beta, but should not be tax-effected.

[ 40 ]

Mechanics of Unlevering & Relevering

Common approach:

1. Enter the levered betas for the comparable companies

2. Unlever at each company's D/E ratio

3. Calculate the average unlevered "beta

4. RELEVER the average unlevered beta (or an appropriate beta)

• Use a range appropriate for the Target company

D/E: use "net debt" or "total debt?"

– Both are common and generally acceptable

– Be consistent and justify your rationale!

• Are there industry specific approaches?

[ 41 ]

Exercise: Unlevering Betas

Assumption – Company A:

BL

T = 38.0%

D= $475 MM

E= $788 MM

Q1: Calculate the unlevered beta of Company A:

[ 42 ]

Exercise: Relevering Betas

Assumptions – Comparable Companies:

Company B u = 1.01 Company D u = 0.87

Company C u = 0.95 Company E u = 1.13

Q2: Calculate the average unlevered beta of the comparable companies:

Q3: Calculate the implied levered beta for Company A (use the average unlevered beta above, Company A's debt to equity ratio and tax rate):

[ 43 ]

What is "Market Risk Premium?"

Total return of stocks over the risk-free rate

– Estimation of reward for bearing equity risk

Popular sources:

– Long-term equity risk premium from Ibbotson Associates' SBBI Valuation Edition Yearbook

• Based on historical market returns vs. risk-free rate

– Forward-looking models estimating expected equity market returns

Estimates vary from ~4% – 7%

[ 44 ]

Small-Cap Adjustments to CAPM

Small stocks tend to be riskier than large stocks

– Historically, small stocks tend to have:

• Higher returns & larger betas

Higher betas do not account entirely for the higher returns of small companies

– Higher returns tend to be in excess of CAPM

CAPM modified for firm size:

Ke = rf + [B x (rm – rf)] + SP SP = appropriate size premium based on the firm’s market capitalization

Common source: Ibbotson Associates’ SBBI Valuation Edition

[ 45 ]

Exercise: Calculating WACC

Assumptions – Company A:

L = 1.36(from prior exercise) Market risk premium = 7.2%

T = 38.0% Kd = 8.0%

D = $475 MM rf = 4.00%

E = $788 MM Size premium = 1.70%

Q1: Calculate the Ke of Company A:

Q2: Calculate the WACC of Company A:

[ 46 ]

International Issues with Cost of Capital

Risks will vary from country to country

Calculating cost of capital internationally more challenging

– Limited data

– Lack of integrated markets

– Emerging markets even more difficult!

Possible to obtain country specific assumptions, especially with developed

countries

– Equity risk premium & betas

– Risk-free rate (such as UK Treasury 10-year bond)

Seek specialists and internal resources!

Download - Discounted Cash Flow

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