Determining the valuation is often an art as well as a science. It requires the combination of knowledge, experience, and professional judgment in arriving at a fair valuation of any asset. The purpose of valuation is to relate market price of the stock to its intrinsic value. Make judgement whether it is fairly priced, over-priced, or under-priced.
The discounted cashflow approach is one of most popular approach. It is as follows
Discounted Cash Flow Model:
Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate approach for valuations when three things are known:
Stream of future cash flows,
Timings of these cash flows, and
Expected rate of return of the investors (called discount rate).
Once these three pieces of information are available. It is simple mathematics to find the present value of these cash flows. A potential investor will be willing to pay today this amount to receive the expected cash flow stream over a period of time.
Typically, any investment involves the outflow of cash. Later the investor expects, cash inflows during the investment horizon. Finally, at the time of disinvestment, the investor expects a large cash inflow – preferably larger than the original investment. It represents the return of original investment with some appreciation.
Apply the same framework to valuing businesses. Popularly, compare profits to the regular inflows from traditional investments. However, appreciate that profits are accounting estimates rather than facts. Aaccounting standards and tax authorities permit accrual accounting. So there can be many valid adjustments to the figure of profit without any involvement of cashflows.
Therefore profits in business and returns in the form of cashflows in financial investments are not comparable.
Philosophy
This gave birth to the philosophy of estimating cashflows in business from the profit figures.
Business valuation professionals applied the philosophy of discounting to valuation of business entities. They drew from the postulates of time value of money and the fundamental framework, that “the intrinsic value of any asset, should be equal to the present value of future benefits that accrue from owning it”.
For instance, when one holds a real asset, like land and buildings, its value should logically depend on the future rental income and resale value that generated from it, measured in present value terms. In case of a Bond, the intrinsic value of a bond should depend on the future coupons and the redemption value, measured in present value terms.
Intrinsic value calculation
In both the cases, the entity that estimated the intrinsic value, uses a particular discounting rate, which includes, the minimum risk free rate, the compensation for the term period of the investment, the premia for the asset specific risks, the transaction costs, and the taxes. The aggregate of all these components are rate of return. However, in common parlance the transaction costs and taxes are taken as given, so they are ignored.
Tax ccalculation
Extending the logic to business valuation or equity valuation, the investor should logically discount the future benefits accruing to the business or by being an equity investor. In case of a business that has not taken any debt in its capital structure, the entire profits belong to the owners. However when the company engages borrowed capital in the business, then the lenders also have a claim in the assets and profits of the business.
EBITDA/PAT/EAT calculation
If you consider booked profits as the future benefits, then Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) are the profits left for both the lenders and owners to share along with government for tax. Earnings After Tax (EAT or PAT) are the profits left for only the owners of the business, as other stakeholders (lender, and government) have taken away their dues.
. As discussed earlier, the inherent weaknesses with the EBITDA and EAT figures, valuation experts preferred cashflow versions of the two accounting figures mentioned above.FCFF represents the cashflow left for both the lenders and owners, out of which lenders can take their interest and principal repayments, and the owners can take their dividends. FCFE represents the cashflow left only for the owners of the business. Therefore depending on the purpose of valuation, i.e. to value a firm or equity, either FCFF or FCFE is used, respectively.
FCFF for a future year is calculated as = Expected EBIT (1-Tax Rate) + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm –Expected Increase in Working Capital
FCFE for a future year is calculate as = [(Expected EBIT – INTEREST EXPENSE) * (1 – Tax Rate)] + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm – Expected Increase in Working Capital – Expected Debt Repayments + Expected Fresh Borrowings
or
FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + (Expected Fresh Borrowings – Expected Debt Repayments)
or
FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + Expected Net Debt Issues
or
FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) – Expected Preference Dividend + Expected Net Debt Issues + Expected Net Preference Share Issues
Apart from depreciation, other non-cash charges include amortization of intangible assets and loss on sale of assets, which need to add back. Unrealised Gains on assets get deducted from the FCFF and FCFE calculations.
The FCFF and FCFE figures are “free” because all the other stakeholders, leaving the financiers of the business, are paid their dues before arriving at the figures. Further, the business is also treated as a stakeholder, and the funds required for its growth and sustenance are also provided in the form of CAPEX, and working capital. Therefore what is left is for the financiers’ to claim free of all encumbrancesRarely, FCFF may be negative, but there are reasonable chances that FCFE may be negative.
Valuation calculation
In such cases the FCFF may be used for valuing the firm, and then the value of equity can be calculated by deducting the value of debt from it.
Valuation requires forecasting cashflows into the future. This can be done by applying historical growth rate exhibited by company or a rate estimated by the analysts based on their information and analysis. A firm may show a period of high growth in revenues, profitability, capex and other performance parameters, and then stabilize to a steady growth. It may be noted that growth rate in one parameter like sales, should not be considered as growth in assets, similarly the growth in assets cannot be considered as growth in profits or cashflows.
However a good proxy that is used in the valuation industry for growth in profits is the product of retention ratio and return on equity as follows
Growth in profits in a dividend paying firm = Retention Ratio * Return on Equity
OR
(1 – DPR) * ROE
Since equity is for perpetuity and it is not possible to forecast the cashflows forever, the practice is to calculate a terminal value of the firm. This terminal value is calculated as at the end of the year, till which time one could comfortably forecast the cash flows with all the available information. The terminal value may be calculated using the formula of a perpetually growing annuity. In this case cash flows are expected to grow, forever, at a steady though modest rate. The average long term GDP growth rate or inflation rate is a good proxy for this growth rate
The terminal value is calculated by multiplying the cash flow for the last year of forecasted period, by (1+ Normal Growth rate) and dividing the resultant value by (Discounting rate- Growth rate). The terminal value is added as an additional independent component, to the stream of cash flows projected during the growth period or the projection period, and then aggregate of all these cashflows are discounted to today (the day of valuation).
Say for instance one could confidently forecast cashflows for the next 5 years. Then 5th year is the last year of the confident forecast, and from the 6th year onwards the cashflows are expected to grow constantly at a particular rate as described above. The terminal value is calculated as at the end of 5th year and finally this value is discounted to today, when the valuation exercise is undertaken. The other method to calculate the terminal value is by applying a multiple to either a financial or non-financial metric of performance of the firm, such as the EBITDA, at the end of the confident forecasted year. Meaning in the 5th year as discussed in the previous paragraph. The multiple of a comparable firm is used for the purpose.
The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and also the expectations of the investors. In most of the valuation exercises, cost of debt is taken as the prevailing interest rates in the economy for borrowers with comparable credit quality. And, cost of equity is the rate of return on investment that is required by the company’s common shareholders.
Capital Asset Pricing Model – CAPM,
which establishes the relationship between risk and expected return forms the basis for cost of equity.
As per Capital Asset Pricing Model (CAPM) ,the cost of equity is computed as follows:
Ke = Rf + β * (Rm – Rf)
where: Rf : Risk Free Rate (usually the ongoing 10 years government bond yield) (Rm – Rf): Market risk premium (MRP) (which is a historical average value for a particular market or country) β = Beta (it is the sensitivity of a security’s return to an index’s return, which is chosen as a proxy for market portfolio)
The Weighted Average Cost of Capital of the firm (WACC) is then calculated as under
WACC = [Ke * (Equity / (Equity+ Debt))] + [Kd * (1-Tax)* (Debt / (Equity+ Debt))]
OR
WACC = [Ke * We] + [Kd * (1-Tx)*Wd]where: Ke : Cost of Equity, Kd : Cost of Debt, Wd: Weight of Debt We: Weight of Equity
To calculate the value of the firm, its FCFF is discounted by the weighted average cost of capital (WACC). To calculate the value of equity, its FCFE is discounted using the cost of equity.
𝑊eighted average cost of capital= ∑ 𝐺𝐷𝐺𝐺𝑖 (1 + 𝑋𝐴𝐷𝐷)𝑖 𝑜 1=1 + 𝑇𝑊 (1 + 𝑋𝐴𝐷𝐷)𝑖
Wherei = the period for which confident projects of cashflows are done, starting from 1 to n number of years in future
n = the last year for which the cashflows are projected year wise ‘FCFF’ and ‘wacc’ are as explained above
Terminal value=((FCFF) n+1) /(WACC-g)
where g=constant growth rate of the FCFE in the future
The same questions are used to calculate the value of equity of the firm, the only changes are FCFF replaced with . ‘Wacc’ is being replaced with ‘ke’, g is constant growth rate.
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