Description
This is a presentation describes valuation using DCF methodology in detail.
Valuation using DCF Methodology
Discounted Cash Flow 2
? Values a business based on the expected
cash flows over a given period of time
? Involves determination of discount factor
and growth rate for perpetuity
? Value of business is aggregate of discounted
value of the cash flows for the explicit period and perpetuity
Valuation using DCF Methodology
Discounted Cash Flow
3
? Considers Cash Flow and Not Profits
? Cash is King
? Free Cash Flow (‘FCF’)
? FCF ? FCF
to Firm to Equity
Valuation using DCF Methodology
FCFF Vs. FCFE
4
? In FCFE, value of equity is obtained by
discounting cash flows to equity (cash flows after meeting all expenses, tax, interest and principal payments) at the cost of equity. ? In FCFF, value of firm is obtained by discounting cash flows to firm (cash flows after meeting all operating expenses and taxes, but prior to debt payments) at the weighted average cost of capital.
Valuation using DCF Methodology
DCF - Key Factors
5
? Cash Flows
?
? ?
Projections
Horizon period Growth rate
?
Residual value
Cost of Equity (‘Ke’)
? Discounting
?
?
?
Cost of Debt (‘Kd ’)
Weighted Average Cost of Capital (‘WACC’)
Valuation using DCF Methodology
DCF - Projections
6
Factors to be considered for reviewing projections:
? Appraisal by institutions and understanding of
the Business
? Industry / Company Analysis ? Dependence on single customer/ market ? Dependence on a single supplier & Import
dependence
? Installed capacity, Projected Volume, Capex
Required
? Existing policy / legal framework
Valuation using DCF Methodology
DCF – Projections (Cont..)
7
Factors to be considered for reviewing projections ? Lapsing of patents or copyrights ? Working capital requirements ? Alternate scenarios / Sensitivities
Valuation using DCF Methodology
DCF – Horizon Period
8
? Horizon period and Residual value
? Horizon period at least for about 3-5 years
? Basic criteria – achieve stage of stable growth
?
If industry is passing through rough phase – horizon period should cover a period till rationalization is reached
? For cyclical businesses – cover at least one full
business cycle
Valuation using DCF Methodology
DCF – Growth Rate 9
? Growth rate during horizon period
Historical data ? Competitors’ growth rate ? Macro economic factors (GDP growth rate, inflation, etc.) ? Can also be derived as Reinvestment rate X Return on Invested Capital (‘ROIC’) ? Perpetuity growth rate ? Ideally should not be more than the expected economic growth rate ? Growth rate should consider the inflation rate
?
Valuation using DCF Methodology
DCF – Discounting
10
? Weighted Average Cost of Capital (WACC)
WACC = D (D + E) x Kd x (1 - t) + E (D + E) x Ke
D = Debt T = Income tax rate cost Ke = Cost of Equity
E = Equity Kd = Pre–tax
Valuation using DCF Methodology
Cost of Equity
11
? In CAPM Method, all the market risk is captured
in the beta, measured relative to a market portfolio, which atleast in theory should include all traded assets in the market place held in proportion to their market value. Ke = (Rf + (? x Erp)) Where , Ke = Cost of Equity Rf = Risk free return Erp = Equity risk premium ? = Beta
Valuation using DCF Methodology
Risk Free Rate
12
? Risk Free Rate : It is the rate where investor
knows the expected return with certainity.
For an investment to be risk free, two conditions have to be met
a) No default risk (b) No uncertainty about reinvestment rates
Valuation using DCF Methodology
Risk Premium
? Risk Premium : It measures the extra return that
13
would be demanded by investors for shifting their money from a riskless investment to an average risk investment There are 3 ways of estimating risk premium in CAPM.
? ? ?
Large investors can be surveyed about their expectations for the future The actual premiums earned over a past period can be obtained from historical data The implied premium can be extracted from current market data
Valuation using DCF Methodology
? Beta : A measure of the volatility, or
Beta 14
systematic risk, of a security or a portfolio in comparison to the market as a whole In CAPM, the beta of the asset has to be estimated relative to the market portfolio.
There are 3 approaches available for estimating these parameters:
?
Historic Market Betas
?
?
Fundamental Betas
Accounting Betas
Valuation using DCF Methodology
Historical Market Beta 15
? Historical
Market Betas : This is the conventional approach for estimating betas.
Beta of an asset = Covariance of asset with market portfolio / Variance of the market Portfolio
Valuation using DCF Methodology
Fundamental Beta
16
?
Fundamental Beta : The beta for a firm may be estimated from a regression but it is determined by fundamental decisions that the firm has made on (1) What business to be in (2) How much operating leverage to use in business
(3) The degree to which the firm uses financial leverage
Valuation using DCF Methodology
Accounting Beta
17
? Accounting Beta : It estimates the market risk
parameters from accounting earnings rather than from traded prices.
Thus, changes in earnings of a division or a firm, on a quarterly or an annual basis, can be regressed against changes in earnings for the market, in the same periods, to arrive at an estimate of a market beta to use in the CAPM
Valuation using DCF Methodology
A type of metric that compares the risk of an unlevered Company to the risk of the market. The unlevered beta is the beta of a company without any debt. Unlevering a beta removes the financial effects from leverage.
The formula to calculate a company's unlevered beta is:
Unlevered Beta 18
BU=
BL
Where: BL is the firm's beta with leverage. Tc is the corporate tax rate. D/E is the company's debt/equity ratio.
[1+( 1-Tc ) X (D/E)]
Valuation using DCF Methodology
Unlevered Cost of Equity
19
? Unlevered cost of equity : The cost of equity that
would result from using an unlevered beta is called the unlevered cost of equity.
Unlevered cost of equity = Risk free rate + Unlevered beta x risk premium
Valuation using DCF Methodology
Cost of Equity (cont..) 20
? Gordon Dividend Model: It relates the value of a
stock to its expected dividends in the next time period, and the expected growth of dividends.
Ke =
Dividend per share value of stock
+ Growth Rate
Valuation using DCF Methodology
Cost of Debt
21
? Cost of Debt : The cost of debt is the rate at which a
firm can borrow money today and will depend on the
default risk embedded in the firm. Default risk can be measured using a bond rating or by looking at financial ratios.
Valuation using DCF Methodology
WACC – Key Issues 22
WACC determination – Some key issues
? Debt : Equity ratio
? Cost of Debt – Weighted average ? Tax rate based on projections of discrete
period
Valuation using DCF Methodology
Terminal value
Terminal Value is the residual value of business at the end of projection period used in discounted cash flow method. Terminal Value
Liquidation Approach
Multiple Approach
Stable Growth Approach
Valuation using DCF Methodology
23
Liquidation Approach
24
? In this approach, it is assumed that the
firm will cease operations at a point of time in future and sell the assets it has accumulated.
? Value
? Value
based on Book value
based on Earning power of
assets
Valuation using DCF Methodology
Multiple Approach
25
? In this approach, the value of firm in a future
year is estimated by applying a multiple to the firm’s earning or revenue in that year
For instance, a firm with expected revenues of Rs.6 billion ten years from now will have an estimated terminal value in that year of Rs.12 billion if a value to sales multiple of 2 is used. If valuing equity, we use equity multiples such as price earnings ratios to arrive at the terminal value.
Valuation using DCF Methodology
Stable Growth Approach 26
? Stable Growth Model: It is assumed that
firm has a finite life with constant growth rate. Terminal Value = t+1 (r – g stable)
Cash flow
Valuation using DCF Methodology
The Final Value
27
? Under the FCF to the firm approach - the Value is the
summation of ? PV of the FCF to Firm during the horizon period ? PV of the residual value ? PV of the tax benefit on the WDV of the assets, 80IA, 10A/10B, sales tax, etc. beyond the horizon period ? Market value of the investments and other nonoperating/ surplus assets (net of tax)/ surplus cash as at the valuation date ? Adjustment for contingent liabilities/ assets (net of taxes)
Valuation using DCF Methodology
The Final Value (Cont..)
28
? Under this approach, value to the equity
shareholder can be derived as value to the firm less value of debts and preference shares.
? Value as determined above to be divided by
number of equity share outstanding as at the valuation date
Valuation using DCF Methodology
The Final Value (Cont..)
29
? Under the FCF to equity shareholder approach
?
PV of FCF to equity shareholders during the horizon period PV of the residual value All the adjustments mentioned under Value to the Firm approach except adjustment for debt
?
?
Valuation using DCF Methodology
DCF – When to use?
30
? Most appropriate for valuing firms
?
Limited life projects Large initial investments and predictable cash flows Regulated business
?
?
Valuation using DCF Methodology
Advantages of DCF 31
? It provides more sophisticated and reliable
picture of company’s value than the accounting approach
? Helpful to all stakeholders ? Reduces subjectivity to valuation
Valuation using DCF Methodology
DCF – Disadvantages
32
? Projections are highly subjective hence could be
inaccurate
? Inapplicable where projections cannot be made
for the horizon period
? Difficulties in measuring risks (calculation of ?)
Valuation using DCF Methodology
Limitations of DCF Method
33
? DCF may not be the right method in
following scenarios
? Valuation ? Valuation
of Holding Companies of Banks / NBFC’s.
? Start
up Companies where business cannot be carried out without infusion of funds from Investors
Valuation using DCF Methodology
34
THANK YOU
Valuation using DCF Methodology
doc_478352436.pptx
This is a presentation describes valuation using DCF methodology in detail.
Valuation using DCF Methodology
Discounted Cash Flow 2
? Values a business based on the expected
cash flows over a given period of time
? Involves determination of discount factor
and growth rate for perpetuity
? Value of business is aggregate of discounted
value of the cash flows for the explicit period and perpetuity
Valuation using DCF Methodology
Discounted Cash Flow
3
? Considers Cash Flow and Not Profits
? Cash is King
? Free Cash Flow (‘FCF’)
? FCF ? FCF
to Firm to Equity
Valuation using DCF Methodology
FCFF Vs. FCFE
4
? In FCFE, value of equity is obtained by
discounting cash flows to equity (cash flows after meeting all expenses, tax, interest and principal payments) at the cost of equity. ? In FCFF, value of firm is obtained by discounting cash flows to firm (cash flows after meeting all operating expenses and taxes, but prior to debt payments) at the weighted average cost of capital.
Valuation using DCF Methodology
DCF - Key Factors
5
? Cash Flows
?
? ?
Projections
Horizon period Growth rate
?
Residual value
Cost of Equity (‘Ke’)
? Discounting
?
?
?
Cost of Debt (‘Kd ’)
Weighted Average Cost of Capital (‘WACC’)
Valuation using DCF Methodology
DCF - Projections
6
Factors to be considered for reviewing projections:
? Appraisal by institutions and understanding of
the Business
? Industry / Company Analysis ? Dependence on single customer/ market ? Dependence on a single supplier & Import
dependence
? Installed capacity, Projected Volume, Capex
Required
? Existing policy / legal framework
Valuation using DCF Methodology
DCF – Projections (Cont..)
7
Factors to be considered for reviewing projections ? Lapsing of patents or copyrights ? Working capital requirements ? Alternate scenarios / Sensitivities
Valuation using DCF Methodology
DCF – Horizon Period
8
? Horizon period and Residual value
? Horizon period at least for about 3-5 years
? Basic criteria – achieve stage of stable growth
?
If industry is passing through rough phase – horizon period should cover a period till rationalization is reached
? For cyclical businesses – cover at least one full
business cycle
Valuation using DCF Methodology
DCF – Growth Rate 9
? Growth rate during horizon period
Historical data ? Competitors’ growth rate ? Macro economic factors (GDP growth rate, inflation, etc.) ? Can also be derived as Reinvestment rate X Return on Invested Capital (‘ROIC’) ? Perpetuity growth rate ? Ideally should not be more than the expected economic growth rate ? Growth rate should consider the inflation rate
?
Valuation using DCF Methodology
DCF – Discounting
10
? Weighted Average Cost of Capital (WACC)
WACC = D (D + E) x Kd x (1 - t) + E (D + E) x Ke
D = Debt T = Income tax rate cost Ke = Cost of Equity
E = Equity Kd = Pre–tax
Valuation using DCF Methodology
Cost of Equity
11
? In CAPM Method, all the market risk is captured
in the beta, measured relative to a market portfolio, which atleast in theory should include all traded assets in the market place held in proportion to their market value. Ke = (Rf + (? x Erp)) Where , Ke = Cost of Equity Rf = Risk free return Erp = Equity risk premium ? = Beta
Valuation using DCF Methodology
Risk Free Rate
12
? Risk Free Rate : It is the rate where investor
knows the expected return with certainity.
For an investment to be risk free, two conditions have to be met
a) No default risk (b) No uncertainty about reinvestment ratesValuation using DCF Methodology
Risk Premium
? Risk Premium : It measures the extra return that
13
would be demanded by investors for shifting their money from a riskless investment to an average risk investment There are 3 ways of estimating risk premium in CAPM.
? ? ?
Large investors can be surveyed about their expectations for the future The actual premiums earned over a past period can be obtained from historical data The implied premium can be extracted from current market data
Valuation using DCF Methodology
? Beta : A measure of the volatility, or
Beta 14
systematic risk, of a security or a portfolio in comparison to the market as a whole In CAPM, the beta of the asset has to be estimated relative to the market portfolio.
There are 3 approaches available for estimating these parameters:
?
Historic Market Betas
?
?
Fundamental Betas
Accounting Betas
Valuation using DCF Methodology
Historical Market Beta 15
? Historical
Market Betas : This is the conventional approach for estimating betas.
Beta of an asset = Covariance of asset with market portfolio / Variance of the market Portfolio
Valuation using DCF Methodology
Fundamental Beta
16
?
Fundamental Beta : The beta for a firm may be estimated from a regression but it is determined by fundamental decisions that the firm has made on (1) What business to be in (2) How much operating leverage to use in business
(3) The degree to which the firm uses financial leverage
Valuation using DCF Methodology
Accounting Beta
17
? Accounting Beta : It estimates the market risk
parameters from accounting earnings rather than from traded prices.
Thus, changes in earnings of a division or a firm, on a quarterly or an annual basis, can be regressed against changes in earnings for the market, in the same periods, to arrive at an estimate of a market beta to use in the CAPM
Valuation using DCF Methodology
A type of metric that compares the risk of an unlevered Company to the risk of the market. The unlevered beta is the beta of a company without any debt. Unlevering a beta removes the financial effects from leverage.
The formula to calculate a company's unlevered beta is:
Unlevered Beta 18
BU=
BL
Where: BL is the firm's beta with leverage. Tc is the corporate tax rate. D/E is the company's debt/equity ratio.
[1+( 1-Tc ) X (D/E)]
Valuation using DCF Methodology
Unlevered Cost of Equity
19
? Unlevered cost of equity : The cost of equity that
would result from using an unlevered beta is called the unlevered cost of equity.
Unlevered cost of equity = Risk free rate + Unlevered beta x risk premium
Valuation using DCF Methodology
Cost of Equity (cont..) 20
? Gordon Dividend Model: It relates the value of a
stock to its expected dividends in the next time period, and the expected growth of dividends.
Ke =
Dividend per share value of stock
+ Growth Rate
Valuation using DCF Methodology
Cost of Debt
21
? Cost of Debt : The cost of debt is the rate at which a
firm can borrow money today and will depend on the
default risk embedded in the firm. Default risk can be measured using a bond rating or by looking at financial ratios.
Valuation using DCF Methodology
WACC – Key Issues 22
WACC determination – Some key issues
? Debt : Equity ratio
? Cost of Debt – Weighted average ? Tax rate based on projections of discrete
period
Valuation using DCF Methodology
Terminal value
Terminal Value is the residual value of business at the end of projection period used in discounted cash flow method. Terminal Value
Liquidation Approach
Multiple Approach
Stable Growth Approach
Valuation using DCF Methodology
23
Liquidation Approach
24
? In this approach, it is assumed that the
firm will cease operations at a point of time in future and sell the assets it has accumulated.
? Value
? Value
based on Book value
based on Earning power of
assets
Valuation using DCF Methodology
Multiple Approach
25
? In this approach, the value of firm in a future
year is estimated by applying a multiple to the firm’s earning or revenue in that year
For instance, a firm with expected revenues of Rs.6 billion ten years from now will have an estimated terminal value in that year of Rs.12 billion if a value to sales multiple of 2 is used. If valuing equity, we use equity multiples such as price earnings ratios to arrive at the terminal value.
Valuation using DCF Methodology
Stable Growth Approach 26
? Stable Growth Model: It is assumed that
firm has a finite life with constant growth rate. Terminal Value = t+1 (r – g stable)
Cash flow
Valuation using DCF Methodology
The Final Value
27
? Under the FCF to the firm approach - the Value is the
summation of ? PV of the FCF to Firm during the horizon period ? PV of the residual value ? PV of the tax benefit on the WDV of the assets, 80IA, 10A/10B, sales tax, etc. beyond the horizon period ? Market value of the investments and other nonoperating/ surplus assets (net of tax)/ surplus cash as at the valuation date ? Adjustment for contingent liabilities/ assets (net of taxes)
Valuation using DCF Methodology
The Final Value (Cont..)
28
? Under this approach, value to the equity
shareholder can be derived as value to the firm less value of debts and preference shares.
? Value as determined above to be divided by
number of equity share outstanding as at the valuation date
Valuation using DCF Methodology
The Final Value (Cont..)
29
? Under the FCF to equity shareholder approach
?
PV of FCF to equity shareholders during the horizon period PV of the residual value All the adjustments mentioned under Value to the Firm approach except adjustment for debt
?
?
Valuation using DCF Methodology
DCF – When to use?
30
? Most appropriate for valuing firms
?
Limited life projects Large initial investments and predictable cash flows Regulated business
?
?
Valuation using DCF Methodology
Advantages of DCF 31
? It provides more sophisticated and reliable
picture of company’s value than the accounting approach
? Helpful to all stakeholders ? Reduces subjectivity to valuation
Valuation using DCF Methodology
DCF – Disadvantages
32
? Projections are highly subjective hence could be
inaccurate
? Inapplicable where projections cannot be made
for the horizon period
? Difficulties in measuring risks (calculation of ?)
Valuation using DCF Methodology
Limitations of DCF Method
33
? DCF may not be the right method in
following scenarios
? Valuation ? Valuation
of Holding Companies of Banks / NBFC’s.
? Start
up Companies where business cannot be carried out without infusion of funds from Investors
Valuation using DCF Methodology
34
THANK YOU
Valuation using DCF Methodology
doc_478352436.pptx