eal Pie Ree eae METHODOLOGIES pISCOUNTED CASH FLOWS METHOD In Financial Management, it has been discussed that a way to determine the value of an investment opportunity is by determining the actual cash generated by a particular asset. Recall that discounted cash flows analysis can be done by determining the present value of the net cash flows of the investment opportunity. In Conceptual Framework and Accounting Standards, it was discussed that the cash flows are presented and analyzed based on their sources and activities which are categorized as operating, investing and financing. In determining the value of an asset, the cash flows are important reference or inputs. In determining the value of the asset, it is essential to include amount of cash that will be available for the claims of the equity owners. The Net Cash Flows refer to the amount of cash available for distribution to both debt and equity claims of the business or asset. This is calculated from the net cash generated from operations and for investment over time. For GCBO, the net cash flows generated will be based on the cash flows from operating and investing activities, since this represents already the amount earned or will be earned from the business and the amount that is required to be infused in the operations to generate more profit. Net Cash Flows is preferred as basis of valuation if any of the following conditions are present: * Company does not pay dividends * Company pays dividends but the amount paid out significantly differs from its capacity to pay dividends Net Cash Flows and profits are aligned within a reasonable forecast period Investor has a control perspective. If an investor can exert control over a company, dividends can be adjusted based on the decision of the controlling investor. Using net cash flows over other cash flow concepts is more advantageous in @ valuation activity since this metric can be directly used as input to a DCF Model. This is not the case for other cash flow or earnings measure such as EBITDA, EBIT, net income and cash flow from operations since these metrics might have missed or double counted an item. * EBITDA and EBIT are both metrics that are before taxes; cash flows that are available to investors should be after satisfying tax Tequirements of the governmentMETHODOLOGIES VALUATION ao) asa b ee Iso do not consider differences ° EBIDA ort is not capture interest payments, dividers preference shares and funds sourced from bondholders é 1m iti in ents. < : a ee also do not consider reinvestment of cash, og made into the firm for additional working capital and fixeg ase, investment that are necessary to maximize long-term Stability of = business. e In valuation, analysts find analyzing cash flows and its sources helptu i, understanding the following: * Source of financing for needed investments - Are investments internally funded by cash generated from operations or debtiequs, financing is necessary? The best case for firms is to fund is investments wholly or partly through cash from operations. Heavy, reliance on external financing from lenders or shareholders may signa that cash from operations is not enough to support the firm's Jong. stability, ¢ Reliance on debt financing — Debt financing is an excellent financing Strategy especially for expanding companies. However, it can become @ problem for a firm if its cash from operations is insufficient to repay existing debt obligations. The situation worsens if firms continuously refinance borrowings that come due by another borrowing. * Quality of earnings — Significant disparities between cash flows ant income may indicate earnings does not get converted to cash easily ‘suggesting low quality. There are two levels of Net Cash Flows: (1) Net Cash Flows to the Firm: a4 liabilities to the creditors less avai, The ne pattes © te ce Goa wiable cash balance of the company. The company ined by referring to the financial statements of Net Cash Flow to the Firm Capital as required by business ood Capital expenditures and wa NCF to the firm is cas" esenerated from operating activities of quired return of fund providers, Valuan ness which is intended to pay lui lation models based on enterprise value ae all investors — whether debt or equity. vi Enterprise value of a company refers to the theoretical value of its core pusiness activities as reflected by its net P of most corporate valuation methodologies" flows. This is the basic premise encompass Cash flows available to Net cash flow only capture items that are directly related to the operating and investing activities of the business. Consequently, net cash flow excludes items associated with financing activities. Net cash flows to the firm can be computed or derived using the following approaches A, Based from Net Income (or indirect approach) Net Income Available to Common shareholders Php xxx Add: Non Cash Charges (net) XK Add: Interest Expense (net of Taxes) YOK ‘Add/Less: Adjustment in Working Capital XXX Less: Net Investment in Fixed Capital (Purchases - Sales of Fixed Capital Investment) OK Net Cash Flows to the Firm Php xxx * Net Income Available To Common Shareholders. Basic measure of a firm's profitability which refers to the bottom line figure in an income statement. This is the amount left for the common shareholders after deducting all costs, expenses, depreciation, amortization, interest, taxes and dividends to preferred shareholders. This is an accounting measure, meaning that non-cash items like depreciation and amortization is also included as a deduction to arrive at net income, However, this measure does not include changes in working capital nor capital investments made during the specific period which significantly affects a firm's cash flows. * Non-Cash Charges (Net). Pertains to non-cash items that are included in the eomoutalion 7 income. Analyst usually look at the statement of cash ore io “ ‘ fate potential non-cash charges. If amount in the income. stat ares st hot match amount reflected in the cash flows a temens tw a ibs indicative that a portion of that expense is non-ca: cash items are the following: —— inLUATION CON AND METHODOLOGIE © Depreciation and amortization When a firm acquires a fixed asset like equipment or intangible asset, the initial cash outflow is made at point of acquisition and is presented in the balance sheet. In succeeding periods, a portion of the initial cash outflow is recorded as depreciation and amortization which reduces net income, despite not having an actual cash outflow. As a result, this should be added back to arrive at the real cash flow. © Restructuring charges Restructuring refers to the change in the organizational structure or business model of a company adapt to changing economic climate or business needs. Most restructuring involves involuntary separation of employees. As a result, the restructuring requires the company to pay them severance pay. Severance pay should comply with the minimum requirements set in the Labor Code of the Philippines. Severance pays are normally outright cash outflows. The company may also need to record write-down in value of pension assets (or reversal of previous accruals) as a result of the restructuring activity. This is usually recorded as part of the restructuring expenses (income) in the income statement. However, since there are no cash outlays involved in write- downs (reversal gains), this should be added back to (deducted from) net income to get NCF. © Provisions for Doubtful Accounts These are estimated amount to be incurred for the customers inability to pay on time which is cumulatively accounted under the statement of financial position reported against the accounts receivable. Since these amounts represent the value that may have high probability of collection but not yet written off, meaning there is a positive chance that it can still be collected then it should be added back to the net income attributable to common.AND METHODOLOG VALUATION CONCEP » After-Tax Interest Expense Interest expense (net of any tax savings) This interest expense |s a cash flow intended for the debt providers. In the Philippines, interest expense is a tax-deductible expense for the company. This means that when the company pays interest, it reduces tax to be paid. Hence, the cash outflow is the amount of interest expense less any tax savings. After-tax interest expense is added back to net income since the objective of NCF is to measure the cash flows associated with the operating activity of the business, The impact of financing should be neutralized to arrive at the real business value based on its operations. » Working Capital Adjustment Also known as working capital, this item represents the net investment in current assets such as receivables and inventory reduced by current liabilities like payables, The amount captured is based on the movements in these accounts from prior year. Required investment in current assets tend to increase when a firm's sales grow consistently year on year. Higher receivables and inventories are needed in order to support rising revenues. The company also needs higher financing through accounts payable or taxes payable to fund these receivables and inventories. Increase in current assets means cash outflow while higher current liabilities are cash inflows. Otherwise, the company may miss out on sales growth if they lack the current assets and liabilities to support it. Fast growing firms engaged in industries with high working capital needs like retailing and manufacturing tend to have substantial rise in working capital. Companies do not need to pay for taxes when they are investing in their operating capital. On the other hand, if current assets requirement decline, this means that more cash is available to debt and equity providers, thus, added back. For NCF and valuation purposes, movements in cash, marketable securities short-term notes payable and current portion of long-term debt is excluded in the computation. Cash is excluded since the purpose of the NCF exercise is to identity what is the real cash flow of the business, Marketable securities are also excluded since these are not directly linked to op' ions, On the other hand, notes payable and current portion of long-term debt are excluded si associated with the financing side of the business.vei Investment in Fixed Capital. made to purchase or pay for ca pera oe rpouired to support existing and future operas woe nal expenditures range from property, Plant and equipmen, naeseaary ft production requirements to intangible assets jig trademark, patent and copyrights. Firms expect that they will reap benefits for more than one year as @ result of these investments. The investment in fixed capital assumes that the projects financeg acceptable and has positive net present value. Increases in fixed capital investments use cash, hence, a reduction to Net Cash Flow. This is captured in the year that the cash outflow is made. Information related to these can be found in the balance sheet and statement of cash flows. Once initial cash payment is made, this is charged to succeeding year's income statement as depreciation and amortization. Treatment for depreciation and amortization applies. When gaps exist between amount of capital investment and depreciation (called as net capital expenditures), this is usual related to the growth profile of the company. Company expecting high growth tend to report high net capital expenditures compared to earings while low-growth companies usually have negative net capital expenditures, ae to acquisition of a new business also falls into this fea (aas full purchase amount reduces the Net Cash Flow in the Au'sition. If the acquisition involves non-cash settlement analysts should be caref ul in captu i instee» On the oth occurred, this ead + there are sale of capital expenditures et increase the cash ings, «170d back to the Net Cash Flow. This s&s in fixed capital for that men’ Consequently reduces the invest™=” Php 1,000,000 then hele For example, if a property is Sold fixed capital (6. ultimar youd feduce the amount of investment mately, an additi Hence, net investment in ition to net cash flows). low computation, a y/%€4 Capital is deducted to arrive at Net C2" Feceiver legat . d Cash since it aoe Net investment signifies that fi nalyst shou °Fe assets than it purchased for the Y Id us purchas: elated to State; $ "ed capital inert OF cash flows to analyze cash 1" Sstments. There are instances ¥"*"Te Ree aaa ERs e rks companies may Obtain fixed capital in exchange of shares which doesn't necessarily have impact to cash flows Even though transactions Might be non-cash for the current year, analysts should be careful in forecasting future fixed capital investments especially if will require cash outlays. From Statement of Cash Flows NCF can also be computed using cash flows from operating activities (in the statement of cash flows) as the starting point. Analysts usually start from this item since it already considers adjustment for noncash expenses and working capital investments. As a refresher, the statement of cash flows classifies cash flow into three major sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Cash Flows from Operating Activities Php xxx Add: Interest Expense (net of Taxes)” KKK | Less: Cash Flows from Investing Activities YKK Net Cash Flows to the Firm Php xxx *only if deducted from the operations * Cash flow from operating activities This represents how much cash the company generated from its operations. This shows how much cash is received from customers and how much cash outflows are paid to vendors. This also captures changes in current assets and current liabilities. Normally, this is computed from net income by considering non- cash items and working capital changes. This is considered in computing for NCFF. * Cash flow from investing activities This represents how much cash is disbursed (received) for investments in (sale of) long-term assets like property, plant and ‘equipment and strategic investments in other companies. This is considered in computing for NCFF If this section reflects transactions involving financial assets, this should be excluded. * Cash flow from financing activities nts how much cash was raised (or repaid) to finance This repr not considered when computing NCFF. This|ETHODOLOGIES VALUATION C INCEPTS rN figures will be accounted fo, these : a h Flows to the Equity. In th Net Cas e is simply beca' calculation of the e mindful how interest and dividends are Classi cash flows. IFRS allows interest and divin .d under operating or investing activities tis placed under operating or financin dinary items should also be Climinatey Analysts should b in the statement of received to be classifies interest and dividends paid ou activities. One-time or extraor' from the computation C. From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) EBITDA, net of Taxes Php xxx. Add: Tax Savings on Noncash Charges XXX Add / Less: Working Capital Adjustments. XXX Less: Investment in Fixed Capital Xxx Net Cash Flows to the Firm Php xxx * EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization pertains to income before deducting interest, taxes, depreciation and amortization expenses, net of taxes Since the basis of the computation for the NCFF is already the earnings after excluding the financing costs, taxes and other non on aes the NCFF should only consider the amount net of eso icable taxes to be paid. This to conservatively show the at the amount net to be realized by the investor. * Tax Savings on Non-cash Charges. Non-cash charges a EBITDA. However. it not typically adjusted it NCFF starts wit whether non, important that analyst should check EBITDA or not qar8e8 were already deducted in computing back. Ifnon-cash che oe then there is a need to add the item iS no need to add it back to me = fees from EBITDA, ther® Instead of adjustin, ' 19 for th the correspondin, © full amount, an , anal dd bac’ EBITDA. Severs nora as polated to this non cash cares sj amortization are tay. Charges such as depreciation 4! th deducti eS® expenses reduces hee _ Means that occurrence © that the compan: Id pay yy shoul 113Ne) Eee) APR iN thus, reducing cash outflow. This is added back to EBITDA to capture this impact. Concepts on investments in fixed and working capital is sarne a5 previous discussion. Net Cash Flow to Equity Net Cash Flow to Equity or NCFE refers to cash available for common equity participants or shareholders only after paying operating expenses, satisfying operating and fixed capital requirements and settling cash flow transactions involving debt providers and preferred shareholders. NCFE can be computed fom NCFF by considering items related to lenders and preferred shareholders. NCFE signifies the level of available cash that a business can freely declare as dividends to its common shareholders. This may still differ significantly from the dividends actually declared and paid out since this decision is made upon the discretion of a company’s board of directors. Companies tend to manage their dividend policy: some slowly increase dividends over time while some maintain current dividends despite actual profitability. As a result, dividend trend is seen as less volatile compared to earnings as this is managed by the board of directors. Net Cash Flows to the Firm | Php xxx ‘Add: Proceeds from Borrowings. KKK Less: Debt Service | YH ‘Add : Proceeds from Preferred Shares Issuance | KK | Less: Dividends on Preferred Shares | XKK Net Cash Flows to the Equity _ Php xxx Proceeds from Borrowing received by the company as a result of ICFF did not include items related to ived by the company from lenders. is with the company already, it is the cash flow available to common This refers to the amount of cash borrowing of long-term debt. Since N financing, it did not capture cash rece Since the cash from the borrowing i Added back to NCFF and forms part of Shareholders. eS ee—y—~—K_&~—_E—_e—eo"'t—i‘Cs:S:sS '; + Debt Service 5, | amount used to service the loang o, Debt Service is the total ‘ financing. This is the total amount of loan repayment and the interes expenses, net of income tax benefit The interest expense |S considered as part of the financing activities 5. hence deducted from Net Cash Flow since this is associated with ign, term debt of the company The amount to be included must exclude j, equivalent tax benefits from the interest. The tax benefit must accorg wth what was allowed by the tax regime where the business operates, Pie... note that this amount must be similar should an adjustment was made ». compute for the NCFF «Proceeds from Issuance of Preferred Shares Same with the debt, preferred shares as another form of financing, other than the issuance of ordinary equity, must also be factored in the calculation of the net cash flows available to equity. * Dividends on Preferred Shares. Since payments made to preferential shareholders in the form of dividends are outflows. This must be incorporated in the calculation as 2 reduction of the net cash flows to equity. Similarly, given the above formula as guiding principle, NCFE can be determined under the following approaches: A. Based from Net Income (or indirect approach) Net Income Available to Common shareholders Php xx i: Non Cash Charges (net) 200 xpense (net of Taxes: wx XXX A 3: Adjustment in Working Capital Less: Net Investment in Fixed Capital (Purchases - Sales of Fixed Capital __Investment)_ Add: Proceeds from Bon Less: Debt Service __ Add : Proceeds from Preferred Sh reds f "referred Shares |: Less: Dividends on Preferred Shares sevance Net Cash Flows to the EquityNTC RAG GUD MT En mT Inn p, From Statement of Cash Flows Cash Flows font) Gperating Activities Vhip een Add: Interest | pense (Het of Taves)! vin Less Gash | lows froin Investing Av tivities wo. Net Cash [lows to the }inm wen Add: Proceeds fom Lorrowing wen Less: Debt Lervice wun Add; Procesds fom eferied Ghares Issuance Kun Less; Dividends on Prefered hares hon Net Cash Flows to the Equity Php xxx C, From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) EBITDA, net of Taxes Php xxx AC x Savings on Noncash Charges HHH Working Capital Adjustinents KKK \ n ment in Fixed Capital KK Net Cash Flows to the Firm, Xxx de from Borrowing HAX XxX XXX sa XK Php xxx Terminal Value Since GCBOs Is assumed to operate in a long period of time to almost Perpetuity, the risk and returns are inherent to the opportunity at the end of ‘he projection period should also be quantified, Furthermore, the economic Value that will be generated by the assets is expected to be stable after some Point in time since the projections are reliant on certain assumptions made. he challenge for the determination of the value of the asset js to also account or the economic returns that it wil in perpetuity. This is addressed by the Terminal Value, Terminal Value represents the value of the company in Perpetulty or ina going concern environment. In practice, there are several ‘4Y8 on how to determine the terminal value,(I; Basis of Terminal Value 1. Liquidation Value gome analysts find that the terminal value be based on the estimatey salvage value of the assets. Methodologies on how to determine the salvage or liquidation value was discussed in Chapter 3. ) Estimated Perpetual Value terminal value is by using the farthest Another way to determine the divided by the cost of capital less the ash flows you can estimate growth rate, TV = Terminal Value CFn+1 = Farthest net cash flows r= cost of capital g = growth rate For example, a Filipino company is expecting for 15% returns fora venture and assumes that their net cash flows for the next five yeas are as follows: Year Net Cash Flows (in million Php) 5.00 5.50 3 6.05 eT] 6.66 en 7.32 In th ; Traine wan lustraton, you may note that the net cash fur « Growing annual. Assuming this is a GCBO, and it is exbectes wa is computed usi will behave on a normal trend. The growth rate sing Compounded annual growth rate formula: |-+100%(IE NCFo ™ net cash flows at the beginning NCF) = latest net cash flows n = latest time Substituting the given figures, the growth is computed as in (ae “ 500) g = (1.10 = 1) x 100% ‘ x 100% g = 10% Since the growth rate is 10%, it will be applied on the farthest cash flows i.e. on the 5" year equivalent to Php7.32, thus the farthest cash flows is now Php8.05 or will substitute the CFy.1. It is now assumed that the cash flows will continuously growth at the rate of 10% per annum. Thus, the formula can now be applied. py a Sines r=g __Php 8.05 ~ 15% — 10% Php 8.05 = 5% Php 8.05 = 5% TV = Php161 In some cases, that the historical growth pattern is undetermined, some analysts only consider the cost of capital or their required return to determine the terminal value. In the given illustration, you may note that difference on the terminal value: _ CF uss rg | TVND METHODOLOGIES ATION fon caged Al [ Ba Pop 805- TV = 75% — 0% Php 8.05 J Phpe® TV =—15% TV = Php53.66 You may observe that the terminal value in this case is more conservative by about Php107. 3. Constant Growth Challenges for some valuators is to determine the amount of required return for a specific type of asset or investment. In lieu of the required return, they use the growth rate as the proxy especially if the growth is constant and significant. 4. Scientific Estimates Other valuators especially those with vast experience already in some types of investments uses other basis for them to determine the reasonable terminal value. Using guesstimates is not prevented because in the end, equity values will still be based on negotiation. There is no perfect approach to determine the terminal value. Actually, some risk averse investors don't consider the terminal value in their valuation. The eierones in their appreciation on the determination or even the inclusion the terme is dependent on their risk appetite. Then 292!" id vee teeth will only serve as a reference to determine the reason” * the equity or the asset being purchased, This is why negotste plays a key role in finalizing the determined value. Bet ” Other inputs in the Net Cash Flows The present The e s hese a ie Net Cash Flows represents the value of the asset Hence, these are the caine ke assets are financed by debt 2 ie Statement of Financial Position, ae aa oF fi is on eo. : unt form of reporting: The discounted cash flows anal fn flows that the Project, opportuni of ert in all the projected stream ime investment and valuing gVALUATION CONCEPTS AND METHODOLOGIES the value it will generate in the future, that means the investment yielded an amount sufficient to cover the investment and allowing the investors to earn more. Same principle applies that the best opportunity is the one that will yield the highest present value or solely if the opportunity will result into a positive amount it should be accepted. Conservatively, the total outstanding liabilities must be considered and deducted versus the asset value to determine the amount appropriated to the equity shareholders. This is called the equity value. The opportunity that will result in the highest equity value is considered. DCF Analysis is most applicable to use when the following are available: « Validated Operational and Financial Information « Reasonable appropriated cost of capital or required rate of return « New quantifiable information Illustrative Example No.1 Bagets Corporation has projected to generate revenues, cash operating expenses, and the corresponding tax payments for the next five years: | Revenue Cash Operating Taxes Working Capital Expenses Adjustments 4 92.88 65.02 45.57 18.58 2 97.52 68.26 48.23 19.50 3 102.40 71.68 51.04 20.48 4 107.52 75.26 54.01 21.50 Ls 112.90 79.03 $7.15 22.58 ital that was purchased and invested in the The investment in fixed capi To be financed by: company amounted to Php100 Million. ith an annual interest of 10% payable ment will be due after 1 year; and coupon rate. * 60% from loan borrowing wi equally in five years. First pay! * 10% preferred shares with 8% of Bagets Corporation, assuming a 15% ' you are going to purchase 50% delat u be willing to pay? Fequired return, how much would yo! of Bagets Corporation equity is ion, the value ly 50% then the amount to be at stake is onl 0 x 50%). Based on the foregoing informati hp22.80 Million. If the amount Paid is Php11.4 Million (Php22.8! 2° |Bagets Corporation alysis: Discounted Cash Flows Analysis —___—____ ma «9782 1024 Revenue 65.02 - 6826, 7.68 Less: Cash operating Expenses 4557-4823 - $1.08 tess: Tax Payments 1858-1950 - 2048 Ad / (Less) : Working Capital Adjustment aS Net Cash Flows ‘moo Less: Investment in Fixed Capital A Add: Terminal Value ee Net Cash Flows to Firm 2 | 00 Aad: Proceeds from Borrowing, a ‘aoa. aaa on Less: Debt Service Add: Proceeds from Preferred shares B Less: Dividends to Preferred Shares B Net Cash Flows to Equity Discount Factor Discounted Net Cash Flows (NCFE,) Equity Value “4 Notes to Analysis 1 Terminal Value Calculation CFasy _ 45.86x(1+5%) 48.15 - = = = 5 VS Fg” 15% =5% = “Thay = Php 481.50 /2 Proceeds from Borrowings and Debt Service Financial Models in Discounted Cash Flows Analysis Financial Modelling is a sophisticated ar or for an analyst. Information is can advantage of a com Modelers to assist nd confidential activity in a company also be considered as competitive Most of the companies hire financial ind vast knowled, normally are economists, financial mi accountants are good candidate for Operational models and design long anagers, and accountants. Manager this role given their ability to understa term financial Strategies.VALUATION CONCEPTS AND METHODOLOGIES in order to develop financial models, the following steps needs to be opserved: 1, Gather historical information and references Historical information must be made available before the financial model is to be constructed. Historical information may be generated from, but not limited to the following: audited financial statements, corporate disclosures, contracts, and peer information. Audited Financial Statements are the most ideal reference for the historical performance of the company. The components of the Audited Financial statements enable the analyst or the financial modeler to assess the future ofthe company based on its past performance. Statement of Income are used to determine the historical financial performance, Statement of Financial Position is used to determine the book value of the assets and the disclosed stakes of the debt and equity financiers, Statement of Cash Flows illustrate how the company historically financing its operations and investments. Statement of Changes in Stockholder’s Equity provides the information on how much is the claim and dividend background of the company. One of the most important components of the financial statements are the Notes to the Financial Statements. It provides the summary of important disclosure that should be considered in the valuation. The financial modeler must be able to quantify these disclosures and more importantly the risks involved. Corporate disclosures are also key in developing the financial model. Corporate disclosures provide more context for the future plans and strategies he analysts or the financial modelers to of the company. This will enable ti identify the risks about the GCBO and quantify them accordingly. Since these formation that is known to others. are available to the public, it is the same int The difference among modelers are their personal appreciation to risk and their client's appetite for risks. tween parties. In valuing the GCBOs, it know the existing contracts and the ing firms offer transaction advisory Contracts are formal agreements be 'S important for the modeler to also kno Covenants contained in it. Large accounti Services to assist their clients who enter into new ventures. Due diligence is Necessary to verify any contingent liability and other legal risks surrounding at Opportunity and quantify it accordingly to have a more conservative value. © modeler must be able to classify the probability of these from occurring. Gathering this information is important to have a reasonable basis to quantify Nd incorporate it in the financial model. Ces 322 |AV7VRU VL (oro) eae AND METHODOLOGIES re also essential in, d other public information al Puts to Cae F rovides more context and even Suppo ‘odel, Peer information C financial mod: ‘ed in the valuation process. Peers ma, be the risks identified or will be assum other analysts, industry experts and other consultants. Internal members 4 the organization may also be considered as peers. However, the information sharing is restricted by law since these are insider information and is not fair for the public. Researches and studies can also be used as peer information In the Philippines, reliable sources could be the National Library ang lopment Studies. Researches and studies shareq Philippine Institute on Devel through conventions and forums will also be relevant inputs in the development of the financial model and in valuation. Collectively, the financial mode! must be able to filter the information that would be necessary for the valuation. Relevance and reliability of information are important. Not all information should be given consideration. Materiality is another consideration. Even if there are additional information gathered, there should be a sense of materiality assessment involved. Note that projections remain to be estimates. Therefore, only relevant items should be considered in the valuation 2. Establish drivers for growth and assumptions Once all relevant information was gathered and validated, drivers and assumptions can be established by conducting financial analysis. Drivers af@ suggested to be those validated and is represented by authorities like government or experts. Growth drivers are normally based on population, since most of the businesses are consumer goods. If services, industry growth may be used as a driver. In the Philippines, information is available from the Philippine Statistics Authority. Because the government needs to be transparent to its citizens, it fortunate that the information can be found in the government website or is disc i i governs isclosed to public through media with wider re@PP TIUULONRSOMGHURMG RMT nyt snyation National tues ea Aecounts al stations tena ® nr tb s% : 10 GNI TF0% tn totaly Mega fanaa ro rove Awome and ahh a Uivebiages, eat Gera, Labor wala, Are Fon twcome Kligh 87% thy 39,000.00 iy ate ey Philippine Statistics Authority Dashboard For other economic factors, drivers, and estimates, Bangko Sentral ng Pilipinas and National Economic and Development Authority are also other agencies that can be relied with. Certain statistical information can also be found from the websites or research centers of the Local Government Units and National Government Agencies. Research organizations may also be used, however, strong validation and evaluation needs to be done to isolate any form of biases that may affect value, The usual growth indicators used are: inflation, population growth, GNP or GDP growth. In economics, the inflation is the result of the movement of prices from a year to another. This is calculated by comparing the movement of the price of the basket of commodities from a year to another or a period to another. Inflation is computed using this formula: CPI Inflation = (ae) = 1x 100% CPlo CPI, = consumer price index — current year CPI, = consumer price index ~ base year rice of the basket of commodities you need the inflation to be used s. There are two ways: The consumer price index represents the PI ‘or a particular period. In financial modelling, 88 driver for certain operating and capital expenditure’ t0-calculate the value: (1) nominal and (2) real. Nominal financial models are already in current PE nite Mated inthe model already assumes thal aoe oe headline inflation to Cae of inflation or deflation respectively. SOM ues mar te an rac Ace he Bc incde the effect of changes in prices. Dut Ta aVALUATION CONCEPTS AND METHODOLOGIES operating expenses and capital expenditures, as if No changes in occur, If the financial model is in real prices, the cost of capita) shouig aes excludes the effect of inflation With the given equation, to illustrate, that in year 2019 the CPI is 154 Mean the cost of the basket is Php151. In year 2020, the CPI published is Phoise Obviously, the price of the basket grew, hence, inflation is expected to 2.64% [(185/151)-1 x 100%]. On the other hand, i the CPI published for 975 is Php 149, then it will be a deflation or decrease in prices at 1.32% (149159) = 1x 100%] To illustrate its application, supposed you are projecting for how much is the communication costs for 2021 when the cost in 2020 is Php5 Million, Given the calculated inflation of 2.64%, the communication costs to be incorporated in the financial model is Php5.132 Million. Other indicator is population growth rate. Population growth rate is factored in to serve as a growth driver for the demand of the product, particularly for the merchandising or manufacturing business. The services sector May use the growth rate in the businesses or the industry or sector that they are going to serve. The formula to calculate for the population growth rate is similar with the inflation, except that the input is the population count of a Particular segment in a particular year. To illustrate, suppose that in Barangay A in 2019 the population is 25,200. The survey is conducted in 2020 and the population is 26,460. Using the formula of inflation to calculate for population growth rate = (248) 08 ~ \25;200)~** 9=5% To illustrate the application, assuming that the estimated consumption of pan de sal in Barangay A is 5 pcs average per head. If you are going to project the number of pan de sal to be sold in 2021, it will be 138,915 units computed as follows: Current pan de sal sold (26,460 x 5) 132,300 Increase in pan de sal (26,460 x 5% x 5) Total estimated pan de sal 6,615 Financial ratios may be used as tools to determine the growth drivers a4 assumptions. Trend analysis will also help you establish the trajectory’ growth pattern. The financial modeler Must assess whether the company esVALUATION CONCEPTS AND METH velKelel a4 gustan the pattem otherwise it is conservative to assume a less aggressive vowth Normally the weighted growth pattern will be considered in the long- tern financial perspective. It must be assessed whether the average year on yeat growth will be sustained or may be surpassed zoilustrate, PUP Company's historical production grows 10% per year. It is expected that in the next five years the probability are as follows: Scenario Rate | Probability cS 5% | 10% B 10% | 40% Cc 15% | 50% With the given information, the weighted average growth rate to be used is 42% computed as follows: ‘Scenario Rate Probability | Weighted (1) (2) Tx (2). A 5% 10% | 0.5% B 10% 40% | 4.0% c 15% 50% | 7.5% Total | | 120% | In this situation, the financial modeler can safely use the 12.0% for projecting sales moving forward. Hence, if the sales for this year was reported to 8,500 units then under the average sales computed will result to 9,520 units sold. 3. Determine the reasonable cost of capital In determining the reasonable cost of capita, the financial modeler must be able to use the appropriate parameters for the company Generally, cost of debt and cost of equity are weighted to determine the cost of capital ‘easonable for the valuation +. Apply the formulae to compute for the value Nosmally in Financial Modelling, DCF is used to eed oe ee Sue "08 information are already available in Financia ee ye cnn Se other capital budgeting techniques like Internal . p "ofitablity Index etc. —EE—[Nee esare nu uaelrelerct sy For example, Delight Bakery Inc. projected volume of pan de sal to be Year 1 is 138,915 units, assuming 5% growth every year, and the est; required return of 10%. The pan de sal is sold at Php15 per unit with a. net income margin of 20%. Delight's equipment is capable of Producin, volume required for 10 years. It was noted that the company has utstang le debt of Php500,000 "9 in Using the inputs, the financial model may be presented through: a 8 ¢ ° F 6 7 1 Delight Bakery ine Financial Model Year Yea? Years veara Years Volume SK 138915 M5861 183.158 160819 aaa Price 45 5 ub 15 z Revenue "2083,725 2,187,915 2,297,810 2al2180 —aaagae Cash Net Income Margin 20% 20% 20% 20% ang Cash Net income 416,705 437,583 459,462 482,496 Sons” Discount Factor 10% os” 03" 075” 068” og 11) Discounted Net Cash Flows 378,859.09 361,638.84 345,200.60 329,510.28 sas 12) Enterprise Value (sum) 4,728,742.10_=SUM(D1L:H11) 13, Less: Debt 500,000 14) Equity Value Observe that the enterprise value is calculated by getting the sum of al discounted net cash flows. Alternatively, NPV function can be used in electronic spreadsheets. Below is an illustration where both should arrive at the same results. bs. D Fee eer 5| Volume 5% 138,915 | 245,861 153,158 160,812 18S 6] Price as 1s 15 15 2 4 Pssst 8 7|_ Revenue 2,083,725 2,187,915 2,297,310 2,412,180 253.78 8 | CashNet Income Margin 20% 20% 20% 2s _* 9, _ CashNetincome 416,745 437,583 459,462, 482496, SN 10] Discount Factor 10%” ccs eel cas aatemee oust <8” 14] Discounted Net Cash Flows 378,859.09 _ 361,638.84 345,200.60 329,510.28 31458 12| Enterprise Value (sum) 1,729,742.10 =SUM(D1i:#14) 13) _ Enterprise Value (NPV) 1,729,742.10 =NPV(10%,D9:H9) 14] Less: Debt 500,000 320,000. 13) Equity Value 1,229,742.10 RT 10Pe Sees ret METHODOLOGIES 5, Make scenarios and Sensitivity analysis based on the results. the advantage of having a financial Model is the , fat you car given information and get the results immediately For er Hs revious illustration the cost of capital used is 10%, How about if you ‘ind that cost of capital will be 12% or 15%, what will be the Enterprise Value? Ifthis is the Case, we need to design the financial Model to accommodate this through the use of Data Table feature in Microsoft Excel First, design a table where the values will be inputted : Next, select the table we prepared by highlightin, d g cells C17 to D19 and you go to DATA Tab and go to ‘What if Analysis then select ‘Data Table’. Data Table Dialogue box will appear and will ask you to enter the inputs. Since the table we are doing provides for a columnar input. Then we'll input C17 in the COLUMN INPUT and click OK. Data Table ? x Row input celk + 13) Column input celk $5171 | L Then the results will now be shown to you in the table | | | | j D An Se = r Equity Value 16) 40% 1,229,742.10 17, Base 12% 1,142,000.20 a aa i 15% 1,023,049.99 }TION CONCEPTS AND METHODOLOGIES It will be easier for you to determine which value to use. Since, in or the outstanding debt is Php500,000 then you have to play in the Mp Php1.2 Million to Php1.02 Million. © range oy The scenarios will be developed based on the set of possible like level of operating expense, mode of operations, capital development period etc. Emerging trend is having a Risk Base; wherein major systematic risk is incorporate such as climate economic sabotage, pandemic etc. Occurrences ©xPENditure 'd Valuation change, war. Sensitivity Analysis is almost similar with Scenario Modelling. The differen is that sensitivity analysis will have to select a driver or few drivers, cotore paribus, and check the degree of change it will cause to the results. Sensity analysis is a useful exercise in developing ballpark estimates. Components of Financial Model As described in the earlier part of this chapter, a financial model should be understandable, printable and auditable. The financial model should be designed in a way that the investor or the client of the analysts or the proponent themselves can understand the dynamics and follow the drivers to enable them to have a better appreciation and sound judgment of the results. Please bear in mind that the results of the financial models are just guide for the investors or even sellers of investment to determine the reasonable value. As a quick guide in developing a financial model the following components are recommended, particularly when using Microsoft Excel: e Title Page This provides an overview and the project being valued or assessed This includes also necessary information to secure the proprietary rights of the modeler or the firm he or she is working with. It may as include data cut-off to serve as a guide to the readers e Data Key Results This sheet summarizes the results of the study. This wi dashboard to enable the modelers to analyze the res' facilitate the readers’ appreciation on the results of the P! also facilitate preparation of pertinent reports. II serve as the sults and '° roject. TS : sitivity This also contains the valuation results, scenarios, and se” analysis. Graphs can also be found in this sheet. eeeVALUATION CONCEPTS AND METHODOLOGIES Assumption Sheet This sheet summarizes the assumptions used in the model. This is normally an input sheet where all inputs should be made. The information that can be found in this sheet must be linked to all the output sheets like Pro-forma Financial Statements, Supporting Schedules and Data Key Results. Pro-forma Financial Statements This presents the 3 components of the financial statements namely: Statement of Income, Statement of Financial Position and Statement of Cash Flows. In this sheet, you can also find some key financial ratios particularly those that has to do with financial performance and efficiency ratios. Some modelers also find it convenient to have their valuation computation be done in this sheet since the inputs of cash flows are already available here. Supporting Schedules This is like a subsidiary ledger which provides supporting computation to the components of the pr limit for the supporting sch electronic financial models co! the supporting schedules. ‘0 forma financial statements. There is no edules the only challenge is that the nsume large amount of data because of