Note on DCF Valuation

Ole-Kristian Hope

Note on Valuation Using Cash Flow Approaches

DCF methods are simply one of many methods to value firms. In the next note, you will
learn about accounting based valuation methods. The DCF method is one of the most
prevalent methods for valuation, and is used extensively in the investment banking
community.

Theory behind DCF Methods

The fundamental concept motivating the DCF model is that a firm's current value

∞
𝐸(𝐶𝐹𝑖 )
𝑉=∑
(1 + 𝑟)𝑖
𝑖=1

is the present value of the entire stream of cash flows.

Here, CF1, CF2, represent the future cash flows. The E in front of them represents the fact
that these are "expected" cash flow. No one know for sure what these are, but these are the
"expected" cash flows in the eyes of the stock market.

"r" is the discount rate. That represents the rate at which future cash flows are discounted
to the present.

"i" represents the number of periods in the future. The more in the future a cash flow is, the
more we will discount it.

Critical Elements of DCF Estimation

Note that the earlier expression requires an infinite stream of expected cash flows,
something that would be impossible and tedious to forecast. One way of simplify the
process is to rewrite the expression as

𝑁 ∞
𝐸(𝐶𝐹𝑖 ) 𝐸(𝐶𝐹𝑖 )
𝑉=∑ 𝑖
+ ∑
(1 + 𝑟) (1 + 𝑟)𝑖
𝑖=1 𝑖=𝑁+1

or

𝑁
𝐸(𝐶𝐹𝑖 )
𝑉=∑ + 𝑇𝑉
(1 + 𝑟)𝑖
𝑖=1
 Note on DCF Valuation
Ole-Kristian Hope

The second term on the right hand side is referred to as the "terminal value." How do we
get around the problem of "infinite" estimation? We do that by making forecasts for the
first N periods (the forecast horizon) and then using some simplifying assumptions about
cash flows way out there in the future. This makes the job of putting a number to this
"terminal value" easier.

The critical elements of DCF valuation are

i) The Cash Flow Estimates: Deciding how much these CF1, CF2, and CF3 are going
to be: this is done by means of a process such as forecasting.
ii) The Discount Rate: What discount rate do we use? How is it related to a firm's
financial structure and risk?
iii) Terminal Value: How do we decide what the terminal value should be?

We will talk about each of these elements in depth in the rest of this note. First, a conceptual
look at what we are valuing.

What are We Valuing?

The end result of our valuation process is to be able to say that "I believe Company X's
stock ought to be worth $ Y." Hence we are interested in the value of the stock.

Are we valuing the firm as a whole, or are we valuing the equity of the firm? Essentially,
one could think of firm value as the sum of value of the firm's debt and value of the firm's
equity. In the first case, one would value the firm as a whole and subtract out the value of
the debt to get the value of the equity. In the second case, we would value the firm's equity
straight away.

Both approaches are valid and acceptable, but what the definition of "cash flow" is and
what the discount rates are will vary based on the method.
 Note on DCF Valuation
Ole-Kristian Hope

1st Element: Cash Flow Estimates

The 1st element into the valuation process is the cash flow estimates. What are the cash
flows to use as the input to the valuation process? The answer is "unleveraged free cash
flows." What does that mean? Let us study the two words, "unleveraged" and "free."
Remember that we are valuing the firm and not just the equity alone. So we should consider
the cash flowing to both shareholders and debtholders. We should add back the (after tax)
interest that the firm pays to any cash flow measures that we get from our cash flow
statement. This is "unleveraged" cash flow as it takes out the effect of debt or leverage.

The second key word is "free." "Free" cash flow is that cash that the firm generates after
taking care of whatever it needs to continue to stay in business. We must subtract changes
in working capital items from net income (which we anyway do to get CFO), as well as
capital expenditure.

We define free cash flow, FCF, as

FCF = Cash from Operations - Net Capital Expenditures + Interest (1-Tax Rate)

If we break up how we get CFO from Net Income (NI)

FCF = (NI + Depreciation - ∆Working Capital) - Net Capital Expenditures + Interest(1Tax

Rate)

Rearranging

= NI + (Depreciation - Net Capital Expenditures) - ∆Working Capital + Interest(1Tax Rate)

Think about what this means in steady state (no growth). At that time, the firm simply
makes capital expenditures to replace used up assets (Depreciation = Net Capital
Expenditure) and Change in Working Capital is zero. This means that Free Cash Flow
essentially equals Net Income + Interest(1-Tax Rate). Looks Familiar? It is the numerator
of the ROA ratio.

2nd Element: Discount Rate

The second element is figuring out what discount rate to discount the future free cash flows.
For this, we will rely heavily on Finance theory, specifically, on the Capital Asset Pricing
Model.

Let us first define two expressions - cost of debt and cost of equity.
 Note on DCF Valuation
Ole-Kristian Hope

Cost of Debt

The cost of debt is a relatively simple concept. It is simply the interest rate the firm has to
pay for its borrowing. Hence, if a firm has $150 million in debt, and the average interest
rate the firm pays on it is 9%, the cost of debt is 9%. Note that this is a "pre-tax" cost of
debt. To get the after tax cost, we must multiply this by (1-tax rate). If the tax rate is 35%,
the after tax cost of debt is 9%*(1-0.35) = 5.85%

Cost of Equity

The cost of equity is a measure of the expected return on the firm's equity. One fundamental
concept in finance (and generally in life), is that risk and return are highly positively related.
If you take high risks, you will get higher "expected" returns. Similarly, if you eschew risks,
your "expected" returns will be lower. Hence, the cost of equity is also a measure of the
risk of a firm's equity.

The Capital Asset Pricing Model, we can determine the cost of equity as

Re = Rf + β*(E[Rm] - Rf)

where

Rf is the "risk free rate" β or Beta, is referred

to as "systematic risk" (E[Rm] - Rf) is referred
to as "market premium"

The risk free rate measures the rate of return on a risk less investment, and is usually the
interest rate on longer (or intermediate) term government bonds (treasury bonds).

β is a measure of how much more risky is a stock than the market as a whole. If a stock has
a β of 1, it means that if the stock market goes up 5%, we expect the stock to also go up 5%,
and if the stock market down 5%, we expect the stock to also go down 5%. If a stock has a
β of 1.5, then for a stock market increase of 5%, we expect the stock to go up 7.5%, and
similarly, if the stock market declines by 5%, the stock will go down 7.5%. A higher β,
means that market level movements ("systematic") are amplified, hence increasing risk. β
is calculated by regressions of past stock price movements on market movements. Firm βs
are easily available from any number of sources, including on-line research web sites.

The last term represents the market premium, or the extent to which the stock market has
outperformed risk free investments historically. For the entire last expression, one usually
plugs in a number usually in the range of 4% to 8%, which is a commonly used estimate of
what market premium is. Note that one does not calculate Rm - Rf explicitly. The reason is
that the CAPM is a model of "expected" returns and not a model of "realized" returns.
 Note on DCF Valuation
Ole-Kristian Hope

Let us look at a small example to calculate the cost of equity.

Example 1

Firm A has a β of 1.2. Return on a 15 year government Treasury Bond is 5%. What is the
cost of equity?

What we know is β = 1.2

Rf = 5%

Also, we know that (E[Rm] - Rf) has been 7.5% historically.

Hence Re = 5% + 1.2*7.5% = 14%

Weighted Average Cost of Capital

Remember that the free cash flows as we define them are unleveraged, that is, flows to both
shareholders as well as debtholders. The appropriate rate at which to discount them is the
"Weighted Average Cost of Capital."

WACC is a measure that uses the proportion of debt and equity in a firm to weight the cost
of debt and cost of equity to come up with a measure of the "riskiness" or "expected return"
of the firm as a whole.

The measures we use for weights are the market values of debt and market values of equity

WACC = (V d /V d +V e )*Cost of Debt(1-Tax rate) + (V e /V d +V e )*Cost of

Equity

where

Vd = Market Value of debt (usually same as book value of debt, unless there has been a
drastic change in interest rates)

Ve = Market Value of Equity (market capitalization) = No of Shares Outstanding * Stock

Price

Cost of Equity and Cost of Debt are as defined earlier.

Let us do another example to calculate cost of equity, cost of debt and finally WACC
 Note on DCF Valuation
Ole-Kristian Hope

Example 2:

Firm B has $ 500 million of debt on which it pays an average of 8% interest. Its stock price
is $25, and the firm has 40 million shares outstanding. Its β is 1.1. The rate of interest on a
15 year government bond is 5%. The tax rate is 30%.What is firm B's
WACC?

Step 1: Cost of Debt

The cost of debt is 8%. The after tax cost of debt is (1-0.3)*8% = 5.6%

Step 2: Cost of Equity

Here Rf = T Bond rate = 5%, Market Premium = 7.5% and β = 1.1

From CAPM
Re = Rf + β*(E[Rm] - Rf)
= 5% + 1.1*7.5% = 13.25%

Step 3: WACC

WACC = (Vd/Vd+Ve)*Cost of Debt(1-Tax rate) + (Ve/Vd+Ve)*Cost of Equity

Vd = $500 million
Ve = $25 per share * 40 million shares = $1000 million

Hence WACC

= (500/(500+1000))*5.6% + (1000/(500+1000))*13.25%
= (1/3)*5.6% + (2/3)*13.25% = 10.7%

What do the weights of 1/3 and 2/3 mean? They mean that firm B is 1/3rd debt financed
and 2/3rd equity financed ($500 million in debt and $1000 in equity).
 Note on DCF Valuation
Ole-Kristian Hope

3rd Element: Terminal Value Calculation

The third element in the calculation of the value of a firm is the calculation of terminal
value. Note that the terminal value is a simplification we included because we cannot
forecast cash flows for an infinite horizon. To calculate terminal value, we make
simplifying assumptions about cash flows and growth in the time period after the forecast
horizon.

Remember that the forecast horizon is the number of periods (n) for which we have
explicitly forecast the cash flows. After a certain horizon, we make the assumption that the
firm has attained steady state, that is, the firm's future cash flows will show some steady
pattern (which could include some growth).

Remember that

P = PV (CF1, CF2, ……CFn, …….) until infinity

or PV (CF1,…CFn) + PV(CFn+1,………) until infinity.

The second term is the Terminal Value.

Let us assume that from period n onwards, all future cash flows will grow at a growth rate
of g from the previous years.

Hence, the stream of cash flows is

CFn(1+g), CFn(1+g)2, CFn(1+g)3 ………..

As of Year n, the present value of these cash flows can obtained by discounting these
numbers using the wacc just as before.

The discounted stream is the terminal value as of Year n.

TVn = CFn(1+g) + CFn(1+g)2 + CFn(1+g)3 + ……….

(1+wacc) (1+wacc)2 (1+wacc)3

This is a perpetuity with growth, i.e. the sum geometric series with a factor of (1+g)
(1+wacc)

Simplifying the expression

 Note on DCF Valuation
Ole-Kristian Hope

TVn = CFn(1+g)
(wacc-g)

It is important to remember that this is the terminal value as of year n.

What we have done is to convert all the cash flows from period n+1 onwards until infinity
into a simple expression in terms of cash flow in period n, growth rate and
WACC.

What happens if growth rate is zero? The expression simplifies to TVn = CFn/wacc

What determines the forecast horizon? It depends on two factors. The first is "How soon
do we expect the firm to reach a steady state?" If we expect this soon, we can use a short
forecast horizon. If not, we should use a longer forecast horizon. The second factor is "How
sure are we about our assumptions for the terminal value calculation?" If we are reasonably
sure of our assumptions, we can use a short horizon. If not, we should use a longer horizon,
so that we can be sure that not too much of the value we calculate lies in the terminal value.
 Note on DCF Valuation
Ole-Kristian Hope

Step 4: Putting It All Together

We have essentially learnt how to do the following.

i) Figure out the free cash flows for up to the first n periods
(forecast horizon)
ii) Calculate the discount rate we are going to use (WACC) iii)
Calculate the terminal value as of period N

Now all we need to do is to put it all together. That is quite straightforward. We have the
free cash flows for first n periods. We also know what the terminal value is as of year n.
All we have to do is discount it all back to the present (i.e., time 0). Remember that the
terminal value is also discounted back, as we calculated it for year n. Hence

V = CF1/(1+wacc) + CF2/(1+wacc)2 +….+ CFn/(1+wacc)n + TVn/(1+wacc)n

Refinement: Some people multiply the figure they get by (1+wacc/2). This is to adjust for
the fact that cash flows on average come in the middle of the year, while in this model we
assume they come at the end of the year, and hence discount them by half a year too much.

Are we done? Not quite yet. Note that V is the value of the enterprise, that is, the value of
the debt and equity. To get the value of equity, we need to subtract the value of debt. To
get the price per share, we need to divide the value of equity by number of shares.

Projected Value of Equity = Projected Value of firm - Value of

debt

Price per share = Projected Value of Equity/No of shares

outstanding

Let us illustrate the entire process of DCF valuation with the following example.

Example 3

Firm C's forecasts for the next 5 years are in the table below. The firm has 100 million
shares and has debt of $100 million. The tax rate is 30%. The Weighted Average Cost of
Capital is 12%. Assume 5% terminal growth. Calculate the price per share.

All numbers in $ millions

Year 1 Year 2 Year 3 Year 4 Year 5
CFO 100 110 125 140 150
 Note on DCF Valuation
Ole-Kristian Hope

Interest 10 10 10 10 10
Capital 10 12 14 16 17
Expenditure

Step 1: Calculate Free Cash Flows

FCF = CFO + Int(1-T) - Capital Expenditure

For the next five years

Year 1 Year 2 Year 3 Year 4 Year 5

CFO 100 110 125 140 150
PLUS 10*(10.3) 10*(10.3) 10*(10.3) 10*(10.3) 10*(10.3)
Interest*(1- =7 =7 =7 =7 =7
t)
MINUS 10 12 14 16 17
Cap.
Expenditure
EQUALS 97 105 118 131 140
Free Cash
Flows

Step 2: Calculate the Discount Rate

This step has already been done for us as WACC has been given as 12%

Step 3: Calculate Terminal Value

We use year 5's cash flow as the benchmark for TV Calculations (CFn). Here n=5.
The formula for TV as of year 5 is

TVn = CFn(1+g)
(wacc-g)

Here CFn is the free cash flow for year 5, that is, 140. g = 5% or 0.05

wacc = 12% or 0.12

Hence TVn = 140*(1+0.05) = 140*1.05 = 2100

(0.12-0.05) 0.07
 Note on DCF Valuation
Ole-Kristian Hope

Step 4: Put it all together

Let us put all the cash flows and terminal values and discount them to get value. We use
wacc (12%) to do the discounting.

FCF 1 FCF 2 FCF 3 FCF 4 FCF 5 TV 5

Amount 97 105 118 131 140 2100
Years in 1 2 3 4 5 5
Future
PV Factor 0.8929 0.7972 0.7118 0.6355 0.5674 0.5674
Present Value 87 84 84 83 79 1192

Hence the Value of the Firm equals the sum of the last row, or 1609.

Let us also adjust for the middle of the year, by multiplying this by (1+wacc/2) or (1 +
0.12/2) or 1.06. This gives us 1609*1.06 = 1706.

What is the Value of Equity?

Value of Equity = Value of firm - Value of debt = 1706 - 100 = 1606.

What is price per share?

The price per share = $1606 million = $ 16.06

100 million shares

Hence according to DCF calculations, Firm C's stock should be worth $16.06
 Note on DCF Valuation
Ole-Kristian Hope

Problems with DCF Valuation Models

DCF models are used quite extensively. They are not however free of problems. Here are
some problems that exist in DCF valuation.

First, a large part of the value lies in the terminal value calculations. Look at the previous
example. Out of the total value of 1609 (before mid-year adjustment), 1192 came from
terminal value. This is more than 2/3 of the total value. Terminal value calculations are at
best approximations, and are very sensitive to assumptions that are made. If we had
assumed 7% growth instead of 5%, the terminal value would have been 2996, while if we
had assumed 3% growth, the terminal value would have been 1602.

(Check these out yourselves). These are huge fluctuations for small changes

Second, there is a circularity in argument in how we calculate value. To calculate the value
of the equity, we need the value of the firm, for which we need WACC, for which we need
the value of equity (for the weights). That's not too comforting. To get around this, we use
the actual prevailing market value of equity as the weight in order to get the discount rate,
but that is an approximation, and not accurate.

Third, research shows that cash flows are much more variable than earnings and that current
earnings are better predictors of future earnings and cash flows than current cash flows.
The improved predictability of earnings is what has led to a class of valuation models we
refer to as accounting-based valuation models. EVA is one such model, popularized by
Stern Stewart and Company. We will talk about these as well as other simpler earnings
multiple models in the next note.