Discounted Cash Flow Valuation

The Inputs
K.VISWANATHAN

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 The Key Inputs in DCF Valuation

•Discount Rate
– Cost of Equity, in valuing equity
– Cost of Capital, in valuing the firm
• Cash Flows
– Cash Flows to Equity
– Cash Flows to Firm
• Growth (to get future cash flows)
– Growth in Equity Earnings
– Growth in Firm Earnings (Operating Income)

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 I. Discount Rate

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 Estimating Inputs: Discount Rates
Critical ingredient in discounted cash flow valuation.
Errors in estimating the discount rate or mismatching cash flows and
discount rates can lead to serious errors in valuation.
• At an intuitive level, the discount rate used should be consistent
with both the riskiness and the type of cash flow being
discounted.
– Equity versus Firm: If the cash flows being discounted are cash
flows to equity, the appropriate discount rate is the cost of equity.

If the cash flows are cash flows to the firm, the appropriate
discount rate is the cost of capital.
– Currency: The currency in which the cash flows are estimated
should also be the currency in which the discount rate is
estimated.
– Nominal versus Real: If the cash flows being discounted are
nominal cash flows (i.e., reflect expected inflation), the discount
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rate should be nominal
 Cost of Equity
The cost of equity is the rate of return that investors require to
make an equity investment in a firm. There are two approaches to
estimating the cost of equity;
– a dividend-growth model.
– a risk and return model
The dividend growth model (which specifies the cost of equity to
be the sum of the dividend yield and the expected growth in
earnings) is based upon the premise that the current price is equal
to the value. It cannot be used in valuation, if the objective is to
find out if an asset is correctly valued.
 A risk and return model, on the other hand, tries to answer two
questions:
– How do you measure risk?
– How do you translate this risk measure into a risk premium?

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 Risk and Return Models
Step 1 : Defining Risk :
The risk in an investment can be measured by the variance in actual
returns around an expected return
Step 2: Differentiating between Rewarded and Unrewarded Risk
Specific Risk Market Risk
Risk that is specific to investment (Firm Risk that affects all investments (Market
Specific) Risk)

Can be diversified away in a diversified Cannot be diversified away since it affects

portfolio . most assets
1. Each investment is a small proportion
of portfolio.
2. Risk averages out across investments
in portfolio

The marginal investor is assumed to hold a “diversified” portfolio.

Thus, only market risk will be rewarded and priced
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 Risk and Return Models
Step 3: Market Risk
The CAPM The APM Multi- factor Proxy Models
If there is If there are no Models In an efficient market,
1. no private arbitrage Since market risk differences in returns
information opportunities affects most or all across long periods
2. no transactions cost then the market risk investments, it must must be due to market
the optimal diversified of any asset must be come from risk differences. Looking
portfolio includes every captured by betas macro economic for variables correlated
traded asset. Everyone relative to factors factors. with returns should
will hold this market that affect all Market Risk = Risk then give us proxies for
portfolio investments. exposures of any this risk.
Market Risk = Risk Market Risk = Risk asset to macro Market Risk =
added by any exposures of any economic factors. Captured by the
investment to the asset to market Proxy Variable(s)
market portfolio: factors
Beta of asset relative to Betas of asset Betas of assets Equation relating
Market portfolio (from a relative to relative to specified returns to proxy
regression) unspecified market macro variables (from a
factors (from a economic factors Regression)
factor analysis) (from a Regression)

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 Beta’s Properties

•Betas are standardized around one.

• If
β = 1 ... Average risk investment
β > 1 ... Above Average risk investment
β b < 1 ... Below Average risk investment
β = 0 ... Riskless investment
•The average beta across all investments is one

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 Limitations of the CAPM
1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated
precisely
- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be
• a linear relationship between returns and betas
• the only variable that should explain returns is betas
4. The reality is that
• the relationship between betas and returns is weak
• Other variables (size, price/book value) seem to explain
differences in returns better.
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 Inputs required to use the CAPM
(a) the current risk-free rate
(b) the expected return on the market index and
(c) the beta of the asset being analyzed.
Risk free Rate in Valuation
The correct risk free rate to use in a risk and return model is
• a short-term Government Security rate (eg. T.Bill), since it has no default risk or
price risk
• a long-term Government Security rate, since it has no default risk
The Risk Free Rate:
On a risk free asset, the actual return is equal to the expected return.
Therefore, there is no variance around the expected return.
For an investment to be risk free, i.e., to have an actual return be equal to the
expected return, two conditions have to be met –
– There has to be no default risk, which generally implies that the security has to
be issued by the government. Note, however, that not all governments can be
viewed as default free.
– There can be no uncertainty about reinvestment rates, which implies that it is a
zero coupon security with the same maturity as the cash flow being analyzed.
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 Risk free Rate in Practice
• The risk free rate is the rate on a zero coupon
government bond matching the time horizon of the cash
flow being analyzed.
• Theoretically, this translates into using different risk free
rates for each cash flow - the 1 year zero coupon rate for

the cash flow in year 2, the 2-year zero coupon rate for
the cash flow in year 2 ...
• Practically speaking, if there is substantial uncertainty
about expected cash flows, the present value effect of
using time varying risk free rates is small enough that it
may not be worth it.

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 The Bottom Line on Risk free Rates
• Using a long term government rate (even on a coupon
bond) as the risk free rate on all of the cash flows in a
long term analysis will yield a close approximation of the
true value.
• For short term analysis, it is entirely appropriate to use a
short term government security rate as the risk free rate.
• If the analysis is being done in real terms (rather than
nominal terms) use a real risk free rate, which can be
obtained in one of two ways –
– from an inflation-indexed government bond, if one
exists
– set equal, approximately, to the long term real growth
rate of the economy in which the valuation is being
done.
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 The Bottom Line on Risk free Rates
• Using a long term government rate (even on a coupon
bond) as the risk free rate on all of the cash flows in a
long term analysis will yield a close approximation of the
true value.
• For short term analysis, it is entirely appropriate to use a
short term government security rate as the risk free rate.
• If the analysis is being done in real terms (rather than
nominal terms) use a real risk free rate, which can be
obtained in one of two ways –
– from an inflation-indexed government bond, if one
exists
– set equal, approximately, to the long term real growth
rate of the economy in which the valuation is being
done.
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 Measurement of Risk Premium
• The risk premium is the premium that
investors demand for investing in an average
risk investment, relative to the risk free rate.
• As a general proposition, this premium should
be
– greater than zero
– increase with the risk aversion of the investors
in that market
– increase with the riskiness of the “average”
risk investment
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 Risk Aversion & Risk Premium
• If this were the capital market line, the risk premium would be a
weighted average of the risk premiums demanded by each and
every investor.
• The weights will be determined by the magnitude of wealth that
each investor has. Thus, Warren Buffet’s risk aversion counts
more towards determining the “equilibrium” premium than
yours’ and mine.
• As investors become more risk averse, you would expect the
“equilibrium” premium to increase.
Estimating Risk Premiums in Practice
• We may survey investors on their desired risk premiums and use
the average premium from these surveys.
• We may assume that the actual premium delivered over long
time periods is equal to the expected premium - i.e., use
historical data
• We may estimate the implied premium in today’s asset prices. 15
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 The Survey Approach
•Surveying all investors in a market place is impractical.
•However, you can survey a few investors (especially the
larger investors) and use these results. In practice, this
translates into surveys of money managers’ expectations
of expected returns on stocks over the next year.
•The limitations of this approach are:
– there are no constraints on reasonability (the
survey could produce negative risk premiums or
risk premiums of 50%)
– they are extremely volatile
– they tend to be short term; even the longest
surveys do not go beyond one year
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 The Historical Premium Approach
 This is the default approach used by most to arrive at the premium to
use in the model
 In most cases, this approach does the following
– it defines a time period for the estimation (1945-Present,
1965- Present etc.)
– it calculates average returns on a stock index during the
period
– it calculates average returns on a riskless security over the
period
– it calculates the difference between the two and uses it as
a premium looking forward
 The limitations of this approach are:
• – it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from
year to year, but it reverts back to historical averages)
• – it assumes that the riskiness of the “risky” portfolio (stock index)
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has not changed in a systematic way across time.
 Implied Equity Premiums
• If we use a basic discounted cash flow model, we can estimate the
implied risk premium from the current level of stock prices.
• For instance, if stock prices are determined by the simple Gordon
Growth Model:
• Value = Expected Dividends next year/ (Required Returns on Stocks
- Expected Growth Rate)
• Plugging in the current level of the index, the dividends on the index
and expected growth rate will yield a “implied” expected return on
stocks.
• Subtracting out the risk free rate will yield the implied premium.
• The problems with this approach are:
– the discounted cash flow model used to value the stock index has
to be the right one.
– the inputs on dividends and expected growth have to be correct
– it implicitly assumes that the market is currently correctly valued

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 Estimating Beta

• The standard procedure for estimating

betas is to regress stock returns (Rj) against
market returns (Rm)-Rj = a + b Rm
– where ‘a’ is the intercept and ‘b’ is the
slope of the regression.
• The slope of the regression corresponds to
the beta of the stock, and measures the
riskiness of the stock.

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 Measuring Cost of Capital

• It will depend upon:

– (a) the components of financing: Debt,
Equity or Preferred stock
– (b) the cost of each component
• In summary, the cost of capital is the cost
of each component weighted by its relative
market value.
• WACC = ke (E/(D+E)) + kd (D/(D+E))

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 The Cost of Debt

The cost of debt is the market interest rate

that the firm has to pay on its borrowing. It
will depend upon three components-
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate

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 What the cost of debt is and is not..
• The cost of debt is
– the rate at which the company can borrow at
today
– corrected for the tax benefit it gets for interest
payments.
Cost of debt = kd = Interest Rate on Debt (1 - Tax
rate)
• The cost of debt is not
– the interest rate at which the company obtained
the debt it has on its books.
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 Estimating the Cost of Debt
• If the firm has bonds outstanding, and the bonds are
traded, the yield to maturity on a long-term, straight (no
special features) bond can be used as the interest rate.
• If the firm is rated, use the rating and a typical default
spread on bonds with that rating to estimate the cost of
debt.
• If the firm is not rated,
– and it has recently borrowed long term from a bank, use
the interest rate on the borrowing or
– estimate a synthetic rating for the company, and use the
synthetic rating to arrive at a default spread and a cost of
debt
• The cost of debt has to be estimated in the same currency
as the cost of equity and the cash flows in the valuation. 23
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 Estimating Synthetic Ratings
The rating for a firm can be estimated using the
financial characteristics of the firm. In its
simplest form, the rating can be estimated from
the interest coverage ratio
• Interest Coverage Ratio = EBIT / Interest
Expenses

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 Estimating Market Value Weights
• Market Value of Equity should include the following
– Market Value of Shares outstanding
– Market Value of Warrants outstanding
– Market Value of Conversion Option in Convertible
Bonds
• Market Value of Debt is more difficult to estimate
because few firms have only publicly traded debt. There
are two solutions:
– Assume book value of debt is equal to market value
– Estimate the market value of debt from the book
value
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 Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of
debt:
Equity will become riskier -> Cost of Equity will
increase.
2. Estimate the Cost of Debt at different levels of
debt:
Default risk will go up and bond ratings will go
down as debt goes up -> Cost of Debt will increase.
3. Estimate the Cost of Capital at different levels of
debt
4. Calculate the effect on Firm Value and Stock Price.
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 II. Estimating Cash Flows

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 Steps in Cash Flow Estimation
• Estimate the current earnings of the firm
– If looking at cash flows to equity, look at earnings after interest
expenses -i.e. net income
– If looking at cash flows to the firm, look at operating earnings
after taxes
• Consider how much the firm invested to create future growth
– If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash
flow, it will cover some of these expenditures.
– Increasing working capital needs are also investments for future
growth
• If looking at cash flows to equity, consider the cash flows from
net debt issues (debt issued - debt repaid)

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 Earnings Checks
When estimating cash flows, we invariably start with accounting
earnings. To the extent that we start with accounting earnings in a base
year, it is worth considering the following questions:
– Are basic accounting standards being adhered to in the calculation of
the earnings?
– Are the base year earnings skewed by extraordinary items –profits or
losses? (Look at earnings prior to extraordinary items)
– Are the base year earnings affected by any accounting rule changes
made during the period? (Changes in inventory or depreciation
methods can have a material effect on earnings)
– Are the base year earnings abnormally low or high? (If so, it may be
necessary to normalize the earnings.)
– How much of the accounting expenses are operating expenses and
how much are really expenses to create future growth?

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 Three Ways to Think About Earnings
1. Revenues -Operating Expenses= Operating Income
2. Revenues - Operating Margin= Operating Income
3. Capital Invested- Pre-Tax ROC= Operating Income
Capital Invested = Book Value of Debt + Book Value of
Equity
Pre-tax ROC = EBIT / (Book Value of Debt + Book Value
of Equity)
• The equity shortcuts would be as follows:
1. Revenues - Operating Expenses = Taxable Income.
Taxable Income- taxes = Net Income
2. Revenues- Net Margin= Net Income
3. Equity Invested-Return on equity= Net Income
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 Dividends and Cash Flows to Equity
• In the strictest sense, the only cash flow that an
investor will receive from an equity investment in a
publicly traded firm is the dividend that will be paid on
the stock.
• Actual dividends, however, are set by the managers of
the firm and may be much lower than the potential
dividends (that could have been paid out)
– managers are conservative and try to smooth out dividends
– managers like to hold on to cash to meet unforeseen future
contingencies and investment opportunities
• When actual dividends are less than potential
dividends, using a model that focuses only on dividends
will under state the true value of the equity in a firm.
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 Measuring Potential Dividends
• Some analysts assume that the earnings of a firm represent its
potential dividends. This cannot be true for several reasons:
– Earnings are not cash flows, since there are both non-cash revenues and

expenses in the earnings calculation

– Even if earnings were cash flows, a firm that paid its earnings out as
dividends would not be investing in new assets and thus could not grow
– Valuation models, where earnings are discounted back to the present, will
over estimate the value of the equity in the firm
• The potential dividends of a firm are the cash flows left over after
the firm has made any “investments” it needs to make to create
future growth and net debt repayments (debt repayments - new
debt issues)
– The common categorization of capital expenditures into discretionary and
non-discretionary loses its basis when there is future growth built into the
valuation.
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 Measuring Investment Expenditures
• Accounting rules categorize expenses into operating and capital
expenses. In theory, operating expenses are expenses that create
earnings only in the current period, whereas capital expenses are
those that will create earnings over future periods as well.
Operating expenses are netted against revenues to arrive at
operating income.
- There are anomalies in the way in which this principle is applied. Research
and development expenses are treated as operating expenses, when they are
in fact designed to create products in future periods.
• Capital expenditures, while not shown as operating expenses in the
period in which they are made, are depreciated or amortized over
their estimated life. This depreciation and amortization expense is a
noncash charge when it does occur.
• The net cash flow from capital expenditures can be then be written
as:
Net Capital Expenditures = Capital Expenditures - Depreciation
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 The Working Capital Effect
• In accounting terms, the working capital is the difference
between current assets (inventory, cash and accounts receivable)
and current liabilities (accounts payables, short term debt and
debt due within the next year)
• A cleaner definition of working capital from a cash flow
perspective is the difference between non-cash current assets
(inventory and accounts receivable) and non-debt current
liabilities (accounts payable)
• Any investment in this measure of working capital ties up cash.
Therefore any increases (decreases) in working capital will
reduce (increase) cash flows in that period.
• When forecasting future growth, it is important to forecast the
effects of such growth on working capital needs, and building
these effects into the cash flows.

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 Estimating Cash Flows: FCFE
Cash flows to Equity for a Levered Firm
Net Income
+ Depreciation & Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs (Changes in Non-cash Working Capital)
- Principal Repayments
+ Proceeds from New Debt Issues
= Free Cash flow to Equity

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 III. Estimating Growth

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 Ways of Estimating Growth in Earnings
• Look at the past
– The historical growth in earnings per share is usually a good
starting point for growth estimation
• Look at what others are estimating
– Analysts estimate growth in earnings per share for many firms.
It is useful to know what their estimates are.
• Look at fundamentals
– Ultimately, all growth in earnings can be traced to two
fundamentals - how much the firm is investing in new projects,
and what returns these projects are making for the firm.

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 I. Historical Growth in EPS
• Historical growth rates can be estimated in different
ways
– Arithmetic versus Geometric Averages
– Simple versus Regression Models
• Historical growth rates can be sensitive to
– the period used in the estimation
• In using historical growth rates, the following factors
have to be considered
– how to deal with negative earnings
– the effect of changing size

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 II. Analyst Forecasts of Growth
• While the job of an analyst is to find under and over
valued stocks in the sectors that they follow, a
significant proportion of an analyst’s time (outside of
selling) is spent forecasting earnings per share.
– Most of this time, in turn, is spent forecasting
earnings per share in the next earnings report
– While many analysts forecast expected growth in
earnings per share over the next 5 years, the analysis
and information (generally) that goes into this
estimate is far more limited.

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 III. Fundamental Growth Rates
(1) Investment in existing project=Rs. 1000
X Current return on investment on projects ( say 12%)
= Current earnings Rs. 120
(2) Investment in existing project=Rs. 1000
X Next period’s return on investment ( say 12%) +
Investment in new project = Rs. 100
X Return on investment of new project ( Say 12%)
= Next Period’s earnings = Rs. 132
(3) Investment in existing project=Rs. 1000
X change in the ROI from current period to next period (say 0%)
+ Investment in new project = Rs. 100
X Return on investment of new project ( Say 12%)
= Change in earnings = Rs. 12

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 Growth Rate Derivations

Reinvestment Rate x Return on investment = Growth rate in earnings

83.33 % X 12% = 10 %

If the ROI increases from 12% to 13%, the expected growth rate will be

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 IV. Growth Patterns

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 Stable Growth and Terminal Value
• When a firm’s cash flows grow at a “constant” rate forever, the
present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r – g)
Where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
• This “constant” growth rate is called a stable growth rate and
cannot be higher than the growth rate of the economy in which
the firm operates.
• While companies can maintain high growth rates for extended
periods, they will all approach “stable growth” at some point in
time.
• When they do approach stable growth, the valuation formula
above can be used to estimate the “terminal value” of all cash
flows beyond.
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 Growth Patterns
• A key assumption in all discounted cash flow models is the period
of high growth, and the pattern of growth during that period. In
general, we can make one of three assumptions:
– there is no high growth, in which case the firm is already in
stable growth
– there will be high growth for a period, at the end of which the
growth rate will drop to the stable growth rate (2-stage)
– there will be high growth for a period, at the end of which the
growth rate will decline gradually to a stable growth rate(3-stage)
Stable Growth 2-Stage Growth 3-Stage Growth

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 Determinants of Growth Patterns
• Size of the firm
– Success usually makes a firm larger. As firms become larger, it
becomes much more difficult for them to maintain high growth rates
• Current growth rate
– While past growth is not always a reliable indicator of future growth,
there is a correlation between current growth and future growth.
Thus, a firm growing at 30% currently probably has higher growth and
a longer expected growth period than one growing 10% a year now.
• Barriers to entry and differential advantages
– Ultimately, high growth comes from high project returns, which, in
turn, comes from barriers to entry and differential advantages.
– The question of how long growth will last and how high it will be can
therefore be framed as a question about what the barriers to entry
are, how long they will stay up and how strong they will remain.

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 Stable Growth and Fundamentals
• The growth rate of a firm is driven by its fundamentals - how
much it reinvests and how high its project returns are. As growth
rates approach “stability”, the firm should be given the
characteristics of a stable growth firm.
Model High Growth Firms Stable growth firms usually
usually

DDM 1. Pay low or no 1. Pay high dividends

dividends 2. Have average risk
2. Have high Risk
3. Earn high ROC

FCFE/ 1. Have high net capex 1. Have lower net capex

FCFF 2. Have high risk 2. Have average risk
3. Earn high ROC 3. Earn ROC closer WACC
4. Have low leverage 4. Have leverage closer to industry average

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 Discounted Cash Flow Valuation
Inputs

THANK YOU

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