FINM 3005/6005

Lecture 2

DCF Valuation
Lecturer: Dr. Mohammed Abdullah AL Mamun
ANU Research School of Finance, Actuarial Studies and Statistics
Agenda for this week
 Different types of NPV models:
 Enterprise DCF model
 Economic profit model
 Adjusted Present Value (APV)
 Equity cash flow models

 Enterprise DCF valuation . . . in more depth

 Items required to complete an enterprise DCF valuation:

 Estimating free cash flow (FCF)
 Estimating continuing (i.e. terminal) value
 Valuing non-operating assets
 Value of non-equity claims
 Timing adjustments

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Why discounting?
Which would you rather receive: A or B?
Today 1 Year 2 Years

Today 1 Year 2 Years

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Why discounting?
Money received over time
is not equal in value.

So we “value” future money by

discounting.
Today 1 Year 2 Years

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Terminology
Net present value (NPV) General term referring to discounted
value for stream of cash flows

Discounted cash flow (DCF) ■ Another term for NPV

■ Sometimes used to refer to enterprise
DCF model of company valuation

Free cash flow (FCF) ■ Cash flows available for distribution to

providers of capital
■ Mostly used in total enterprise context

Economic profit (EP) ■ Returns, profits or cash flows in excess

of that required to meet cost of capital
■ Also known by other terms such as:
- economic value added (EVA®)
- shareholder value analysis (SVA)
- excess return on capital / excess profit
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NPV Analysis of Companies
 Objective: Estimate cash flow available to providers of capital, and
discount at the return required by those providers

 To meet this objective, you need:

1. Forecasts of cash flows (may arise from a company model)
2. Cost of capital estimate

 Various approaches exist based on the same principle, but employing

different structures and terminology. Key points of differentiation:
– Perspective: total enterprise vs equity holders
– Treatment of tax shield on debt: discount rate vs cash flows
– Discount rate: WACC vs keU vs keL (reflects above 2 points)
– Capital structure assumption: target (static) vs variable
– Presentation: cash flows vs capital invested + economic profit

 Approaches should give same result in theory; but may not in practice.
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NPV valuation models
Model Measure Discount factor Assessment
Enterprise FCF WACC (Weighted Works best for projects, business units,
DCF Average Cost of and companies that manage their
Capital) capital structure to a target level

Economic EP (plus WACC Explicitly highlights when a company

profit invested creates value
capital)
Adjusted FCF + Unlevered cost Highlights changing capital structure
present value Interest of equity (keU) more easily than WAC
WACC-based models
Tax Shield

Capital Capital Unlevered cost Compresses free cash flow and the
cash flow cash flow of equity (keU) interest tax shield in one number

Equity Cash flow Levered cost Difficult to implement correctly because

cash flow to equity = of equity (keL) capital structure is embedded within
dividends + cash flow. Best used when valuing
equity financial institutions.
capital Δs
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Which model?
 FINM3005/6005 will focus on the enterprise DCF model

 Alternatives should be considered in these situations:

– APV if capital structure is likely to be highly variable (eg.
infrastructure stocks)
– Equity DCF method for financials (Lecture 12)
– Dividend discount models (DDM) may be useful for ‘quick and
basic’ valuations. (Note: DDMs are form of equity cash flow valuation.)

 Economic profit approach is probably not worth the additional

effort, particularly as invested capital based on historical cost asset
values can be meaningless

 Capital cash flow method inferior to APV; not widely used

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 Enterprise DCF model - Overview
$ million

427.5
After-tax cash flow to debt holders 427.5

Debt value 1
110
Free cash flow 200.0
70 65
20 15
180
140
110 120
100

Cash flow to equity holders Equity value

227.5

90 85
70 70
Discount free cash flow by the 55
weighted average cost of capital.

Enterprise
value
1
Debt value equals discounted after-tax cash flow to debt holders plus the present value of interest tax shield .

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Steps in Enterprise DCF
1. Estimate NPV of cash flows from operations, discounting at
WACC:
a) Free cash flow generated over forecast horizon
b) Continuing value

2. Value non-operating assets

3. Enterprise value = value of operations + non-operating assets

4. Identify and value of non-equity claims (e.g. debt, options, prefs, etc)

5. Equity value = enterprise value – value of non-equity claims

6. Valuation of shares = equity value / number of shares 10

Enterprise DCF valuation (UPS, KGW p139)

Non-
operating
assets

Non-
equity
claims

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‘Bare Bones’ Enterprise DCF Analysis
Year 0 1 2 3 4 5 Terminal Growth

Value Drivers:
Sales Growth 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Salest+1 / Invested
1.20 1.20 1.20 1.20 1.20 1.20 1.20
Capitalt
NOPLAT Margin 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
Implied ROIC 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8%

Business Size:
Sales 1142.9 1200.0 1260.0 1323.0 1389.2 1458.6 1531.5 5.0%
Invested Capital 1000.0 1050.0 1102.5 1157.6 1215.5 1276.3 5.0%

Cash Flow:
NOPLAT 102.9 108.0 113.4 119.1 125.0 131.3 137.8 5.0%
Net Investment -50.0 -52.5 -55.1 -57.9 -60.8
Free Cash Flow 58.0 60.9 63.9 67.1 70.5
Terminal Value 1480.5

Valuation:
WACC 10.0%
Discount Factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.6209
Present Value 52.7 50.3 48.0 45.9 43.8 919.3
Enterprise Value 1160.0
EV / IC 1.16
See file ‘Enterprise DCF Bare Bones.xls” on Wattle 12
Free Cash Flow (FCF)

Free Cash Flow (FCF) = NOPLAT

+ Non-Cash Items
– Investments in Invested Capital

 FCF is after-tax cash flow available to all investors.

The DCF valuation will be built upon it!

 Excludes non-operating cash flows (treated and valued separately),

and financing items (i.e. shifts in invested capital)

 Make sure you think about appropriate adjustments for: (see KGW)
– Capex, plus any other investment in the operations
– Change in working capital
– Investments in intangibles & goodwill (if treated as assets)
– Change in leases (if capitalized)
– Foreign currency translation effects
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Free Cash Flow

Accountant’s cash flow statement Free cash flow

Current Current
year year
Net income 198 NOPLAT 210
Depreciation 20 Depreciation 20
Decrease (increase) in inventory (25) Gross cash flow 230
Increase (decrease) in accounts payable 25
Decrease (increase) in inventory (25)
Cash flow from operations 218
Increase (decrease) in accounts payable 25
Capital expenditures (70) Capital expenditures (70)
Decrease (increase) in equity investments (10) Gross investment (70)
Cash flow from investing (80) Free cash flow 160
After-tax nonoperating income 3
Increase (decrease) in interest-bearing debt (25) Decrease (increase) in equity investments (10)
Increase (decrease) in common stock 0 Cash flow available to investors 153
Dividends (113)
Cash flow from financing (138) After-tax interest expense 15
Increase (decrease) in interest-bearing debt 25
Increase (decrease) in common stock 0
Dividends 113
Cash flow available to investors 153
* Treat interest as a financial payout to investors, not as an expense
** Investments in operating items are subtracted from gross cash flow 14
*** Cash flow from nonoperating assets should be evaluated separately from core operations.
Continuing value – Background

 Continuing value (CV) is an estimate of the value of operations,

as at the end of the explicit forecast period.

 Calculations should be founded on “steady state” estimates:

– Margins, asset turnover, ROIC, etc should all be at sustainable levels
– NOPLAT, FCF and growth rates at maintainable or trend levels
– Target capital structure
– Note: If CV = 50% of DCF value, then ±10% cash flow => ±5% value

 Start from presumption of no excess returns beyond the period of

analysis (i.e. marginal ROIC or “RONIC” = WACC) . . .
. . . unless there is a good reason to assume otherwise

 Link explicit forecast horizon to duration of competitive advantage

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Methods of calculating continuing value
1. NPV-based valuation formula:
 NPV-based formulas facilitate clear focus on relation of CV with
growth rates, WACC & marginal ROIC beyond forecast horizon
 KGW preferred method is one of many, and has its own issues.
(Use it for FINM3005/6005; but always question if appropriate before
adopting.)
 Sensitivity to assumptions

2. Multiple-based:
 PE, EVM, or Price/Asset Backing
 Use multiples as they should be in future, not now: This may
require resorting to NPV-based formulas for guidance.
 Advantage of simplicity; anchored to plausible levels

3. Asset valuation – may be used in specific circumstances:

 Invested capital – may be valid if ROIC ≈ WACC
 Forecast liquidation value – only if ‘liquidation’ meaningful 16
KGW preferred formula

 g 

NOPLAT t 1  RONIC 
1
CV t  WACC  g Second formula is ‘option 3’
in KGW model.
if RONIC  WACC It should be your 1st choice
- unless there are good
NOPLAT t 1 reasons to expect value
CV t  WACC creation beyond the
forecast period
where:
CV = Continuing Value
NOPLAT = Net Operating Profit Less Adjusted Taxes
g = growth rate of NOPLAT in perpetuity
RONIC = Return On New Invested Capital
WACC = Weighted Average Cost of Capital
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Understanding the KGW formula for CV
(This slide is for information: will be skipped over during lecture)

 ‘g’ is best viewed as reflecting inflation plus any additional growth

arising from discretionary reinvestment

 The term ‘g/RONIC’ plays the role as a retention rate, scaling down
the numerator towards what is distributed out of NOPLAT after
allowing for reinvestment of FCF to support ‘g’

 Under inflation, NOPLAT > FCF because Depreciation < Capex. The
formula implicitly adjusts for this if baseline g = inflation

 The difficult part is estimating how much to top up ‘g’ for additional
reinvestment. Recommended formula below. (Note: This adjusts for fact
that KGW formula erroneously compounds inflation with any excess RONIC)
g = Inflation + % of FCF Retained * Real RONIC

 These complications are avoided if you assume RONIC = WACC

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KGW formula - sensitivity to inputs

Continuing 3,000
values g = 8%
$ Million 2,500

2,000

1,500 g = 6%
g = 4%
1,000

500

0
10 12 14 16 18 20
Return on new invested capital
Percent

WACC = 10 percent; NOPLAT = $100 million

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Valuing non-operating assets

 Ask this question: Is there anything else of value that is not

captured in the DCF valuation of operations?

 Methods to value these other assets:

1. Market value – if this provides the best estimate of value
2. Do your own valuation – e.g. NPV, multiple-based
3. Book value – usually a last resort

 See KGW for treatment of individual items

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Value of non-equity claims
 Other non-equity claims include:
– Debt
– Debt-equivalents – leases, pension liabilities, selected provisions
– Preference shares
– Hybrids – employee options, warrants, convertibles
– Minority interest

 Value attributable to equity holders is residual remaining after the

value of such claims is accounted for

 An underlying concept is that the best measure of the value of

such claims is their market value (where available)

 Many tricky issues . . .

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Value of non-equity claims

 Consistency issues
– What if your valuation differs from the basis of market pricing?
e.g. company priced for distress; but you value for recovery
– Market value of claims tied to enterprise value may then be
inconsistent with your valuation, so . . .
– You might consider alternative valuations / scenario analysis
– Relevant areas: High-yield debt, any options, preference shares

 Debt value
– Market value, in theory
– Book value is often acceptable; but consider whether you should
be finding or estimating an appropriate ‘market value’
– Don’t forget leases

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Non-equity claims (continued)
 Other provisions & claims
Question: Do any other liabilities or similar items of ‘real value’ exist
that could diminish what is left over for equity holders?

 Options (will be skipped over during lecture, see KGW for details)
– KGW walks through 2 treatments:
(A) Option value – valuation of option include in invested capital
(B) Exercise value – analyses capital as if options were exercised
– Option value method preferred conceptually; but exercise value may be
more efficient (and fits nicely with EPS dilution methods)
– Treatment of contingent equity claims may influence number of shares
used to estimate value per share
– Employee options: Distinguish the claim on future value from the
adjustment of (historic) earnings towards maintainable levels
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Timing adjustments
(This slide is for information: may be skipped over during lecture)

 KGW scales up present value of operations by ‘mid-year’ adjustment

factor. This will only be correct if you are valuing company at
beginning of the year.

 Timing issues are tricky: As cash flow accrues, the value of all claims
will vary. For instance, as you progress through the year:
– Cash flow may be applied to reduce debt
– Value of enterprise and equity rise as cash accrues and future cash
flows get nearer, hence increasing NPV

 A suggested practical approach:

– Use latest debt reporting as baseline (i.e. date of last company report),
deducting this to arrive at the value attributable to equity holders
– Adjust DCF valuation for mid-year effect plus time expired
e.g. Adjustment x months into year = (1 + WACC)^((6 + x)/12)
– Warning: It gets messy after a half-yearly report. 24
Wrapping up . . . what’s next??
 Going forward:
– Next week’s topic: “Building a company model”
– Readings: KGW Chapter 9

 What you should be working on:

– Forming a team and sign up for a Group on Wattle, then . . .
– Start reading about the company and its industry, and then . . .
– Perhaps inputting into the ‘Historical Data’ worksheet in KGW Model.
(Teams need to discuss model structure before going any further.)
– If you need to brush up the basics of financial accounting, do it now!

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