Independent Study

DCF caveats in Practice

Linh Dao
Other considerations in reality
 1. The Value of Cash
The simplest and most direct way of dealing with cash and
marketable securities is to keep it out of the valuation - the cash flows
should be before interest income from cash and securities, and the
discount rate should not be contaminated by the inclusion of cash.
(Use betas of the operating assets alone to estimate the cost of
equity).
Once the operating assets have been valued, we should add back
the value of cash and marketable securities.
In many equity valuations, the interest income from cash is included
in the cash flows. The discount rate has to be adjusted then for the
presence of cash. (The beta used will be weighted down by the cash
holdings). Unless cash remains a fixed percentage of overall value
over time, these valuations will tend to break down.
 Discount cash for its low returns?
There are some analysts who argue that companies with a lot of cash
on their balance sheets should be penalized by having the excess
cash discounted to reflect the fact that it earns a low return.
Excess cash is usually defined as holding cash that is greater than what
the firm needs for operations.
A low return is defined as a return lower than what the firm earns on its
non-cash investments.
This is the wrong reason for discounting cash.
If the cash is invested in riskless securities, it should earn a low rate of
return.
As long as the return is high enough, given the riskless nature of the
investment, cash does not destroy value.
However, there is a right reason.
Managers can do crazy things with cash (overpriced acquisitions, pie-in-
the-sky projects.) and we have to discount for this possibility.
 2. Holdings in Other firms
Holdings in other firms can be categorized into
Minority passive holdings (<20%), in which case only the dividend from the
holdings is shown in the balance sheet
Minority active holdings (20-50%), in which case the share of equity
income is shown in the income statements
Majority active holdings (>50%), in which case the financial statements
are fully consolidated.
 Cross Holdings in Practice
Step 1: Value the parent company without any cross holdings.
This will require using unconsolidated financial statements
rather than consolidated ones.
Step 2: Value each of the cross holdings individually. (If we use
the market values of the cross holdings, we will build in errors
the market makes in valuing them into your valuation).
Step 3: The final value of the equity in the parent company
with N cross holdings will be:
Value of un-consolidated parent company
Debt of un-consolidated parent company
j= N
+ % owned of Company j * (Value of Company j - Debt of Company j)
j=1
 Example
Assume that we have valued Company A using consolidated
financials for $ 1 billion (using FCFF and cost of capital) and that the
firm has $ 200 million in debt. How much is the equity in Company A
worth?

Now, additionally assume that we are told that Company A owns

10% of Company B and that the holdings are accounted for as
passive holdings. If the market cap of company B is $ 500 million, how
much is the equity in Company A worth?

Now add on the assumption that Company A owns 60% of Company

C and that the holdings are fully consolidated. The minority interest in
company C is recorded at $ 40 million in Company As balance
sheet. How much is the equity in Company A worth?
 Using Market Value of Holdings
For majority holdings, with full consolidation, convert the
minority interest from book value to market value by applying
a price to book ratio (based upon the sector average for the
subsidiary) to the minority interest.
Estimated market value of minority interest = Minority interest on
balance sheet * Price to Book ratio for sector (of subsidiary)
Subtract this from the estimated value of the consolidated firm to
get to value of the equity in the parent company.
For minority holdings in other companies, convert the book
value of these holdings (which are reported on the balance
sheet) into market value by multiplying by the price to book
ratio of the sector(s). Add this value on to the value of the
operating assets to arrive at total firm value.
 3. Other Assets
Unutilized assets: If we have assets or property that are not being
utilized to generate cash flows (vacant land, for example), we have
not valued it yet. we can assess a market value for these assets and
add them on to the value of the firm.
Overfunded pension plans: If we have a defined benefit plan and
your assets exceed your expected liabilities, we could consider the
over funding:
Collective bargaining agreements may prevent us from laying claim to
these excess assets.
There are tax consequences. Often, withdrawals from pension plans get
taxed at much higher rates.

Avoid double counting an asset. If an asset is contributing to the

cash flows, we cannot count the market value of the asset in your
value.
 4. Discount for Complexity:
Company A Company B
Operating Income $ 1 billion $ 1 billion
Tax rate 40% 40%
ROIC 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Business Multiple Businesses
Holdings Simple Complex
Accounting Transparent Opaque
-> We would expect the complicated company to trade at a discount because what we
dont know (or what managers have not told us) is more likely to contain bad news
than good news
Complexity Score
 Dealing with Complexity
DCF in practice:
The Aggressive Analyst: Trust the firm to tell the truth and value the
firm based upon the firms statements about their value.
The Conservative Analyst: Dont value what we cannot see.
The Compromise: Adjust the value for complexity
Adjust cash flows for complexity
Adjust the discount rate for complexity
Adjust the expected growth rate/ length of growth period
Value the firm and then discount value for complexity
5. Defining debt for cost of capital
purposes
General Rule: Debt generally has the following characteristics:
Commitment to make fixed payments in the future
The fixed payments are tax deductible
Failure to make the payments can lead to either default or loss of control
of the firm to the party to whom payments are due.
Defined as such, debt should include
All interest bearing liabilities, short term as well as long term
All leases, operating as well as capital
Debt should not include
Accounts payable or supplier credit
 Book Value or Market Value
A distressed telecom company
$ 1 billion for the enterprise value
$ 1 billion in face value of debt outstanding but the debt is trading at 50%
of face value (because of the distress).
If valuing the firm as a going concern, the equity is worth $ 500 million (EV minus
Market Value of Debt)
If we were told that the liquidation value of the assets of the firm today is
$1.2 billion and that we were planning to liquidate the firm today
have to pay the face value of the debt, yielding a liquidation value for the equity of $
200 million.
But we should consider other potential
liabilities when getting to equity value

If we have under funded pension fund or health care plans, we

should consider the under funding at this stage in getting to the
value of equity.
Exclude cash needed to meet the unfunded obligation.
Avoid counting these items as debt in the cost of capital calculations.
If we have contingent liabilities - for example, a potential liability from
a lawsuit that has not been decided - we should consider the
expected value of these contingent liabilities
Value of contingent liability = Probability that the liability will occur *
Expected value of liability
 6. Equity Options
It is true that options can increase the number of shares
outstanding but dilution per se is not the problem.
Options affect equity value at exercise because
Shares are issued at below the prevailing market price. Options
get exercised only when they are in the money.
Alternatively, the company can use cash flows that would have
been available to equity investors to buy back shares which are
then used to meet option exercise. The lower cash flows reduce
equity value.
Options affect equity value before exercise because we have
to build in the expectation that there is a probability and a
cost to exercise.
 Example
XYZ company
$ 100 million in free cash flows to the firm
growing 3% a year in perpetuity
cost of capital of 8%
100 million shares outstanding
$ 1 billion in debt.
Value of firm = 100 / (.08-.03) = 2000
- Debt = 1000
= Equity = 1000
Value per share = 1000/100 = $10
 With options
XYZ decides to give 10 million options at the money
(with a strike price of $10) to its CEO.
EPS is decreased by less than 10%. The options will bring in cash
into the firm but they have time value.
 The Dilution Approach
The simplest way of dealing with options is to try to
adjust the denominator for shares that will become
outstanding if the options get exercised.
In the example cited, this would imply the following:
Value of firm = 100 / (.08-.03) = 2000
- Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Value per share = 1000/110 = $9.09
 The Treasury Stock Approach
The diluted approach fails to consider that exercising
options will bring in cash into the firm
The treasury stock approach adds the proceeds from
the exercise of options to the value of the equity before
dividing by the diluted number of shares outstanding.
In the example cited, this would imply the following:
Value of firm = 100 / (.08-.03) = 2000
- Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Proceeds from option exercise = 10 * 10 = 100 (Exercise price
= 10)
Value per share = (1000+ 100)/110 = $ 10
 Problems with the Treasury Stock
Approach
The treasury stock approach fails to consider the time
premium on the options. In the example used, we are
assuming that an at the money option is essentially
worth nothing.
The treasury stock approach also has problems with out-
of-the-money options. If considered, they can increase
the value of equity per share. If ignored, they are
treated as non-existent.
 Options In Practice
Step 1: Value the firm, using discounted cash flow or other valuation
models.
Step 2: Subtract out the value of the outstanding debt to arrive at the
value of equity. Alternatively, skip step 1 and estimate the of equity
directly.
Step 3: Subtract out the market value (or estimated market value) of
other equity claims:
Value of Warrants = Market Price per Warrant * Number of Warrants :
Alternatively estimate the value using option pricing model
Value of Conversion Option = Market Value of Convertible Bonds - Value of
Straight Debt Portion of Convertible Bonds
Value of employee Options: Value using the average exercise price and
maturity.
Step 4: Divide the remaining value of equity by the number of shares
outstanding to get value per share.
 Options considerations

Option grants affect value more

The lower the strike price is set relative to the stock price
The longer the term to maturity of the option
The more volatile the stock price
The effect on value will be magnified if companies are allowed to
revisit option grants and reset the exercise price if the stock price
moves down.