💹Business Valuation Unit 3 – Discounted cash flow methods

Key Concepts and Definitions

• Discounted cash flow (DCF) valuation estimates the intrinsic value of an investment based on its expected future cash flows
• Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain capital assets
• Net present value (NPV) calculates the present value of a project's expected cash inflows and outflows, discounted at the required rate of return
• Internal rate of return (IRR) represents the discount rate that makes the NPV of a project's cash flows equal to zero
• Terminal value estimates the value of a company's cash flows beyond the explicit forecast period, assuming a stable growth rate
• Weighted average cost of capital (WACC) calculates a firm's cost of capital, considering the proportional weights of each component of its capital structure
• Perpetuity assumes a constant stream of cash flows that continues indefinitely, with no end date
• Discount rate reflects the required rate of return and the risk associated with an investment or project

Time Value of Money Basics

• Time value of money (TVM) recognizes that money available now is worth more than an identical sum in the future due to its potential earning capacity
• Present value (PV) calculates the current equivalent value of a future sum of money or stream of cash flows given a specified rate of return
  • PV is calculated using the formula: $PV = \frac{FV}{(1+r)^n}$, where FV is the future value, r is the discount rate, and n is the number of periods
• Future value (FV) determines the value of a current asset at a specified date in the future based on an assumed rate of return
  • FV is calculated using the formula: $FV = PV(1+r)^n$
• Compounding refers to the process of generating earnings on an asset's reinvested earnings
  • Compound interest can be calculated using the formula: $A = P(1+\frac{r}{n})^{nt}$, where A is the final amount, P is the principal, r is the annual interest rate, n is the number of times interest is compounded per year, and t is the number of years
• Discounting is the process of finding the present value of a future cash flow or series of cash flows

Types of Discounted Cash Flow Methods

• Firm valuation estimates the value of an entire company by discounting its expected free cash flows to the firm (FCFF) at the weighted average cost of capital (WACC)
• Equity valuation values a company's equity directly by discounting expected free cash flows to equity (FCFE) at the cost of equity
• Adjusted present value (APV) separates the value of a levered firm into the value of the firm without debt and the present value of the tax shield provided by debt financing
• Dividend discount model (DDM) values a company's equity based on the present value of its expected future dividend payments
  • The Gordon growth model, a variant of the DDM, assumes a constant dividend growth rate and calculates the stock price using the formula: $P = \frac{D_1}{r-g}$, where $D_1$ is the expected dividend per share in the next period, r is the required rate of return, and g is the constant growth rate in perpetuity
• Discounted abnormal earnings model values a company based on its book value of equity plus the present value of its expected abnormal earnings (earnings above the required rate of return on equity)

Calculating Free Cash Flows

• Free cash flow to the firm (FCFF) represents the cash available to all investors, including common stockholders, bondholders, and preferred stockholders
  • FCFF is calculated as: FCFF = EBIT(1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital
• Free cash flow to equity (FCFE) represents the cash available to common stockholders after considering capital expenditures, working capital changes, debt repayments, and new debt issues
  • FCFE is calculated as: FCFE = Net Income + Depreciation & Amortization - Capital Expenditures - Change in Working Capital + Net Borrowing
• Normalized free cash flow adjusts a company's current cash flow to reflect a more sustainable level by removing one-time items and accounting for cyclicality
• Projected free cash flows should be based on reasonable assumptions about a company's future growth, profitability, and investment requirements
• Sensitivity analysis assesses the impact of changes in key assumptions (growth rates, margins, discount rates) on a company's valuation

Determining Discount Rates

• Discount rates should reflect the riskiness of the cash flows being discounted and the opportunity cost of capital
• Weighted average cost of capital (WACC) represents the overall required return on a company's total capital, considering the cost of equity and the after-tax cost of debt
  • WACC is calculated as: $WACC = \frac{E}{V}r_E + \frac{D}{V}r_D(1-T_C)$, where E is the market value of equity, D is the market value of debt, V is the total market value of the firm (E + D), $r_E$ is the cost of equity, $r_D$ is the cost of debt, and $T_C$ is the corporate tax rate
• Capital asset pricing model (CAPM) estimates the required rate of return on equity based on the risk-free rate, the market risk premium, and the company's beta
  • CAPM is calculated as: $r_E = r_f + \beta_E(r_M - r_f)$, where $r_E$ is the cost of equity, $r_f$ is the risk-free rate, $\beta_E$ is the equity beta, and $r_M$ is the expected return on the market portfolio
• Cost of debt is the effective rate a company pays on its debt obligations, such as bonds and loans
  • The after-tax cost of debt is calculated as: $r_D(1-T_C)$, where $r_D$ is the pre-tax cost of debt and $T_C$ is the corporate tax rate
• Risk-free rate is typically based on the yield of long-term government bonds, as they are considered to have minimal default risk
• Market risk premium represents the additional return investors require for holding risky assets over risk-free assets

DCF Valuation Process

• Develop financial projections for the company, including revenue growth, operating margins, capital expenditures, and working capital requirements
• Calculate the free cash flows (FCFF or FCFE) based on the financial projections
• Determine the appropriate discount rate (WACC for FCFF, cost of equity for FCFE) based on the company's risk profile and capital structure
• Estimate the terminal value, which represents the value of the company's cash flows beyond the explicit forecast period
  • The perpetuity growth method calculates terminal value using the formula: $TV = \frac{FCF_{t+1}}{WACC-g}$, where $FCF_{t+1}$ is the free cash flow in the first year after the explicit forecast period, WACC is the weighted average cost of capital, and g is the perpetual growth rate
• Discount the projected free cash flows and terminal value to their present values using the appropriate discount rate
• Sum the present values of the free cash flows and terminal value to determine the enterprise value (for FCFF) or equity value (for FCFE)
• Conduct sensitivity analysis to assess the impact of changes in key assumptions on the valuation

Advantages and Limitations of DCF

• Advantages:
  • DCF valuation is based on a company's intrinsic value and fundamental cash flow generating ability, rather than market sentiment or short-term fluctuations
  • It allows for detailed modeling of a company's financial performance and growth prospects
  • DCF can be adapted to value different types of assets, including entire companies, individual projects, or specific investments
• Limitations:
  • DCF relies heavily on the accuracy of financial projections, which are subject to uncertainty and estimation errors
  • Selecting appropriate discount rates can be challenging and subjective, as they require estimates of a company's risk profile and cost of capital
  • DCF may not fully capture the value of strategic options or intangible assets, such as brand value or intellectual property
  • The model's sensitivity to key assumptions can lead to a wide range of possible valuation outcomes
  • DCF may not be suitable for early-stage or high-growth companies with limited historical data and uncertain cash flow projections

Real-World Applications and Case Studies

• Mergers and acquisitions: DCF is commonly used to value target companies and assess the potential synergies and value creation of a proposed transaction
  • Example: In 2016, Microsoft acquired LinkedIn for $26.2 billion, using DCF analysis to value the company based on its projected cash flows and growth prospects
• Initial public offerings (IPOs): DCF can be used to determine the intrinsic value of a company going public and help set an appropriate price range for its shares
  • Example: In 2019, Uber's IPO valuation was based in part on DCF analysis, which considered the company's potential for long-term growth and profitability in the ride-hailing and food delivery markets
• Capital budgeting: Companies use DCF to evaluate the NPV and IRR of proposed projects or investments, helping to allocate capital to the most value-creating opportunities
  • Example: An oil and gas company might use DCF to assess the viability of a new exploration project, considering the projected cash inflows from oil production and the required capital expenditures
• Equity research: Analysts use DCF to estimate the fair value of publicly traded companies and make investment recommendations to clients
  • Example: A research analyst might use DCF to determine whether a company's current stock price is overvalued or undervalued relative to its intrinsic value based on future cash flow projections