Discounted Cash Flow model

While valuing a company using a discounted cash flow model there are some key
inputs, which has to be carefully determined. The key inputs are cash flow, expected
growth, discount rate and maturity state of the company.

Determining a cash flow, there are three key types of cash flow. One is in the form of
dividends; dividends are payouts made to the equity holders of the firm. Second is in
the form free cash flow to equity, which is also to equity holders. Free cash flow to
equity (FCFE) is the maximum possible payout to the equity holders after the
deduction of all expenditures required. Finally, third is the free cash flow to the firm
(FCFF); FCFF is the amount of cash that a firm received after all necessary expenses
and before debt repayment.

While estimating growth for the cash flow, desired component of the cash flow is
necessary to be identified. For estimated growth in dividend, growth must be
estimated for equity income and dividend itself. Similarly, for estimated growth in
FCFE, growth must be estimated for equity income and FCFE. However, while
estimating FCFF growth must be estimated in the growth of operating income and
FCFF.

Growth of a company can be estimated to have different growth patterns according
to its maturity in the market. Mature companies with a large capital base are more
likely to have a stable growth whereas young companies may have a high growth
rate in the beginning followed by a steady decrease in growth rate which is again
followed by a steady growth rate at the end. Three choices of growth pattern can be
estimated as follows:

1: Stable growth:

2: Two stage growth:


3: Thee stage growth:


Where,
V0= Value of Equity (if cash flows to equity are discounted) or Firm (if cash flows to
firm are discounted)

CFt = Cash Flow in period t; Dividends or FCFE if valuing equity or FCFF if valuing
firm.

r = Cost of Equity (if discounting Dividends or FCFE) or Cost of Capital (if
discounting FCFF)

g = Expected growth rate in Cash Flow being discounted

ga= Expected growth in Cash Flow being discounted in first stage of three stage
growth model

gn= Expected growth in Cash Flow being discounted in stable period

n = Length of the high growth period in two-stage model

n1 = Length of the first high growth period in three-stage model

n2 - n1 = Transition period in three-stage model

When it comes to discounting cash flow, the key is to discount the cash flow with its
respective cost. While discounting cash flows to equity holders, such as in the case
of dividends and FCFE cost of equity must be used, similarly, while discounting cash
flow to firm cost of capital (COC) must be used. The reason being, a firm uses both
equity and debt as its investment.

It is assumed that every cash flow will reach maturity in its life once the company
and the market reaches maturity. At mature state dividends, FCFE and FCFF are
expected to have stable growth respective to its concerned cash flows.

Estimation of discount rate

Estimating the discount rate is one of the most important parts in discounted cash
flow model. Discount rate is the cost of capital of the investment such that the
investing entity seeks the discount rate as its minimum rate of return. Discount rate
is the weighted average cost of the invested capital.

Cost of equity

Cost of equity is the minimum rate of return that the investor seeks for its invested
equity. Capital asset pricing model (CAPM) is one of many methods of estimating
cost of equity. CAPM measures risk in terms of non-diversifiable variance and hence
relates expected return to this risk measure. Key assumptions for CAPM are

1. investors have homogenous expectations about asset return and variances
2. investors borrow and lend at a risk free rate
3. all assets are marketable and perfectly divisible
4. there are no transaction costs and there are no restriction on short sales.

According to CAPM method

Cost of equity = Rf + Equity Beta * (Rm Rf)

Where,

Rf = Risk free rate
Rm = Expected return on the market index

Inputs required for CAPM method are
a. risk free rate
b. expected return on market index and
c. beta of the asset being analyzed

Risk free rate for any company could be a long-term bond rate of the country where
it is operating.

Expected return on market index could be estimated by using the implied equity
premium formula. The method would be to equate the index with future cash flows
(dividends and buy backs) to calculate the discount rate. This discount rate would
give the expected return on stocks.

Further, implied market risk premium is the difference between risk free rate and
the market risk premium.

Example:
Current Index: 1468.36
Last year cash flow to index: 4.02% of index = 61.86
Expected growth rate for 5 years: 5%
After 5 years it is assumed that earnings on the index will grow at the rate as the
economy (risk free rate = 4.02%)




1468.36 = 61.98/(1+r) + 65.08/(1+r)
2
+ 68.33/(1+r)
3
+ 71.75/(1+r)
4
+ 75.34/(1+r)
5

+ 75.35*1.0402/(r-0402)(1+r)
5

With the above model, expected return on model would be 8.39%
Hence, Implied equity risk premium = expected equity on stocks Treasury bond =
8.39% - 4.02% = 4.37%

There are different ways of estimating betas of a firm. Typically, equity beta of the
firm is estimated by regressing stock returns (Rj) against market returns (Rm)

Rj = + Rm

Here, is the intercept and is the slope of the regression. Slope of the regression
corresponds to the beta of the stock and measures the riskiness of the stock.
However, this beta as three limitations.
1. it has a high standard error
2. it considers past business performance and not just the current performance
3. it reflects the firms average financial leverage over the period rather than
current financial leverage.

Beta of a firm is directly related to the sensitivity of the business and market
conditions. Higher beta reflects higher sensitivity with market conditions. In
addition, a firm with different business lines have a beta as weighted average of
different betas.

Beta is also related to the degree of operating leverage of a firm. Higher will be the
ratio of fixed costs to variable costs, higher will be the variability in earnings before
interest and taxes (EBIT), which will lead to higher beta.

Another factor, which leads to higher beta, would be a higher financial leverage. An
increased financial leverage would lead to a higher equity beta of a firm.

Levered beta = Unlevered beta (1+ (1-t) (D/E))

Where t = tax rate
D/E = debt to equity ratio

Another approach of estimating could be by using the beta of a publicly traded firm,
which are comparable in terms of business risk and operating leverage. However,
this beta must be adjusted correcting for the differences in financial leverage.

Estimation of cash flows

Cash flows to equity for a levered firm

Revenue
-Operating Expenses
=Earnings before interest, taxes and depreciation (EBITDA)
-Depreciation & Amortization
=Earning before interest and taxes (EBIT)
-Interest Expenses
=Earning before tases
-Taxes
=Net Income

+Depreciation & Amortization
=Cash flow from Operations
-Preferred Dividends
-Capital Expenditure
-Working Capital Needs
-Principal Repayments
+Proceeds from New Debt Issues
=Free cash flow to equity

*Proceeds from new debt issues = Principal repayments + Debt Ratio * (Capital
expenditures Depreciation + Working capital needs)

Cash flows to the firm

EBIT (1 tax rate)
+ Depreciation
-Capital Spending
-Change in working capital
=Cash flow to the firm

Estimating growth rates

Growth = retained earnings (t-1) / NI (t-1) * ROE
= Retention Ratio * ROE

ROE and leverage

ROE = ROA + D/E (ROA I (1-t))

Where,
ROA = (Net Income + Interest (1-tax rate))/BV of Total Assets
= EBIT (1-t) / BV of Total Assets

D/E = BV of debt/ Book value of equity

I = Interest Expense on debt / BV of Debt

t = Tax rate on ordinary income

Note that BV of Assets = BV of debt + BV of Equity

Return on Assets, Profit margin and asset turnover

ROA = EBIT (1-t) / Total Assets
= [EBIT (1-t)]/Sales * (Sales/Total Assets)
= Pre-interest profit margin * Asset Turnover