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Nov 13, 2014

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discounted cash flow valuation

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Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company (or asset). In simple

terms, discounted cash flow tries to work out the value today, based on projections of all of the cash that it could

make available to investors in the future. It is described as "discounted" cash flow because of the principle of

"time value of money" (i.e. cash in the future is worth less than cash today).

The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value - relative valuation

metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't very useful if an entire sector or market is

overvalued. In addition, the DCF method is forward-looking and depends more on future expectations than

historical results. The method is also based on free cash flow (FCF), which is less subject to manipulatio than

some other figures and ratios calculated out of the income statement or balance sheet.

DCF does however have its weaknesses as an approach. As it is a mechanical valuation tool, it is subject to the

principle of "garbage in, garbage out". In particular, small changes in inputs can result in large changes in the

value of a company, given the need to project cash-flow to infinity. James Montier argues that, "while the algebra

of DCF is simple, neat and compelling, the implementation becomes a minefield of problems" (he cites, in

particular, problems with estimating cash flows and estimating discount rates). Despite the issues, DCF analysis

is very widely used and is perhaps the primary valuation tool amongst the financial analyst community. As part

of Stockopedia Premium, we provide pre-baked DCF valuation models for all stocks, which you can then modify

with your own assumptions.

In summary, the key steps in a DCF analysis are as follows:

1.

Estimate Cashflows

2.

Estimate Growth Profile (1 stage, 2 stage, 3 stage etc) & Growth Rates

3.

4.

5.

In a DCF model, the first step is to estimate how much cash that the business will generate and could be paid to

the investors. In the strictest sense, the only cash flow that an investor will receive from an equity investment is

the dividend. Actual dividends, however, may be much lower than the potential dividends because i) managers

are conservative and 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 understate the true value of the equity in a firm. Some analysts assume that the earnings of a firm

represent its potential dividends but this will typically over estimate the value of the equity in the firm. Earnings

are not cash flows, since there are both non-cash revenues and expenses in the earnings calculation. This also

fails to take into account the need for a firm to invest in new assets in order to grow.

For that reason, the best option is to focus on free cash flow - there are two main such definitions:

i) Free Cash Flow to the Firm (FCFF). This is the cash available to bond holders and stock holders after all

expense and investments have taken place. It is defined as:

EBIT * ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital.

ii) Free Cash Flow to the Equity (FCFE). This is the cash is available to pay to a company's equity

shareholders after accounting for all expenses, reinvestment, and debt repayment. It is defined as:

Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal

Repayments - New Debt Issues) OR alternatively Cash From Operations - (Capital Expenditures Depreciation) + Net Borrowing.

If we are looking to value the equity, then the most obvious option is to use FCFE. FCFF is preferred if the

company is unstable or has huge amount of debt because the FCFE might be very low or negative in this case.

Basically, the drawback of FCFE is that it will change if the capital structure changes. That is, FCFE will go up if

the company replaces debt with equity (an action that reduces interest paid and therefore increases CFO) and

vice versa.

growth profile?

The next step is to estimate how fast will the company grow its free cash flow. This is a critical part of any

valuation and is typically where the biggest errors creep in. People tend to overestimate how fast a company can

grow. First, we need to decide whether how many different stages of growth the DCF will have. A 1 stage DCF

model would be used for a company expected to see consistent stable growth. The prevalent form of the DCF

model in practice is the two-stage DCF model - this involves an explicit projection of free cash flows generally for

5-10 years, following which a terminal terminal value is calculated to account for all the cash flows beyond the

forecast period - but a more involved 3+ stage DCF model could also be used.

Once this is decided, there are three basic ways of estimating growth for any firm:

i) Extrapolate from historic growth - One option is to use historic growth rates, but unfortunately these rates

tend to have considerable noise associated with them. In an study of the relationship between past growth rates

and future growth rates, Little (1960) coined the term 'Higgledy Piggledy Growth" because he found little

evidence that firms that grew fast in one period continued to grow fast in the next period. In addition,

measurement is not straightforward - growth rates can be different depending the period selected or they may be

complicated by the presence of negative earnings.

ii) Trust the Analysts - The second approach is to trust the equity research analysts that follow the firm to come

up with the right estimate of growth for the firm, and to use that growth rate in valuation. However, the evidence

suggests that analysts are very poor forecasters, especially over the long-term. Work by James Montier found

that the average 24-month forecast error is around 94%, and the average 12-month forecast error is around 45%.

iii) Fundamental Determinants - With both historical and analyst estimates, growth is treated as an exogenous

variable that affects value but is divorced from the operating details of the firm. As Professor Damodaran

notes, the alternative way of incorporating growth into value is to make it endogenous, i.e., to make it a function

of how much a firm reinvests for future growth and the quality of its reinvestment. When a firm has a stable return

on capital, its expected growth in operating income (and therefore cashflow) is a product of the reinvestment rate,

i.e., the proportion of the after-tax operating income that is invested in net capital expenditures and non-cash

working capital, and the quality of these reinvestments, measured as the return on the capital invested. The

formula is:

Reinvestment Rate * Return on Capital where Reinvestment Rate = Capital Expenditure Depreciation + Change in Non-cash WC and Return on Capital = EBIT (1-t) / Capital Invested

Option iii) is probably the best option but may feel a bit involved. A simpler approach would be to look at historic

growth over the past several years, take an average, and then reduce that in stages. A three-stage model might

take the last 3-years' growth rate, apply it to the next five years, chop it in half for the next five years, and then

reduce it to 3% (the long term rate of inflation, e.g. no "real" growth) from then on.

Having projected the company's free cash flow for the next X years, we need an appropriate discount rate which

we can use to calculate the net present value (NPV) of the cash flows. This is a critical ingredient in discounted

cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead

to serious errors in valuation. It is important that the Discount Rate should be consistent with the cash flow being

discounted. If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of

equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital (or WACC the weighted average cost of capital).

Cost of Equity

Equity shareholders expect to obtain a certain return on their equity investment in a company. From the

company's perspective, the equity holders' required rate of return is a cost. However, unlike the cost of debt

which is relatively easy to determine from observation of interest rates in the capital markets, a company's

current cost of equity is unobservable and must be estimated.

CAPM

There are various models for doing so, the most commonly accepted of which is the Capital Asset Pricing Model,

or CAPM where:

Cost of Equity (Re) = Risk Free Rate (Rf) + Beta * Equity Risk Premium.

To explain these terms:

i) Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such

as US government bonds.

ii) - Beta - This measures how much a company's share price moves against the market as a whole. A beta of

one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the

share is amplifying the market's movements; less than one means the share is more stable.

iii) Equity Market Risk Premium - The equity market risk premium represents the returns investors expect, over

and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other

words, it is the difference between the risk-free rate and the market rate. Practitioners never seem to agree on

the premium; it is sensitive to how far back you go in history, what bonds you use as a reference point, and

whether you use geometric or arithmetic averages.

While widely used, CAPM has been widely criticised as being empirically flawed - according to Montier, "CAPM

woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta

stocks. Over the long run there has been essentially no relationship between beta and return" - as well as being

based on a highly unrealistic set of assumptions. For that reason, it may be better to just adopt a discount rate

that seems intuitively consistent with both the riskiness and the type of cashflow being discounted.

Interestingly, Buffett uses something like the thirty-year U.S. treasury bond rate but without a risk premium on the

basis that he avoids risks. "I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't

make any sense to me. Risk comes from not knowing what you're doing." (although, presumably, as a value

investor, he builds a significant margin of safety elsewhere).

Instead of trying to project the cash flows to infinity, terminal value techniques are used. One way of calculating

the terminal value (TV) is by using the Gordon Growth Model, which essentially assumes that company's cash

flow will stabilize after last projected year and will continue at the same rate forever. Here is the formula:

Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) / (Discount Rate Long-Term Cash

Flow Growth Rate).

Another possibility of determining terminal value of the company is to use multipliers of income or cash flow

measures (net income, net operating profit, EBITDA, operating cash flow or FCF), which are determined with

reference to comparable companies on the market.

The TV often represents a large percentage of the total DCF valuation. As Montier notes:

"If we assume a perpetual growth rate of 5% and a cost of capital of 9% then the terminal multiple is 25x.

However, if we are off by one percent on either or both of our inputs, then the terminal multiple can range from

16x to 50x!".

Valuation, in such cases, can unfortunately become largely dependent on TV assumptions rather than operating

assumptions for the business or the asset.

To arrive at a total company value, or enterprise value (EV), we simply have to take the present value of the cash

flows and the Terminal value, divide them by the discount rate and, finally, add up the results. If we are

discounting FCFE at the cost of equity, this will give the value of the equity. If we are discounting FCFF at the

weighted average cost of capital, this would give the value of the firm, so it would be necessary to deduct net

debt in order to arrive at the equity value.

Conclusions

Although Montier argues that DCF "should be consigned to the dustbin of theory, alongside the efficient markets

hypothesis, and CAPM", this seem a little harsh. It is a useful tool, provided that its constraints are clearly

understood (e.g. the sensitivity to inputs), and it is best used with other tools such as Earnings Power Value and

Relative Value techniques as a sense check. In order to use DCF most effectively, the target company should

generally have positive and predictable free cash flows (i.e. typically it's best with mature firms that are past the

growth stages). DCF works less well when a company's operations lack "visibility" - i.e, when it's difficult to

predict revenue and cost trends with much certainty. DCF analysis also demands vigilance so if Company X

delivers disappointing quarterly results, or if interest rates change dramatically, you may need to adjust your

assumptions.

- See more at: http://www.stockopedia.com/content/valuation-101-how-to-do-a-discounted-cashflow-analysis63489/#sthash.n47s0UaO.dpuf

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