Equity Valuation-DCF Technique

Group9

CONTENTS

1) Basics of the approach 2) Determining Denominator and Numerator 3) Template and items for calculating free Cash Flow . 4) Examples & relevance. 5) Advantages & disadvantages.

TECHNIQUES OF FUNDAMENTAL EQUITY

VALUATION

Balance sheet techniques

Book value Liquidation value Replacement cost

Discounted cash flow techniques discount model Free cash flow model Relative valuation techniques

P/E ratio P/B ratio P/S ratio

DISCOUNTED CASH FLOW TECHNIQUES

Dividend discount model

Single period valuation model

P0 = D1 / (1+r)+

P1 / (1+r)

Multiperiod valuation model

P0 = D1 / (1+r) + D2 (1+r)2 + ..+ Dn / (1+r)n P0 = D/ (1+r) + D/ (1+r)2 + + D(1+r)n P0 = D1 / (1+r) + D1(1+g) / (1+r)2 + + D1 (1+g)n / (1+r)n+1 + .

Zero growth model

Constant growth model(Gordon model)

2 stage growth model H model

FREE CASH FLOW MODEL-BASICS

NUMERATOR & DENOMINATOR

Cash Flow/ Stream of Expected Return

Accounting Approach- Earnings Finance Approach-Cash Generated for Investor

Empirical evidence favors, free cash flow (FCFE) over earnings

Size, Form , Time Pattern are important Growth Rate & Growth Duration

Growth Rate of Dividend

Growth Rate of Earnings Payout Ratio

Growth Rate of OCF or FCFF

G= B*R= Retention Rate * Rate of Return ROE = Net Income/Sales*Sales/Total Assets*Total Assets/Equity =Profit Margin*Total Asset Turnover*Financial leverage

Use Historical Growth Rate

Arithmetic or Geometric Mean Regression Model

Required Rate of Return(K)

Real Risk Free Rate of Return Expected Inflation Rate during Holding Period

NRFR= (1+RFRR)(1+Expected Inflation Rate)-1 Required Rate of Return(K)

Risk Premium
Business Risk Financial Risk Profitability Risk Country Risk Exchange Rate Risk Cost of Equity is used in Dividend Discount Model & PV of FCFE WACC is used as Discount Rate in PV of OCF/FCFF Model

DCF METHOD: STARTING DATA

Free Cash Flow (FCF) of the firm Cost of debt of firm Cost of equity of firm Target debt ratio (debt to total value) of the firm.

TEMPLATE FOR FREE CASH FLOW

Working capital Year Revenue Costs Depreciation of equipment Profit/Loss from asset sales Taxable income Tax Net oper proft after tax (NOPAT) Depreciation Profit/Loss from asset sales Operating cash flow Change in working capital Capital Expenditure Salvage of assets Free cash flow 0 1 2

Income Statement

Noncash item Noncash item

Adjustment for for non-cash

Capital items

TEMPLATE FOR FREE CASH FLOW

The goal of the template is to estimate cash flows, not profits. Template is made up of three parts.

An Income Statement Adjustments for non-cash items included in the Income statement to calculate taxes Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc. The Income Statement portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting. Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.

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TEMPLATE FOR FREE CASH FLOW

There are four categories of items in our Income Statement. While the first three items occur most of the time, the last one is likely to be less frequent.

Revenue items Cost items Depreciation items Profit from asset sales

Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e.g. depreciation) and subtract all non-cash items added earlier (e.g. gain from salvage). There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E)) Working capital

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TEMPLATE FOR FREE CASH FLOW

It is important to recover both at the end of a finite-lived project.

Salvage the market value property plant and equipment Recover the working capital left in the project (assume full recovery)

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ADVANTAGES OF DCF METHOD

It produces the closest thing to an intrinsic stock value Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. DCF analysis can help investors identify where the company's value is coming from and whether or not its current share price is justified.

ADVANTAGES

It can be applied for valuing business as a whole and also for valuing individual business components of a company or firm. It is simple to understand and apply and also if needed it can be modified to deal with complex circumstances also. It can be used by both equity shareholders because on the basis of DCF valuation they can compare two companies and take decision whether to invest or not, and also debt holders can use DCF method to take decision regarding the company.

DIS-ADVANTAGES OF DCF METHOD

DCF valuations can fluctuate to extremes DCF works best only when there is a high degree of confidence about future cash flows- future cash flows as an input are difficult to predict for any company and hence the success of DCF method is directly related to the prediction the future cash flows.

The investor's ability to make good forward-looking projections is critical - and that's why DCF is susceptible to error.
The model is not suited to short-term investing. DCF focuses on longterm value DCF analysis is a moving target that demands constant vigilance and modification.

Since it is a valuation tool it is dependent heavily on the inputs used for valuation purpose, so if inputs are changed slightly there can be large change in the value of a company.

Therefore anybody who is using discounted cash flow method should also use other methods of valuation along with in order to take right decision regarding the investment in the company.

REFERENCES

Investment Analysis & Portfolio Management by Reilly & Brown

THANK YOU