- August 28, 2019
- Posted by: Ramkumar
- Category: Mergers And Acquisitions

## Discounted Cash Flow Valuation

In this blog, we shall discuss about the most common method used to value a company – Discounted Cash Flow valuation.This method is used to predict the free cash flow that is available with the company after accounting for Operational and Capital expenditures.

This free cash flow to the firm is then used by the company to pay back the long term debt, Pensions obligations and Operating Leases.The remaining cash available is distributed to the equity investors.

We shall look at the steps to be followed to arrive at Valuation of a company using DCF model.

### Steps to be followed to arrive at Discounted cash flow valuation

- DCF is the most reliable and stable method used by the valuation analysts to value a company. This method can be used to value even a Startup because this method forecasts the future projections of the Target company.
- There are 10 steps to arrive at the the equity value of the Target company.They are:

**Identifying extraordinary and non recurring items in the Financials**

- The extraordinary one time non recurring expenditure/income are added and removed from the Target financials to arrive at Normalised Income statement and Balance sheet.
- This is because we are identifying the recurring costs and expenses incurred by the company during normal course of operations.
- Some of the non recurring items are Restructuring costs, Acquisition Integration costs, Impairment Costs and Litigation costs.
- By removing these non recurring items, we arrive at the Normalised Financials of the company.

**Derive Pro Forma assumptions from Normalized Financial Statements**

- Once we have the Normalized Financials statements, we arrive at the Pro Forma assumptions of the company.
- For convenience, it is better to have COGS and SGA items as % of Revenues, Depreciation expense as % of Plant, Property and Equipment and Interest expense as % of Average long term debt balance of last two year period.
- After having the percentages of various components, perform a trend analysis on historical statements to identify the pattern of each components in the Income statement.

**Decide on the Forecast Horizon and the Growth period**

- Once the growth rates are finalized, then we need to model the cash flows by deciding on the Forecast horizon.Forecast horizon might vary from 5 to 15 years and depends on the maturity of the company.
- Companies that are matured and in existence for more than 50 years have a forecast horizon of 15 years.For companies with less than 10 years of existence, a shorter growth horizon is preferred.
- Firms have multiple growth stages and analyst use 1 stage 2 stage and 3stage growth model.
- Matured companies generally have one stage of growth where as Startups have 2 growth stages.This is because startups have a high growth in the early stage and then matures to a stable rate in the middle stage.
- Valuation analysts can vary the Forecast horizon and growth stage to their convenience and objective.

**Build the Pro Forma Income and Balance Sheet**

- Once the proforma assumptions and the growth stages are decided, then the proforma Income statement and Balance sheet is prepared.
- The sales of the firm is projected to the forecast horizon with the decided growth rate.Other components like COGS and SGA are then derived using the Pro Forma assumptions.
- The Pro Forma balance sheet is also built using the pro forma assumptions but one needs to ensure that the balance sheet is balanced with Assets= Liability + Equity.

**Derive Free Cash flow to Firm – FCFF**

- After the Pro Forma Income sheet and Balance sheet is prepared, the Free Cash flow to firm is calculated.
- The most common way to calculate the FCFF is by EBIT method.
*FCFF = Post Tax EBIT + Depreciation/amortization – (Increase in Operating Assets – Increase in Operating Liabilities) – Capital Expenditure*

**Determine the Cost of Debt, Cost of equity and WACC**

- The cost of Debt is arrived at by averaging Income expenses with the long term debt balance of the current two periods.

Capital structure of the Firm = Debt + Equity

*Unweighted Pre Tax Cost of Debt = Last Interest expenses/( Average of Long Term debt balance of current two period)*

*Unweighted Post Tax Cost of Debt = Unweighted Pre Tax cost of Debt *(1-Tax Rate)*

*Weighted Post tax cost of Debt = Unweighted Post tax cost of Debt *(Debt/Debt+Equity)*

The Cost of equity is calculated using the CAPM model – Capital Asset Pricing Model

*Equity as Fraction of Total Capital = Equity Price * Shares outstanding *(Equity/Equity+Debt)*

*Unweighted cost of Equity = Rf +Beta(Rf-Rm) *where

Rf = Risk free rate of the target country

Rm = Market risk premium of the Target country

*Weighted Cost of Equity = Unweighted Cost of Equity * Equity as a Fraction of Total Capital*

*WACC = Weighted Cost of Debt + Weighted Cost of Equity*

**Calculation of Long term Free Cash Flow Growth Rate, Terminal Value and Value of Operations**

- The Long term Free cash flow growth rate is generally taken as Target firm country growth rate adjusted by the sector specific RoE.

*Terminal Value = Free Cash Flow of the latest period *(1+Long Term Free Cash Flow Growth Rate)/(WACC-Long Term Free Cash Flow Growth Rate)*

*Value of Operations = Net Present value of Total Free cash flow including the Terminal Value * (1+WACC)^1/2*

**Calculation of Enterprise Value**

*Enterprise value = Value of Operations + Current value of Non Operating Assets*

The value of non operating assets is nothing but the cash available at the balance sheet.

*Enterprise value = Current value of cash + Value of Operations*

**Calculation of non equity claims**

- The non equity claims of the target firm would include long term debts, Pension obligations and Operating leases.These can be identified in the annual reports.
- These non equity claims would reduce the Enterprise value and will go as Cash outflows in each forecasted year.These are then discounted back at WACC.

**Equity Value**

The Final step in DCF calculation would be to evaluate Equity value

*Equity value = Enterprise Value – Non Equity Claims*

The DCF valuations provides both benefits and disadvantages.

Some of the benefits are:

- This method can be even applied to Startups as it forecasts the future cash flows.
- This method also helps us to identify timing of the cash outflows and when it would occur.
- Hence DCF can be used to compare two different investments.

**Disadvantages of Discounted cash flow valuation**

- This method is complex compared to other methods.
- The inputs are totally subjective and a small change in inputs can distort the final value to a large extent.
- Hence DCF needs to be used in combination with other valuation methods like Precedent Transactions and Comparable Analysis to arrive at the approximate Enterprise Value.

### Conclusion

- Discounted Cash Flow is the most common method used to value a target company.
- Other method like Comparable Analysis and Precedent transactions use a Price approach where as DCF determine the intrinsic value of the Target company by looking at the firm internal operations.
- As inputs used for growth rates and the forecast horizon is subjective, the DCF valuations would be different which reiterates that Valuation is both an Art and Science.Hence DCF method is used in conjunction with other valuation methods to arrive at Equity value of the Firm