Nuances in Discounted Cash Flow Valuations

Nuances in Discounted Cash Flow Valuations

Valuing a business using the Discounted Cash Flow method entails discounting the company’s future cash flows with an appropriate discount rate that reflects the risk of the underlying cash flows. Although the above sentence looks simplistic, there are many nuances in DCF that one has to understand before assessing the NPV of the business and deciding whether to move forward with an investment. In this post, i describe the above nuances that can help an investment banker/corporate development executive when tasked to value an asset for capital budgeting or value a company for an M&A/Divestiture.

Cash Flow Nuances

In Valuation, Cash is king and cash flow, not earnings, makes or breaks the firm. A firm can survive with negative earnings but die with negative cash flows over a long period. For instance, many startups close because of the burn rate – the rate at which they burn cash, and their survival is a function of their cash reserves and how long their cash will last.

When valuing a firm, we need clarity on what cash flows to include and exclude. So, first, add back any non-cash items like accruals and depreciation. Then exclude any cash flows that do not change with the incremental investment. Thus, the analyst should not add sunk costs like spending upfront costs on research because cash spent on previous investments does not get included. Investment analysis is always forward-looking.

Thus, when valuing a project, do not include cash flows unrelated to the project but include cash flows that get affected due to the investment in the project. The same applies to the timing of the cash flows. Cash flows should consist of the opportunity costs; for instance, if the project investment disrupts the existing operations or cannibalizes the current revenues, the impact on changes in cash flows needs to be incorporated in the valuation. Sometimes, we need to write off the assets and inventories after the project’s lifetime. We refer to that as abandonment costs and need to get included in the valuation.

To summarize, valuation should include all cash flows – the project cash flows and the cash flows that impact the project investment.

Inflation and Cash flows

We can value real cash flows discounted at real rates or nominal cash flows (including inflation) discounted at nominal rates (market discount rates). In practice, i find valuing nominal cash flows easier because accounting statements use nominal numbers. Further, markets charge returns at nominal discount rates. When valuing a firm with a fixed contract with the union that increases wages at a fixed rate, while the material costs vary at a rate higher than inflation, valuation using nominal cash flows is easier.

Nuances in Cost Of Capital

When arriving at the WACC for the firm, the discount rate should reflect the target state and not the rate at which the project gets financed. For instance, when acquiring a firm, the buyer can finance the acquisition with 100% debt and then issue equity in future to arrive at the target capital structure of 70% equity and 30% debt. In this case, when valuing the combined business, we discount the cash flows at the target capital structure and not the rate at which the buyer funded the acquisition at closing.

If the government gives a subsidy by reducing the interest rate for a project, the firm should not assume the subsidy rate as the cost of debt because the subsidy rate does not reflect the project risk. Thus, we need to value the project at the market rate of debt and then include the value of subsidies separately.

Value of firm = PV of Cash flows at market rate + PV of cash flows for the subsidy period.

Beta for Debt

In a CAPM, we assume the debt beta as zero as there is no correlation between the firm’s value and debt. However, as the firm has higher leverage or a lower rating, the default risk is related to the firm’s value. In this scenario, the beta of debt closely matches the equity beta. However, for investment grade debt, the differences between having a beta of debt and not having a beta do not profoundly affect the firm. Thus, we assume the firm with investment-grade debt has zero default risk for simplicity. However, for the distressed firm or firm with high bankruptcy risk, the debt beta matches the equity beta, and equity becomes an option. In such cases, valuing a firm using the option pricing model gives a better value to the firm.

Separating Cash Flows and Terminal Value

When valuing a business or determining the NPV, it is always better to separate the NPV as a single number and break it into an investment, the value of the cash flows and the terminal value.

For instance, a firm invests $12 million. As a result, the present value of cash flows for the high growth period is $10 million and for the terminal period is $5 million.

As a result, the project has a positive NPV of $3 million.

In another instance, with the same investment of $12 million, the present value for cash flows during the high growth period is -$3 million, and the terminal value is $18 million giving a positive NPV of $3 million.

Though both the projects have an NPV of $3 million, management will choose option one because of the higher payback than option 2. Further, valuation will have higher confidence when the present value of cash flows during the growth period constitutes a higher percentage of the firm’s value than the terminal value.

Further, we can compute the firm’s terminal value using:

  1. Perpetuity Formula
  2. Book value/liquidation value
  3. Earnings/Cash flow multiples

If the project has a limited life where the firm will get liquidated after the period, we compute the terminal value as the liquidation value or the firm’s book value at the end of the project life. When a project earns a return higher than the market return, the market value of the assets is higher than the book value, and the liquidation value will exceed the book value.

VC/PE firms that invest in a company for a definite period and plan to exit will have a terminal value as the market/sector multiple of EBITDA/Revenues. Due to changing leverage, it is better to use Enterprise multiples than equity multiples for terminal value calculation. A firm with high leverage will have a lower PE; thus, comparing firms becomes difficult.

Real Options

Real options help firms take negative NPV projects if the subsequent investment yields higher NPV, essentially helping them make strategic choices. For instance, a firm looking to enter India due to its high market can invest in a negative NPV project if it helps it understand the market, enabling future investments that will result in higher NPV projects. Moreover, the value of the options is highest when the firm has exclusivity. For instance, a patent can limit competition to launch a similar product, thus giving it protection and potential for excess returns. Thus, valuing a drug using an option pricing model gives firms a better chance to decide to invest in R&D for patent development. 

Strategic Considerations

Valuing an investment requires strategic consideration because running the numbers to arrive at NPV is only one step in evaluating a project/acquisition. Therefore, as firms build a valuation model on Pro-forma statements, they should incorporate realistic assumptions in growth rate, operating margins and capital turnover. Thus, strategic and economic issues should indicate the firm’s realistic assumptions.

For instance, if a firm generates a market return (cost of capital = return on capital), there is no way that it can assume a higher market return in the future unless it has a strategic rationale on how it can build its competitive advantages. Thus, economics drives the numbers and not the other way around.

An investment, especially an acquisition, should consider the probability of success. For instance, if the firm pays $100 million to acquire a company, but it writes off the investment in a couple of years, the investment destroys shareholder value. In such instances, structuring payments where the seller shareholders receive a part of the payment subject to the acquisition’s success is a better way for the buyer to protect themselves.

Final Thoughts

Valuing a business has three components – Strategic, Valuation and execution. Therefore, the project’s NPV should incorporate all of the above.

Key points to remember

  1. Cash is king. Valuation is all about the amount and timing of cash flows.
  2. A project’s cash flows must include the cash flows, be they positive or negative, from anywhere and everywhere. In addition, include any cash flows where the project changes its amount or timing.
  3. Overhead and accounting charges don’t matter in valuations since they are not cash flows. 
  4. Do not include sunk costs in valuation.
  5. Incorporate inflation by either valuing nominal cash flows and discounting at nominal WACC or using real cash flows at real discount rates.
  6. We must value the terminal value separately, and the terminal value much match the valuation method. Therefore, we should discount terminal value at the cost of equity for the terminal value of equity and the cost of capital for the firm’s terminal value.
  7. We must incorporate the real options while valuing a firm only when the firm has exclusivity; otherwise, real options do not have significant value.


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