Valuation using Discounted Cash Flow Method
CA Parag Ved
Valuation using Discounted Cash Flow Method
Overview
Discounted Cash Flow (DCF) Method of
Valuation is gaining importance in the recent
past. It got a boost when Reserve Bank of India
has recognised DCF as the only method under
FEMA, for transactions between Residents and
Non-Residents for shares of Indian Company.
DCF is also one of the recognised methods under
section 56(2)(vii)(b) of the Income-tax Act.
Internationally DCF is given more importance
since it is universal method. In theory,
irrespective of the GAAP you follow, the net
cash generated by an Enterprise should not
change. Thus for International acquisitions,
more reliance is placed on the value under DCF
method.
Is DCF superior?
Advocates of DCF argue that it scores over other
traditional methods of valuation as it takes into
account cash requirement for working capital
and capital expenditure, financial gearing of
the enterprise, etc. which are not given much
importance under the traditional methods of
valuation like PECV, EV/EBITDA, Net Assets,
etc.
On the other side, traditional methods are
easy to comprehend. They are generally based
on the historical data which one can vouch.
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Whereas DCF is entirely based on the future
projections. Each and every item of projections,
i.e. Capacity Utilisation, Volume, Price, Raw
Material Cost, Manufacturing and Other
overheads, requirement for Capital Expenditure
and Working Capital, etc. are all assumptions. In
the dynamic world it is very dificult to predict
what will happen 6 months down the line and
still projections are made for 5 to 7 years. I am
yet to see a projection which is actually achieved.
In my view both DCF and traditional methods
are equally important as they give perspective
about the historical performance of the
Enterprise and its future expectation.
Discounted Cash Flow Method
DCF method proceeds on the assumption that
“Cash is King”. The DCF method values the
business by discounting its free cash flows for
the explicit forecast period and the perpetuity
value thereafter. The free cash lows represent
the cash available for distribution to both the
owners and the creditors of the business.
Approaches to DCF
There are two broad approaches for valuation as
per DCF Method. The Free Cash Flow to Equity
(FCFE) approach and the second is the Free Cash
Flow to Firm (FCFF) approach.
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FCFE: Under this approach, the value for
equity holders is obtained by discounting
expected cash flows available for the
equity holders. Cash flows to equity
holders is arrived by reducing from gross
operational cash flows, tax payments,
amount required for incremental working
capital, capital expenditure, interest
payment, principal repayment for loans,
etc. The net cash flows so arrived are
discounted by the cost of equity.
FCFF: Under this approach the value of the
irm is obtained by discounting the expected
cash flows to the firm or the enterprise.
Cash lows to irm are arrived by reducing
from gross operational cash flows, tax
payments, amount required for incremental
working capital, capital expenditure, noncash expenditure (depreciation), etc. In this
approach, the free cash low is discounted
by Weighted Average Cost of Capital
(explained in subsequent paragraphs). The
gross value of the enterprise is arrived and
from this value, amount of loan as on the
valuation date is reduced to arrive at the
value for equity holders.
projections are appraised by any inancial
institution or a bank, the acceptability
of the same is far higher as compared to
unapprised projections.
—
Industry/Company Analysis – While
reviewing the projections, it becomes very
important to understand the industry to
which the Company belongs and the other
players operating in the same industry. It
is also very much required that regulatory
aspects applicable to the industry are
thoroughly reviewed. For eg. there are certain
restrictions for the sugar industry for sale of
their products. Similarly Iron Ore industry
had certain restrictions for export of materials.
—
Dependence on single customer/
supplier – If the Company is dependent
on single customer or supplier, it increases
the risk of achieving the projections in case
of default by them. In such situations a
higher discount rate is applied to capture
the underlying risk.
—
Installed capacity – In case of
manufacturing Companies there are
instances that during the projection period
the projected production quantity exceeds
the installed capacity. The reviewer has to
take care to ensure that appropriate capital
expenditure is projected to capture the extra
capacity requirement or the projections for
production quantity is restricted upto the
reasonable level of installed capacity.
—
Income tax rate and surcharge – Tax is one
of the major cash outlows for most of the
proit making companies. If the Company
is enjoying any tax benefit, it needs to
be captured after taking into account the
period upto which it is available.
—
Working capital requirements – The
underlying assumptions for Debtors,
Creditors and Inventories have to be
thoroughly reviewed by comparing the
same with the historical data / past trends.
—
Alternate scenarios / sensitivities – The
projections need to be tested for sensitivity
In practical scenario, FCFF is used more
frequently and FCFE is used in cases
where the cash lows are more predictable,
for example, Road Projects with Annuity
Payments.
Estimation of cash lows
As stated earlier, DCF valuation is arrived by
taking the present value of expected future cash
flows. Thus it is very important to consider
the reasonable projections which the enterprise
can achieve. It is a known fact that nobody can
predict what the future will be. Thus while
considering the projections instead of being
optimistic or pessimistic one has to be realistic.
Following are the factors that need to be
considered while reviewing the projections:
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Appraisal
by
institutions
and
understanding of the business – If the
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Valuation using Discounted Cash Flow Method
Under CAPM, the cost of equity is deined
as under:
of critical assumptions such as Foreign
Exchange rates, expected inlation, inputoutput ratio, etc.
Cost of equity = Risk Free Return + [Beta
* Equity Risk Premium]
Each activity of the company needs to be
identified and the revenue assumptions need
to be made for each stream of income. An
appropriate Growth rate has to be applied to
this considering the past trend of the enterprise,
present and expected capacity utilisation of
the enterprise, expected trend in the industry,
etc. Various cost and expenditure needs to be
bifurcated into variable cost and ixed cost. The
variable cost should be related to the revenue
assumptions/activity of the company whereas
ixed costs will be mainly time cost.
Where,
Risk Free Return: is the return expected
by an investor where there is no default
risk and there is no reinvestment risk.
Beta: It is the sensitivity of a particular
stock vis-a-vis Market or Index.
Arithmetically, beta can be calculated as
follows
Beta = Covariance (X,Y)
––––––––––––––––
Variance (X)
Discount rate
The discount rate is the most critical item of DCF
valuation. The Cash Flow arrived will have to be
discounted by an appropriate rate. What is an
appropriate rate is subject matter of discussion.
In theory, the discount rate should adequately
reward the investor for the risk he is taking by
investing in an enterprise. Thumb rule is that
higher the risk, higher should be the discount
factor and lower the risk, lower should be the
discount factor. The discount rate is arrived by
determining the cost of each provider of capital
and taking the weighted average of that. The
discount rate so arrived is termed as Weighted
Average Cost of Capital (WACC). The WACC
relects the business as well as inancial risk of
the enterprise. Each component of WACC is
discussed in detail in the following paragraphs.
—
Cost of equity: The cost of equity is
the most important number in the DCF
calculation. It signifies the rate of return
expected by the investor for putting his
money into the enterprise. Large investors
will have their own return expectation.
In that case the return indicated by the
investor becomes the cost of equity.
In the absence of such indication one
can refer to Capital Asset Pricing Model
(CAPM) to determine cost of equity.
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Equity Risk Premium is the expectation of
the investor over and above the risk free
return.
Equity Risk Premium = return generated
by the market - risk free return
—
Cost of Debt
Cost of Debt is the long-term cost of debt
of an enterprise. Interest on the debt is a
tax-deductible item. Thus any enterprise
would like to leverage on that and borrow
funds to meet its requirements. While
arriving at Cost of Debt, one has to take
the tax benefit available on interest and
take cost of debt net of tax.
—
Cost of Preference Shares
Cost of preference shares is the dividend
rate of the preference share along with the
applicable dividend distribution tax.
—
Weighted Average Cost of Capital
(WACC)
The Weighted Average Cost of Capital is
the weighted average of the costs of the
different components of financing used
by an enterprise. Arithmetically, WACC is
calculated as follows
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WACC = [(Cost of Equity*Weight) + (Cost
of Debt*Weight) + (Cost of Preference
Shares*Weight)] / [Weight of Equity +
Weight of Debt + Weight of Preference
Shares]
To arrive at the weights of the different
components of financing used by the
enterprise, one has to consider the
sustainable financing pattern of the
enterprise and also of the industry in
which it operates.
Calculation of terminal value
Discounted Cash Flow Valuation is calculated
in two parts, i.e. present value of cash flow
for explicit period (i.e. the period for which
projections are made) and present value of
terminal value. To work out the terminal value
cash lows, explicit period’s last year’s gross cash
low is taken as base and an appropriate growth
rate is applied to that.
While determining the growth rate for terminal
value, one has to consider the length of the
explicit period cash low, long-term growth rate
of the industry, etc.
From the gross cash low, adjustment will have
to be made for capital expenditure, incremental
working capital requirement, tax payable, etc. to
arrive at net cash low for terminal value.
The cash low so arrived has to be capitalised by
applying following formula to arrive at Gross
Terminal Value
Gross Terminal Value = Net cash low for
terminal value
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(WACC – Growth Rate
for Terminal Value)
Discount rate of last year of explicit period has to
be applied to arrive at present value of terminal
value. If due to certain factors valuer is of the
opinion that discount rate for explicit period and
perpetuity should be different, he may choose
two different discount rates.
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Present value of terminal value = Gross terminal
value * Discount factor for last year of explicit
period
Calculation of Value for Equity Holders
Present value of cash flow for explicit period
and present value of terminal value is added to
arrive at the Gross Value of the business. This
value is for all the fund providers. To arrive at
the value for equity holders under irm approach
of valuation following adjustments needs to be
made:
Value for equity holders = Present Value of
Cash Flows for explicit period + Present value
of Terminal Value – Opening balance of loan as
on valuation date + Opening Surplus cash not
considered for working capital requirement +
Realisable value of surplus assets, etc.
Conclusion
Although Discounted Cash low Method is well
accepted method in the recent times, it may not
be suitable in certain cases. Take an example of
an Investment Company – To have projections
for the Investment Company is very difficult.
How can one assume what dividend will be
declared in future by the investee company?
How can one assume, what will be proit or loss
on sale of investment?
The valuer has to keep in mind the fact that the
projections provided by the management will
generally be growth oriented. Hardly you will
come across the projections which has shown
negative growth. However, in reality, businesses
do go through the cycle of ups and down. Thus
it is important for the valuer to understand
the risk involved in achievement of particular
projections and accordingly discount rate and
growth rate for perpetuity needs to be chosen.
In some cases the valuer may recommend
a range of values and then it is left to the
parties concerned to arrive at the transaction
price.
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