BAV, UNIT 4TH- DCF

DCF: A discounted cash flow model ("DCF model") is

a type of financial model that values a company by
forecasting its' cash flows and discounting the cash
flows to arrive at a current, present value.
In simple words, Discounted Cash Flow or DCF
analysis is a process of evaluating the attractiveness
of an investment opportunity in the future at
present. As such, discounted cash flow valuation
analysis tries to calculate the value of a company
today, based on forecasts of how much money the
company is going to make in the future.
 DCF
DCF Value-

Present Valuet=0 = Cash Flow t=1 / (1+r)t

 Steps-DCF
• Step 1: Project the company’s Free Cash
Flows: Typically, a target’s FCF is projected out 5 to 10
years in the future.
Step 2: Choose a discount rate
Step 3: Calculate the TV
Step 4: Calculate the enterprise value (EV) by discounting
the projected UFCFs and TV to net present value
Step 5: Calculate the equity value by adding debt and
subtracting cash from EV (Note: Debt – Cash is called
Net Debt)
 Assumption- DCF
1. Free cash flow (FCF) – Cash generated by the assets of the business (tangible
and intangible) available for distribution to all providers of capital. FCF is often
referred to as unlevered free cash flow, as it represents cash flow available to
all providers of capital and is not affected by the capital structure of the
business. All cash flows are treated as though they occur at the end of the
year.
2. DCF methods treat cash flows associated with investment projects as though
they were known with certainty.
3. All cash inflows are reinvested in other projects that earn monies for the
company.
4. DCF analysis assumes a perfect capital market.
5. Terminal value (TV) – Value at the end of the FCF projection period is
calculated.
6. Discount rate and growth rate – The rate used to discount projected FCFs
and terminal value to their present values. This is also called WACC. The
growth rate is also known. This is the expected rate of growth in earnings.
 Value Drivers-DCF

Value Dricers: Value drivers are anything that can be

added to a product or service that will increase
its value to consumers.
Valuation drivers refer to factors that increase the
value of a business in the event of a sale
opportunity. Business owners need to consider
essential factors to increase cash flows, as well as
reduce risk, thus enhancing the overall value of
the company. They need to start monitoring their
company’s value a number of years before they
consider an exit.
 Value Drivers-DCF
Any DCF analysis, however, is only as accurate as
the assumptions and forecasts it relies on.
Errors in estimating key value drivers can lead
to a very distorted picture of a company´s fair
price. Depending on the determination of the
key value drivers, the enterprise value for the
same company can differ greatly. Therefore,
every DCF analysis has to focus on a careful
determination and justification of those
important parameters.
 Value Drivers-DCF
Since the cashflows usually have the strongest
influence on the enterprise value, the
projection of the free cashflows is the decisive
aspect of every DCF analysis. The
development of the cashflows depend on
various value drivers such as sales growth,
profit margin, investments in fixed assets
(CAPEX) and investments in working capital.
These value drivers will be discussed below.
 Value Drivers-DCF
1. Sales
Logically, if all other value drivers remain the same,
higher sales lead to higher cash flows and thus to a
higher enterprise value. However, the assumption that
other factors will remain unchanged with higher sales
is unrealistic and untenable. For example, an increase
in sales usually also entails additional investments in
working capital. If the company encounters its
production capacities at certain sales levels,
investments in fixed assets must also be taken into
account. The effects of the change in sales can
therefore not always be clearly determined at first
glance.
 Value Drivers-DCF
2. Profit Margin
In contrast to an increase in turnover, a
reduction in costs always has a value-
increasing effect. If the company succeeds in
reducing costs (ceteris paribus assumption),
the EBIT margin and thus also the free
cashflows and the enterprise value will
increase.
 Value
3. Working Capital and CAPEX
Drivers-DCF
Even if sales remain unchanged, there may be changes in working
capital. Thus for example the payment modalities of the customers or
also the own payment modalities can change. Higher payment terms
of the customers lead to an increase in trade receivables and thus to
an increase in the working capital requirements. The opposite effect
is caused by greater utilization of the company’s own payment terms.
Investments in fixed assets (CAPEX) can largely be derived from the
schedule of fixed assets. If replacement investments in fixed assets
were not made in the past, they must be made sooner or later. In this
case the future investments in fixed assets increase in comparison
with those in the closer past, even if the conversion remains constant.
A further reason for increased investments can be technical
innovations of the own machinery. All these factors must be taken
into account when forecasting capital expenditures.
 Value Drivers-DCF
Cost of Capital – Discount factor
The effect of the costs of capital on the enterprise value is
immediately apparent. If the return requirements for
debt and equity, and thus the discount factor increase,
the cashflows will be discounted with a higher factor
which results in a lower enterprise value.
Mathematically, this relationship is clear because the
present value of the cash flows is directly dependent
on the level of the discount factor and thus on the cost
of capital.
The discount factor is influenced by the following
parameters (if WACC approach is used):
 Value Drivers-DCF
(A) Cost of debt
If the interest rate on borrowed capital increases, higher cash
flows must be made available to the lenders. This results in
a reduction in the cash flows available to the equity
providers and thus also in a reduction in the equity value of
the company.
(B) Cost of equity
If the return requirements of equity investors increases, the
enterprise value decreases. In a DCF analysis, the cost of
equity is usually calculated using the Capital Asset Pricing
Model (CAPM). The amount of the cost of equity depends
on the factors of the risk-free interest rate, the market risk
premium and the beta factor.
 Value Drivers-DCF
4. Growth rate of the Terminal Value
The growth rate of the cashflow in the Terminal Value
reflects the growth of the cashflow at the end of the
detailed forecasting period. This growth rate is
intended to reflect corporate growth to infinity. It
therefore makes sense to use a variable such as general
economic growth as the growth rate for the company.
In practice, growth rates between 0 and 5% are used,
whereby 5% is the upper limit and is only used for
companies in extremely dynamic industries. An
increase in the growth rate from 1% to 5%, for
example, results in an enormous increase in the
Terminal Value and thus also in the enterprise value.
 Value Drivers-DCF
Hence, The analysis of the value drivers not only serves to
sensitize the user to the most important parameters of
a DCF analysis, but is also helpful in decision-making.
Whether an acquisition or sale is the right decision
depends on the price of the company. In the DCF
analysis, however, this fair price is determined on the
basis of forecasted figures that are subject to
uncertainty. Therefore, when determining an
enterprise value, different scenarios should always be
considered that reflect this uncertainty. It is therefore
advisable to analyze the enterprse value with multiple
variants of the key value drivers.
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 Relative Valuation Model
A relative valuation model is a business
valuation method that compares a firm's value
to that of its competitors to determine the
firm's financial worth.
 Relative Valuation
A relative valuation model is a business valuation method
that compares a company's value to that of its
competitors or industry peers to assess the firm's
financial worth. Relative valuation models are an
alternative to absolute value models, which try to
determine a company's intrinsic worth based on its
estimated future free cash flows discounted to
their present value without any reference to another
company or industry average. Like absolute value
models, investors may use relative valuation models
when determining whether a company's stock is a
good buy.
 Relative Valuation
A relative valuation model can be used to assess
the value of a company's stock price
compared to other companies or an industry
average.
 Methods of calculating Relative value
1. Price to Earning Ration (P/E Ratio)-
One of the most popular relative valuation multiples is
the price-to-earnings (P/E) ratio. It is calculated by dividing
stock price by earnings per share (EPS), and is expressed
as a company's share price as a multiple of its earnings. A
company with a high P/E ratio is trading at a higher price
per dollar of earnings than its peers and is considered
overvalued. Likewise, a company with a low P/E ratio is
trading at a lower price per dollar of EPS and is considered
undervalued. This framework can be carried out with any
multiple of price to gauge relative market value.
Therefore, if the average P/E for an industry is 10x and a
particular company in that industry is trading at 5x
earnings, it is relatively undervalued to its peers.
 Price to Earning Ration (P/E Ratio)
In addition to providing a gauge for relative
value, the P/E ratio allows analysts to back
into the price that a stock should be trading at
based on its peers. For example, if the average
P/E for the specialty retail industry is 20x, it
means the average price of stock from a
company in the industry trades at 20 times its
EPS.
 Price to Earning Ration (P/E Ratio)
Assume Company A trades for $50 in the market
and has an EPS of $2. The P/E ratio is calculated
by dividing $50 by $2, which is 25x. This is higher
than the industry average of 20x, which means
Company A is overvalued. If Company A were
trading at 20 times its EPS, the industry average,
it would be trading at a price of $40, which is the
relative value. In other words, based on the
industry average, Company A is trading at a price
that is $10 higher than it should be, representing
an opportunity to sell.
Application of Valuation
 Valuation Multiples
1. PE Ratio
2. EV/EBITDA (1 & 2 are called Earning
Multiples)
3. EV/Sales (is called Revenue Multiple)
4. Price/Book Value (is called Book Value
Multiple) • Book Value is the Investment (Net
Worth) that equity shareholders have put in
& earned in Company
 Valuation Multiples

The book value is referred to as the net asset value

of a company. It is calculated as total assets
minus intangible assets (patents, goodwill) and
liabilities.
• P/B ratio = (Market price per share/ book value
per share)
• As a thumb rule, companies with lower P/B ratio
is undervalued compared to the companies with
higher P/B ratio. The P/BV ratio is compared only
with the companies in the same industry.
 Steps

The Four Basic Steps-

first step is to ensure that the multiple is defined
consistently and that it is measured uniformly
across the firms being compared.
The second step is to be aware of the cross
sectional distribution of the multiple, not only
across firms in the sector being analyzed but
also across the entire market.
 Steps
The third step is to analyze the multiple and
understand not only what fundamentals
determine the multiple but also how changes
in these fundamentals translate into changes
in the multiple.
The final step is finding the right firms to use for
comparison, and controlling for differences
that may persist across these firms.
 Advantage of Relative valuation

• Usefulness: Valuation is about judgment, and multiples

provide a framework for making value judgements.
When used properly, multiples are robust tools that
can provide useful information about relative value.
• Simplicity: Their very simplicity and ease of calculation
makes multiples an appealing and user-friendly
method of assessing value. Multiples can help the user
avoid the potentially misleading precision of other,
more 'precise' approaches such as discounted cash
flow valuation or EVA, which can create a false sense of
comfort.
 Advantage of Relative valuation

• Relevance: Multiples focus on the key

statistics that other investors use. Since
investors in aggregate move markets, the most
commonly used statistics and multiples will
have the most impact.
 Disadvantage of Relative Vauation

No valuation technique can be perfect. There are few

disadvantage/ limitations of relative valuations which
are discussed below:
• The relative valuation approach does not give an exact
result (unlike discounted cash flow) as this approach is
based on the comparison.
• It’s assumed that the market has valued the companies
correctly. If all the companies in the Industry are
overvalued, then the relative valuation approach might
give a misleading result for the company which you are
investigating.
 Disadvantage of Relative Vauation

• Static: A multiple represents a snapshot of where a

firm is at a point in time, but fails to capture the
dynamic and ever-evolving nature of business and
competition.
• Dependence on correctly valued peers: The use of
multiples only reveals patterns in relative values, not
absolute values such as those obtained
from discounted cash flow valuations. If the peer group
as a whole is incorrectly valued (such as may happen
during a stock market "bubble") then the resulting
multiples will also be misvalued.
 Disadvantage of Relative Vauation

• Difficulties in comparisons: Multiples are primarily used to

make comparisons of relative value. But comparing
multiples is an exacting art form, because there are so
many reasons that multiples can differ, not all of which
relate to true differences in value. For example, different
accounting policies can result in diverging multiples for
otherwise identical operating businesses.
• Short-term: Multiples are based on historic data or near-
term forecasts. Valuations based on multiples will therefore
fail to capture differences in projected performance over
the longer term, and will have difficulty correctly valuing
cyclical industries unless somewhat subjective
normalization adjustments are made.
 Important note:
Note: 1. Ensure that both the denominator and
numerator represent same group.
2. PE, Book Value, Mcap/Sales Multiples result in
Equity Value (these are used for Equity Value)
3. EBIT, EBITDA, EV / Sales Multiple result in
Enterprise Value (these are used for Enterprise
Value)
Valuation parameters
 Impact of Different Stakeholders in terms of
Business Valuation
In business, a stakeholder is any individual,
group, or party that has an interest in an
organization and the outcomes of its actions.
Common examples of stakeholders include
employees, customers, shareholders,
suppliers, communities, and governments.
Different stakeholders have different interests,
and companies often face tradeoffs when
trying to please all of them.
Impact of Different Stakeholders
 Impact of Different Stakeholders
The objective of any management today is to
maximize corporate value and shareholder
wealth. This is considered their most
important task. A company is considered
valuable not for its past performance, but for
what it is and its ability to create value to its
various stakeholders in future.
 Impact of Different Stakeholders
The priorities of different stakeholders in terms of
business valuation need to be recognized under
three circumstances. They are given below:
Liquidation: While the major and important
requirements may governed by the relevant
provisions of Company Law, the management
may still be able to influence stakeholder
priorities by negotiating with the various groups,
especially in a voluntary liquidation.
2nd Refinancing: There are occasions when
companies need to obtain new financing or
re-finance existing debt. The company has to
then take into account the views of managers,
shareholders, long term lenders and creditors
 Impact of Different Stakeholders
3rd Mergers and Acquisitions: Other than the
bidder and the bidee, numerous stakeholders,
such as employees, suppliers, customers,
government and local community, will be
involved in the process. For instance, recall
the recent acquisition of Tata Motors of Ford’s
Jaguar and Land Rover (JLR) in UK. The Tatas
had to engage the with the employees of JLR
and provide with adequate assurances as an
essential step in the acquisition process
 Impact of Different Stakeholders
Others points are:
Relational capital comprises not only customer
relations but also the organisation’s external
relationships with its network of suppliers, as well
as its network of strategic partners and
stakeholders. The value of such assets is primarily
influenced by the firm’s reputation. In measuring
relational capital, the challenge remains in
quantifying the strength and loyalty of customer
satisfaction, longevity, and price sensitivity.
 Impact of Different Stakeholders
Resolve disputes among stakeholders/litigation:
Divorce, bankruptcy, breach of contract,
dissenting shareholder and minority
oppression cases, economic damages
computations, ownership disputes, and other
cases.
 Impact of Different Stakeholders
1. Customers
Many would argue that businesses exist to serve
their customers. Customers are actually
stakeholders of a business in that they are
impacted by the quality of service and its
value. For example, passengers traveling on an
airplane literally have their lives in the
company’s hands while flying with the airline.
 Impact of Different Stakeholders
2 Employees: Employees have a direct stake in
the company in that they earn an income to
support themselves, as well as other benefits
(both monetary and non-monetary).
Depending on the nature of the business,
employees may also have a health and safety
interest (for example, transportation, mining,
oil and gas, construction, etc.).
 Impact of Different Stakeholders
3 Investors: Investors include both shareholders
and debtholders. Shareholders invest capital
in the business and expect to earn a certain
rate of return on that capital. Investors are
commonly concerned with the concept
of shareholder value. Lumped in with this
group are all other providers of capital, such
as lenders and different classes of
shareholders.
 Impact of Different Stakeholders
4 Suppliers and Vendors: Suppliers and vendors
sell goods and/or services to the business and
rely on it for revenue generation and on-going
business. In many industries, the suppliers
also have their health and safety on the line,
as they may be directly involved in the
company’s operations.
 Impact of Different Stakeholders
5 Communities: Communities are major
stakeholders in large businesses. They are
impacted by a wide range of things, including
job creation, economic development, health,
and safety. When a big company enters or
exits a small community, they will immediately
feel the impact on employment, incomes, and
spending in the area. In some industries, there
is a potential health impact, as companies
may alter the environment.MM
 Impact of Different Stakeholders
6 Governments: Governments can also be
considered a major stakeholder in a business
as they collect taxes from the company
(corporate income), as well as from all the
people it employs (payroll taxes) and other
spending the company incurs (goods and
services taxes). Governments benefit from the
overall Gross Domestic Product (GDP) that
companies contribute to.
 Priority of stacksholders
The task confronting an organization’s
management begins with understanding these
multiple and sometimes conflicting
expectations and ethically deciding which
stakeholders to focus on and in what
sequence, if not all stakeholders cannot be
addressed simultaneously, that is, stakeholder
prioritization. It helps to actively gather
information about all key stakeholders and
their claims.
 Priority of stacksholders
Jack Ma, the CEO of Alibaba, has famously said
that in his company, they rank stakeholders in
the following priority sequence:
• Customers
• Employees
• Investors
 Priority of stacksholders
• Much of the prioritization will be based on the
stage a company is at. For example, if it’s a
startup or an early-stage business, customers and
employees are more likely to be first. If it’s a
mature publicly traded company, shareholders
are likely to be first.
• At the end of the day, it’s up to a company, the
CEO, and the board of directors to determine the
appropriate ranking of stakeholders when
competing interests arise.
 Priority of stacksholders
Management should gather information about all
key stakeholders and their claims. First, managers
must establish that an individual with a concern is
a member of a stakeholder group. Which ones
should be taken seriously as representative of key
stakeholders? After establishing that a key
stakeholder group is being represented, the
manager should identify what the company
needs from the stakeholder. This simply helps
clarify the relationship.
 Value Based Management (VBM)

Value Based Management (VBM) is the

management philosophy and approach that
enables and supports maximum value
creation in organizations, typically the
maximization of shareholder value. VBM
encompasses the processes for creating,
managing, and measuring value.
 Value Based Management (VBM)
The value creation process requires an
understanding of the attractiveness of the
market or industry where one competes,
coupled with one’s competitive position
relative to other players. Once this
understanding is established and is linked with
key value chain drivers for cash flow and
profitability, competitive strategy can be
established or modified to maximize future
returns.
Value Based Management (VBM)
 Value Based Management (VBM)
The three elements of Value Based Management:
• Creating Value. How the company can increase or
generate maximum future value. More or less equal to
strategy.
• Managing for Value. Governance, change
management, organizational culture, communication,
leadership.
• Measuring Value. Value Based Management is
dependent on the corporate purpose and the
corporate values. The corporate purpose can either be
economic (Shareholder Value) or can also aim at other
constituents directly (Stakeholder Value).
 Value Based Management (VBM)
What are the benefits of Value Based Management?
• Can maximize value creation consistently.
• It increases corporate transparency.
• It helps organizations to deal with globalized and
deregulated capital markets.
• Aligns the interests of (top) managers with the
interests of shareholders and stakeholders.
• Facilitates communication with investors, analysts and
communication with stakeholders.
• Improves internal communication about the strategy.
 Value Based Management (VBM)
• Prevents undervaluation of the stock.
• It sets clear management priorities.
• Facilitates to improve decision making.
• It helps to balance short-term, middle-term
and long-term trade-offs.
• Encourages value-creating investments.
 Value Based Management (VBM)
• Improves the allocation of resources.
• Streamlines planning and budgeting.
• It sets effective targets for compensation.
Facilitates the use of stocks for mergers or
acquisitions.
• Prevents takeovers.