Discounted Cash Flows Methods

Discounted Cash Flows Methods

• Discounted cash flow analysis involves determining the present value of the net cash flow of an investment opportunity.
• Cash flows are categorized as operating, investing, and financing activities.

Net Cash Flows

• Net cash flows represent the amount of cash available for distribution to both debt and equity claims of a business or assets.
• Going concern business opportunity (GCBO) net cash flow is based on operating and investing activities.

Net Cash Flows Preferred

• Net cash flows are preferred as a valuation basis if the company does not pay dividends, or pays dividends significantly different from its capacity, or if net cash flows and profits align within a reasonable forecast period, or if investors have a control perspective.

Using Net Cash Flows

• Using net cash flows is more advantageous in valuation activities because it can be directly used as input in a discounted cash flow (DCF) model.
• Other cash flow metrics like EBITDA, EBIT, net income, and cash flow from operations may not be as accurate because they might either miss or double-count items.

Reasons for Using Net Cash Flows

• EBITDA and EBIT are before-tax metrics, while cash flows available to investors are after-tax.
• EBITDA and EBIT do not consider differences in capital structures, interest payments, dividends for preference shares, or funds sourced from bondholders to fund additional investments.
• These measures also do not consider reinvestment of cash flows into the firm for additional working capital and fixed assets investment, which are necessary to maximize long-term business stability.

Analyzing Cash Flows

• Analyzing cash flows and their sources helps analysts understand the source of financing for needed investments, reliance on debt financing, and quality of earnings.

Two Levels of Net Cash Flows

• Net Cash Flow to the Firm is the amount made available to both debt and equity claims.
• It's generated from operating and financing activities intended to pay required returns on funds provided.

Net Cash Flows to the Firm

• This refers to the cash flow available to lenders and shareholders after all operating expenses, including taxes, and investing capital expenditures and working capital, are paid.

Computing Net Cash Flows Using Approaches

• A. Based from Net Income (or Indirect Approach):
  • Add Non-cash charges (net)
  • Add Interest expense (net of Taxes)
  • Adjust working capital
  • Deduct net investments in fixed capital (purchases-sales of fixed capital investments)
• B. From Statement of Cash Flows:
  • Add Interest expenses (net of Taxes) from operating activities
  • Deduct Cash flows from investing activities
• C. From Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
  • Add tax savings on noncash charges
  • Add/less working capital adjustments
  • Deduct investments in fixed capital

Net Cash Flows Equity

• Net cash flows equity represent the cash available to equity shareholders after deducting net debt, outstanding liabilities to creditors, and available cash balance.
• It can be calculated from the net cash flow to the firm by considering items related to lenders and preferred shareholders.

Net Cash Flow Formula

• Add: Proceeds from borrowing
• Less: Debt service
• Add: Proceeds from preferred shares issuance
• Less: Dividends on preferred shares
• Net Cash Flows to the Equity

NCFE Calculation Approaches

• A. Based from Net Income (or Indirect Approach):
  • Net Income available to common shareholders
  • Non-cash charges (net)
  • Interest expense (net of Taxes)
  • Adjustments in Working Capital
  • Net Investments in Fixed Capital (Purchases−Sales of Fixed Capital Investments)
  • Net Cash Flows to the Firm
  • Proceeds from Borrowing
  • Debt Service
  • Proceeds from preferred shares issuance
  • Dividends on Preferred Shares
  • Net Cash flows to the Equity
• B. From Statement of Cash Flows:
  • Add Interest Expenses (net of Taxes) from operating activities
  • Less Cash Flows from Investing Activities
  • Net Cash Flows to the Firm
  • Add Proceeds from Borrowing
  • Less Debt Service
  • Add Proceeds from Preferred Shares Issuance
  • Less Dividends on Preferred Shares
  • Net Cash Flows to the Equity
• C. From Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
  • EBITDA, net of Taxes
  • Tax savings on Noncash Charges
  • Working Capital Adjustments
  • Investments in Fixed Capital
  • Net Cash Flows to the Firm
  • Proceeds from Borrowings
  • Debt Service
  • Proceeds from Preferred Shares Issuance
  • Dividends on Preferred Shares
  • Net Cash Flows to the Equity

Terminal Value

• Terminal value is the value of an asset, business, or project beyond the forecasted period when future cash flows are estimated. Value is determined into perpetuity beyond a set forecast period, usually five years.

Basis of Terminal Value

• 1. Liquidity Value
• 2. Estimated Perpetual Value: TV = CF_n+1 / (r - g)
  • TV = Terminal value
  • CF_n+1 = farthest net cash flow
  • r = Cost of Capital
  • g = growth rate

Growth Rate

• g = [(NCF_n / NCF₀)^(1/n) - 1] x 100%
  • NCF_n = latest net cash flow
  • NCF₀ = net cash flow at the beginning
  • n = Latest Time

Constant Growth

• Constant Growth
• Scientific Estimates

DCF Analysis Applicability

• Validated operational and financial information
• Reasonable appropriated cost of capital or required rate of return
• New quantifiable information

Financial Model in DCF Analysis

• Sophisticated and confidential activity in a company or for an analyst.
• Information can be a competitive advantage.
• Companies often hire financial modelers to validate estimates and explore opportunities. Modelers possess extensive experience and expertise, often consisting of economists, financial managers, and accountants.

Steps in Creating Financial Models

• Gather historical information and references
• Establish drivers for growth and assumptions
• Determine reasonable cost of capital
• Apply formulas to compute for the value
• Make scenario and sensitivity analysis based on results

Gather Historical Information and References

• Historical information is necessary for financial modeling and is gathered from various sources including audited financial statements, corporate disclosures, contracts, and peer information.

Historical Information

• Audited Financial Statements: used to assess future performance based on past performance
• Financial Performance: used to determine historical financial performance
• Financial Position: used to determine the book value of assets and disclosed stakes of debt and equity financiers
• Cash flows: illustrate how a company historically finances operations and investments
• Changes in Equity: answers how much is the claim and dividend background of the company
• Notes: to the Financial Statement provides important disclosures
• Corporate Disclosures: of future plans and strategies
• Contracts: formal agreements between parties.
• Due Diligence: to verify contingent liability and other legal risks to quantify accordingly for conservative value.
• Peer Information: provides context, supports identified risks, includes analysts, industry experts, and consultants; research and studies and data shared in conventions, forums are additional relevant input for development of financial model and valuation.

Gather Historical Information

• Financial models must filter necessary information for valuation based on relevance and reliability.
• Materiality is a key consideration; only relevant items should be considered during valuation.

Establishing Driver for Growth and Assumptions

• Financial analysis helps in establishing drivers and assumptions.
• Validated drivers and assumptions are represented by authorities, such as government bodies or experts.
  • Business growth often tied to consumer goods, population.
  • While service businesses follow industry growth.
• Data from government entities including Philippine Statistics Authority, Bangko Sentral ng Pilipinas and the National Economic and Development Authority. (Government sources).

Establishing Drivers for Growth

• Population growth, GDP, GNP growth, and inflation rates are usual growth indicators for businesses.
  • Calculating Inflation: Inflation = [(CPI_n - CPI₀) / CPI₀] * 100% (where CPI_n is the consumer price index for the current year and CPI₀ is the consumer price index for the base year.)

Illustration of Inflation/Deflation Calculation

• Examples provided calculating inflation or deflation rate from CPI values.

Communication Cost Example

• Illustrates how to calculate communication cost adjusted for inflation

Population Growth Rate

• Population growth rates serve as growth drivers for product demand; the formula parallels inflation calculations.

Growth Rate (Illustration) Calculation

• Example showing growth rate calculation given population figures.

Determining the Reasonable Cost of Capital

• Trend analysis helps determine growth trajectory.
• Financial modelers must determine if the company can sustain the projected pattern or apply a more conservative growth assumption.
• The cost of debt and equity are generally weighted to determine a reasonable cost of capital for valuation.

Applying Formulae to Compute for the Value

• DCF analysis, used in financial modeling to calculate value, can utilize other capital budgeting techniques, such as internal rate of return and profitability index, given available financial information.

Making Scenarios and Sensitivity Analysis

• What-if analysis produces different scenarios and gathers immediate results from these scenarios.

Components of Financial Model

• Title Page: Overview of the project being assessed.
• Data Key Results: Summarized results of the study.
• Assumption Sheets: Assumptions used in the model.
• Pro-forma Financial Statements: Presents financial statements and key ratios.
• Supporting Schedules: Supporting computations for components within the proforma financial statements. 

This quiz explores the principles of discounted cash flow (DCF) analysis, which is essential for evaluating investment opportunities. It discusses how net cash flows are categorized and the advantages of using net cash flows in valuation activities. Test your understanding of cash flow concepts and their significance in financial analysis.