Lecture 7 Discounted Cash Flow (DCF) Method.pptx

VALUATION & INVESTMENTS (FINC 412) Lecture 7: Discounted Cash Flow (DCF) Method Muhammad M. Ma’aji, PhD, A C C A , F M VA Lesson Topic Lesson Plan Discounted cash flow (DCF), Cost of equity, Cost of debt, WACC, Free Cash Flow and Growth rates Learning Outcomes At...

VALUATION & INVESTMENTS (FINC 412) Lecture 7: Discounted Cash Flow (DCF) Method Muhammad M. Ma’aji, PhD, A C C A , F M VA Lesson Topic Lesson Plan Discounted cash flow (DCF), Cost of equity, Cost of debt, WACC, Free Cash Flow and Growth rates Learning Outcomes At the end of this lesson, students will be able to: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market; Explain discounted cash flow (DCF) approach to valuation Explain the rationale for using DCF models to value equity Calculate the cost of capital to be used for the valuation analysis Calculate free cash flow either to the firm or to the equity holder of the firm Calculate growth rate using arithmetic, geometric and regression model Calculate growth rate using fundamentals and explain the different approach to determining terminal growth rate in valuation. Activities/Methods Lecture, discussion, group exercise and excel practice Reading and References Main textbook Reading: CFA Material, Equity: Part I; CFA Material, Portfolio Management: Part I Main textbook Reading: Damodaran A. (2012). Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, 2nd Edition, Wiley Finance. Main textbook Reading: Bodie, Kane & Marcus (2019) Investments, 11th Edition, McGraw Hill Practice: KAPLAN Schweser Notes 2018 Exam Preparation, Equity and Portfolio Management: Part I  Valuation Process Valuation is based on expected future performance not past performance and involves: $ Analysis of the Analysis An analysis of the financial Forecast the future economic of the history and prospects of the operations of the Applying acceptable environment industry business, project or asset business, project or valuation methods asset There are various valuation methodologies which may arrive at differing values for a business, project or asset. Agenda Discounted cash flow (DCF) models Estimating cash flow and growth rate Estimating cost of capital DCF valuation value of the future cash flows generated by the company Company discounted at the required rate of return demanded by the value investors This definition leads to a number of follow-up questions: Q: Q: Q: What is the appropriate What drives future cash What discount rate is cash flow to use? flow generation? appropriate? Calculate the dividend Outline the main Identify what and Calculate free cash drivers of the discount rate to use flows to the firm and to forecast of the equity dividend and free cash flows DCF Formula Stock Value = Note: With growth rate > cost of capital, analyst must use multi-stage model like using the two-stage model Two stage DCF valuation model  Cash flows can be forecast for any number of years. Typically the forecast period is between 5 and 10 years. Forecast period Year 1 2 3 4 5 … Terminal Year Cash flows C1 C2 C3 C4 C5 Ct / (r –g ) Discount rate 1/(1+r)1 1/(1+r)2 1/(1+r)3 1/(1+r)4 1/(1+r)5 1/(1+r)n Present value PV1 PV2 PV3 PV4 PV5 PVt Practice 1 CamEd paid a dividend of $250,000 this year. The current return to shareholders of companies in the same industry as CamEd is 12%, although it is expected that an additional risk premium of 2% will be applicable to CamEd, being a smaller and unquoted company. Compute the expected valuation of CamEd, if: (a) The current level of dividend is expected to continue into the foreseeable future. (b) The dividend is expected to grow at a rate of 4% pa into the foreseeable future. (c) The dividend is expected to grow at a 3% rate for 3 years and 2% afterwards. Answer Practice 2 For example, suppose that current dividend is $2.00. A 14% required rate of return with the following dividend growth pattern. Dividend Year Growth Rate 1-3 25% 4-5 20% 6 on 9% What is the value of the company share price? If the current market price is $83.50, is the company over/under-valued? Answer Answer Practice 4 You would like to invest in Darden Restaurants, Inc (DRI), which has a current market price of $75.44 and a market cap of $8.79 billion. The sales and the net income of the company for the year ended 2020 is $8.51 billion and $1.77 billion, respectively and revenue is expected to grow at 7.72% for the next 5 years. The company maintained a constant payout ratio of 65% every year. At the terminal year, margins and dividends are expected to growth at the GDP rate for the US economy, which is currently at 3.8%. If the company’s cost of equity is 10%, is the stock over/under valued? Answer Agenda Discounted cash flow models Estimating cash flow and growth rate Estimating cost of capital or Discount rate Estimating cash flow Free cash flow (FCF) represents the cash available for the company to repay creditors or pay dividends and interest to investors. Estimate the current earnings of the firm If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income If looking at cash flows to the firm, look at operating earnings after taxes Consider how much the firm invested to create future growth If the investment is not expensed, it will be categorized as capital expenditures. Increasing working capital needs are also investments for future growth If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid) Free cash flows drivers Forecast Drivers Market size Sales mix Revenue Volume/price Materials price Staffing levels Operating EBIT x (1 – margin T) Wage rates (NOPAT) Tax effective structures Taxes Free cash flow A/R, Inventory, Working A/P capital Terms Maintenance capital Plant life Capital Maintenanc expenditures e Scale Free cash flows to the firm Free cash flows to the firm are the cash flows available to all funding providers (debt holders, preference shares investors, shareholders) EBIT (1 – Tax Rate) Depreciation and Amortization Changes in Working Capital (deduct net increase in working capital) Capital Expenditure Free Cash Flows to the Firm Free cash flows to equity Free cash flows to the equity are the cash flows available to all equity providers i.e. shareholders only. Net income Depreciation and Amortization Changes in Working Capital (deduct net increase in working capital) Capital Expenditure Principal Debt Repayments - New Debt Issues Free Cash Flows to the equity  Practice 6 Roomba Inc. is a manufacturer of vacuum cleaners and you have estimated a FCFF of $50 million for firm for the most recent year. Roomba’s total debt decreased from $100 to $85 million during the course of the year and it reported interest expense of $10 million for the year. If Roomba’s tax rate is 30%, estimate the FCFE for the most recent year. Answer Answer  Practice 9 You are trying to compute the change in working capital to use in computing free cash flow to the firm for Zapata Inc. The firm’s total working capital increased from $100 million last year to $120 million this year. However, this working capital includes cash and short term debt; last year’s cash balance had $ 30 million in cash and $15 million in short term debt, whereas this year’s cash balance has $20 million in cash and $25 million in short term debt. What effect did working capital have on your cash flow this year? Answer  Practice 10 Tymba Inc. generated $20 million in after-tax operating income on revenues of $100 million during the course of the most recent year. You expect revenues to grow 10% a year next year and margins to stay stable. The firm’s current assets are $40 million and its current liabilities are $50 million, and working capital as a percent of revenues is expected to remain unchanged next year. If the net cap ex is expected to be $10 million next year, what is your estimate of the FCFF for the next year? Answer Expected Growth Rate Look at the past The historical growth in earnings per share is usually a good starting point for growth estimation Look at what others are estimating Analysts estimate growth in earnings per share for many firms. Look at fundamentals Ultimately, all growth in earnings can be traced to two fundamentals - how much the firm is investing in new projects, and what returns these projects are making for the firm. Historical growth Rate  Historical growth rates can be estimated in a number of different ways Arithmetic average Geometric average Linear regression models  However, historical growth rates can be sensitive to; The period used in the estimation (starting and ending points) The metric that the growth is estimated in..  With historical growth rates, you have to wrestle with the following: How to deal with negative earnings The effects of scaling up (company grows dramatically in short period)  Fundamental Growth Rate Estimating Growth From Fundamentals  the growth of earnings  the proportion of earnings paid in dividends In the short run, dividends can grow at a different rate than earnings if the firm changes its dividend payout ratio Earnings growth is also affected by earnings retention and equity return (Sustainable Growth Rate) Growth in earnings = *Reinvestment Rate x Return on Equity Growth in operating Income = **Reinvestment Rate x Return on Capital *Reinvestment Rate = (Retained Earnings/ Current Earnings) and ROE = (Net Income/Book Value of Equity) **Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t) and ROC = EBIT(1-t)/(BV of Debt + BV of Equity - Cash)  Practice 11 DBK Bank paid out $ 80 million in dividends on net income of $100 million in the most recent year. The book value of equity for the firm is $800 million. Assuming that the bank maintains its current payout ratio and return on equity in perpetuity. What is the expected growth in earnings per share in perpetuity? Answer Terminal growth rate  Terminal growth rate is an estimate of a company’s growth in expected future cash flows beyond a projection period until perpetuity.  It is a critical part of the financial model as it typically makes up a large percentage of the total value of a business.  DCF models are very sensitive to assumptions that are made about terminal value. A common way to help represent this is through sensitivity analysis.  There are three approaches to the terminal value formula:  (1) Perpetual growth,  (2) Liquidation basis  (3) Exit multiple. Terminal growth rate The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). Perpetual growth method Life cycle stage Characteristics Terminal growth rate High growth rate for business in its early Expansion stage of expansion stage The business has established its position in growth rate the industry and is seeking to increase its Usually 10% or above market share. Experience a rapid growth in revenue The company will likely struggle to maintain its high growth rate due to the rising Decelerated competition within the industry. Usually between 5% to 8% growth stage The business will continue to grow, but no longer at the substantial growth rate The company’s growth is minimal as more of the company’s resources are diverted to defending its existing market share from For inflation, usually Mature stage between 2% to 3%. emerging competitors within the industry. growth rate Use risk free rate in the At this stage, the terminal growth rates typically range between the historical inflation rate and country between 1 to 3% the average GDP growth rate.  Practice 14 A key input into your terminal value is the expected growth rate in perpetuity. Assuming that you are valuing a company in a currency with a risk free rate of 3%. Which of the following growth rates is not feasible? A. -3% in perpetuity B. 0% in perpetuity C. 2% in perpetuity D. 4% in perpetuity  Practice 15 Avalon Inc. is a high growth publicly traded firm that is expected to become a stable growth firm after 5 years. You have estimated an expected after-tax operating income of $60 million in year 6 and believe that the firm reinvestment rate is 25% in perpetuity. If the cost of capital is 10% and the expected growth rate in perpetuity after year 5 is 3%. What will the terminal value be at the end of year 5? Answer Agenda Discounted cash flow models Estimating cash flow and growth rate Estimating cost of capital Estimating Discount Rate At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cash flow being discounted. Equity versus Firm: If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal The Cost of Equity  Cost of Equity (Ke)  The cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Ke = Rf + β x (Rm-Rf) or Ke = Rf + CRP + Beta (Mature ERP)  Practice 5 Kroll Inc is all equity-funded, US-based household products company that generates all its revenues in the US and has a beta of 0.90, US equity risk premium of 5% and the US Treasury Bond rate is 1.5%. Inflation in US is 1.2%. Kroll Inc is considering acquiring Maya Inc, an Indian household products company with all of its revenues in India. The expected inflation rate in India is 4% and the country risk premium for India is 2%. A) Estimate the cost of equity of Kroll Inc. B) Estimate the cost of equity that the company should use to discount Maya’s cash flows, if those cash flows will be in Indian rupees. Answer  Cost of Debt The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level of interest rates in the market. Looking up the yield to maturity (YTM) or market price of the outstanding bond from the firm. But very few firms have long term straight bonds that are liquid and widely traded. Looking up the actual rating for the firm and estimate a default spread based upon the rating. But very few firms have a rating. When in trouble (either because you have no ratings or multiple ratings for a firm), estimate a synthetic rating for your firm and the cost of debt based upon that rating. Cost of Debt Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio. Interest Coverage Ratio = EBIT / Interest Expenses Once a synthetic rating is assessed, it can be used to estimate a default spread which when added to the risk free rate yields a pre-tax cost of debt for the firm. Cost of debt = Risk free rate + *(Country default spread) + **Company default *The country default spread is only added in the case for developing countries firms **The company default is based on the synthetic rating lookup table after estimating the interest coverage ratio Sources: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.html  Estimating Synthetic Ratings If interest coverage ratio is: greater than ≤ to Rating is Spread is 12.5 100000 Aaa/AAA 0.69% 9.5 12.499999 Aa2/AA 0.85% 7.5 9.499999 A1/A+ 1.07% 6 7.499999 A2/A 1.18% 4.5 5.999999 A3/A- 1.33% 4 4.499999 Baa2/BBB 1.71% 3.5 3.9999999 Ba1/BB+ 2.31% 3 3.499999 Ba2/BB 2.77% 2.5 2.999999 B1/B+ 4.05% 2 2.499999 B2/B 4.86% 1.5 1.999999 B3/B- 5.94% 1.25 1.499999 Caa/CCC 9.46% 0.8 1.249999 Ca2/CC 9.97% 0.5 0.799999 C2/C 13.09% -100000 0.499999 D2/D 17.44% Sources: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.html Cost of Capital/ WACC Cost of capital is the overall minimum rate of return or profit a company must earn before generating value or satisfying its funds providers. In computing the cost of capital for a publicly traded firm, the general rule for computing weights for debt and equity is that you use market value weights (and not book value weights). Why? A. Because the market is usually right B. Because market values are easy to obtain C. Because book values of debt and equity are meaningless D. None of the above Cost of Capital/ WACC  Practice 6 Estimate the cost of capital of Phnom Pehn Water Supply Authority (PWSA) a listed company on CSX as at today’s date.  Summary The key messages from this session are: DCF valuations are based on the premise that a company’s value equals the value of the future cash flows generated by the company discounted at the required rate of return demanded by the investors. Two stage DCF valuation models are common and are made up of a finite forecast period and a post-forecast period referred to as the continuing value or terminal value. Forecasting free cash flows involves a detailed understanding of cash flow drivers such as revenues, operating margins, tax rates, working capital and capital expenditure. Investment useful links – https://www.investopedia.com/terms/d/dcf.asp – https://www.investopedia.com/terms/f/freecashflow.asp – http://www.morganstanley.com – http://www.globalinsight.com – http://www.yardeni.com Click icon to add picture Thank you for listening Q&A