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2013-04 DCF Valuation presentation

presentation on valuation
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Pratik Singhi

on 13 January 2016

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Transcript of 2013-04 DCF Valuation presentation

CA Pratik K. Singhi
April 2013
Valuation
Agenda
Valuation - Art or Science
Valuation Myths
Valuation Techniques' Overview
DCF Methodology: Detail
DCF Valuation Finer Points
DCF Valuation: Practical Issues
DCF Valuation: Common Errors
Why Valuation
do not buy it for more than its worth
do not sell it for less than its worth
Price is what you pay. Value is what you get. --Warren Buffett
Why Valuation?
Basics of sound investing
For every complex problem there is a simple solution that is wrong. --G B Shaw
E-I-C Analysis
Economic Analysis
If you laid all economists in the world end to end, you still wouldn’t reach a conclusion.
Economic Analysis
An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.
Industry Analysis
We do not have, never have had, and never will have an opinion about where the stock market, interest rates or business activity will be a year from now. --Warren Buffett
Company Analysis
Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted. --Albert Einstein
Valuation methodologies
Valuation Methodologies
Of two equivalent theories or explanations, all other things being equal, the simpler one is to be preferred. –-William Ockham
Discounted Cash Flow (DCF)
Discounted Cash Flow (DCF)
Profit, an accounting convention, does not represent cash generated by business
Profit can be influenced by accounting assumptions, but not cash.
Cash generated in the business cannot be hidden; nor can it be falsely created by accounting gimmickry
Revenue is vanity, Profit is sanity, Cashflow is reality! –-Warren Buffett
Discounted Cash Flow (DCF)
Been used in some form since money was first lent at interest in ancient times
Following the stock market crash of 1929, DCF analysis gained popularity
1930: Irving Fisher in‘Theory of Interest’ talked about modern DCF method
1938: John Burr Williams in 'The Theory of Investment Value’ formally expressed DCF method in modern economic terms
Paper profits on accrual accounting basis is of no more than secondary/tertiary importance for a start up. But cash is what keeps the doors open and pays the bills. –-Guy Kawasaki
Discounted Cash Flow (DCF)
Foundation in Present Value (PV) rule
Assumes CFs are the only source of value
Value can be measured as PV of future CFs
Most contemporary & universally applied
International Good Practice Guidance (IGPG) encourages professional accountants in business to promote use of DCF analysis and NPV to evaluate investments
Why suddenly DCF??
Why suddenly DCF??
Guidelines objective: To ensure that all transactions involving an NR in the shares of an unlisted co take place at a fair value
Share value calculated by DCF shall be
‘floor price’ for subscription of new shares by NR or in case of a transfer of shares by a resident to a non-resident
‘ceiling price’ in case of a transfer of shares by NR to R
Guidelines would also apply in case of a newly-incorporated company
Why suddenly DCF??
Erstwhile Controller of Capital Issues (CCI) guidelines were in use hitherto
RBI issued new guidelines for unlisted entities, amending pricing guidelines for:
issue of shares by Indian company to a NR
transfer of shares of an Indian company from a R to NR, or vice versa
New guidelines stipulate that share value to be determined using DCF method
But, do NOT provide any guidance on ‘discount rates’ or‘perpetual cashflows’
Discounted Cash Flow (DCF)
Time Value of Money (TVM)
Worth of a rupee tomorrow is lower than the worth of a rupee today
Ceteris paribus, a rational investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in future
Very useful in evaluating projects with
Different life
Different cash outflows/inflow
At different periods of time
TVM plays a rather pivotal role in corporate finance decision making
Future value of every investment is a function of its present price. Higher the price you pay, lower your return will be. –-Ben Graham
Plays key role in many allied areas of finance:
portfolio management
sell-offs
acquisitions
mergers
joint ventures
buy-backs
corporate finance
capital budgeting
Why Valuation
DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market risk premium
Beta
Terminal value
Terminal growth rate
Present value of terminal value
Enterprise value/ Equity value
Recap

DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market risk premium
Beta
Terminal value
Enterprise value/ Equity value
Recap

DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market risk premium
Beta
Terminal value
Enterprise value/ Equity value
Recap

DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)

Cost of debt
Cost of equity
Risk-free rate of return
Market risk premium
Beta
Terminal value
Enterprise value/ Equity value
Recap

DCF – WACC
Discounting Factor

Generally, WACC

WACC = [(Kd*D)+(Ke*E)] /(D+E)
where
Kd = post-tax cost of debt
Ke = cost of equity
D = market value of debt
E = market value of equity
Cost of Debt

Kd = Rd (1 – Tc)
where:
Kd = post-tax cost of debt
Rd = coupon rate of interest
Tc = effective rate of tax paid by firm

E.g., if a firm borrows debt at interest rate of 12% and lies in 30% effective tax bracket, its Kd is
DCF – WACC
Cost of Equity – CAPM

Ke = Rf + β * (Rm – Rf)
where:
Ke = cost of equity
Rf = risk-free rate of return
β = risk factor of the cash-flows
Rm = rate of return on a diversified portfolio (SE benchmark index)

E.g., if the Rf is 6% and the Rm is 10%, the Ke of a firm with betaβ of 2 is
DCF – WACC
Cost of Equity – risk premium
As seen below for US stock markets, depends heavily on choice of
index
period of observation
DCF – WACC issues
Beta

Measures volatility of firm’s stock price relative to that of given market index
Statistically, beta is relationship b/w
covariance of selected stock with well- diversified market portfolio and
the variance of that portfolio
β = Covariance of asset with Market/ Variance of the market
DCF – WACC
Uncertainty is not a result of ignorance or the partiality of human knowledge, but is a characteristic of the world itself. --M Taylor
Beta

Symbolic representation of riskiness of the underlying cash flows, vis-à-vis those of a well diversified portfolio
Directly proportionate to firm’s sensitivity to market conditions
E.g., if benchmark index moves up by 5% and simultaneously scrip moves:
DCF – WACC
Beta
In case of calculations based on stock market data
Un-levered industry/segment average beta is considered
Βu = βlv / [1+ (D:E)*(1-t)]


Re-levered to target company’s target D:E ratio
DCF – WACC
Beta is a highly sensitive value driver
To be chosen/calculated carefully. Varies with choice of:
market index (for e.g., Sensex, Nifty, BSE 200, NSE 100, etc.)
time period covered by underlying observational data points (one year, two years, five years, etc.)
return interval (daily, weekly, monthly, bi-monthly, quarterly, semi-annually, annually, etc.)
DCF – WACC

DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market risk premium premium
Beta
Terminal value
Terminal growth rate
Present value of terminal value
Enterprise value/ Equity value
Recap

DCF – Terminal Value
Terminal Value

Business, as a going concern, is assumed to be carrying on operations in perpetuity, i.e., infinity

TV is firm’s value at end of explicit forecast period

TV captures firm’s value for operations beyond explicit forecast period
Do not count your chicken before they stop breeding. --Aesopeus
Present Value of FCFs

FCFs are discounted to their present value, using the WACC

DCF – Present Value of FCF
The really dreadful losses were realised in those common stocks where the buyer forgot to ask “how much?” --Ben Graham
DCF – Terminal Value
Terminal Value

FCFF(n+1)/ (WACC – g)
where:
FCFF(n+1) = FCFF in year after explicit forecast period
g = steady state growth rate of FCF till infinity
E.g., if FCFF for last forecast year is 1000, WACC is 18% and terminal growth rate is 3%, the TV is
DCF – Terminal Value
Terminal Value

Perpetuity formula does not work where g ≥ WACC

BUT this is impossible - g exceeding r in perpetuity implies the business eventually would be larger than the whole economy!!

DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market premium
Beta
Terminal value
Enterprise value/ Equity value
Recap

DCF – Enterprise/Equity Value

Enterprise Value
PV of FCFs during forecast period
Add: PV of terminal value

Equity Value
Enterprise value
Less: Debt
Add: Cash
Add: Market value of Investments
DCF Valuation Process
Future projections
Free cash flows (FCFs)
Weighted average cost of capital (WACC)
Cost of debt
Cost of equity
Risk-free rate of return
Market premium
Beta
Terminal value
Enterprise value/ Equity value
Recap

DCF – Enterprise Value
Enterprise Value – broad steps in DCF-based calculation
“DCF is difficult and subjective”
So, aren’t others?
“Many value drivers need to be combined to produce a DCF valuation”
Multiples also consider same factors
DCF focuses on all value drivers rather than combining these into one multiple

DCF criticism. And, defense
Markets can remain irrational longer than you can remain solvent. –-J M Keynes
DCF criticism. And, defense
“DCF requires WACC and nobody seems to have a clue of what it is”
Differences in required return is a key factor in valuation
“DCF is very sensitive to long term growth assumptions”
So are multiples. The problem is mitigated by using zero value adding long term growth assumptions
Take every gain without remorse for missed profits. --Joseph de la Vega
DCF conclusion
DCF and related techniques are powerful valuation tools
DCF is a very robust methodology, but can only work right if
the assumptions are reasonable
the application is realistic
Investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas or Wall Street. –-Paul Samuelson
DCF – Free Cash Flows
Free Cash Flows to Firm (FCFF)
Not the same as operating CF
Residual CF after meeting all cash operating expenditure, but prior to any payments to financing stakeholder
Net of working capital and capex needed to support future forecast FCF
Always post-tax
Cash available to all finance providers
= Debt cash flow + Equity cash flow
We’d rather be vaguely right than precisely wrong. –-J M Keynes
DCF – Free Cash Flows
Interest Exclusion Principle
Free Cash Flows – calculation

Operating Profit (EBIT)
Less: Adjusted Taxes
Gives: Net Operating Profit Less Adjusted Taxes (NOPLAT)
Add: Book Depreciation
Add: Non-cash expenses/ amortization
Gives: Gross Cash Flow
Less: Increase in net Working Capital
Less: Capital Expenditure
Gives: Free Cash Flows to Firm (FCFF)
DCF – Free Cash Flows
Free Cash Flows – calculation
DCF – Free Cash Flows
Free Cash Flows – calculation
DCF – Free Cash Flows

Free Cash Flows – calculation
DCF – Free Cash Flows

Macro Economic Factors
Text
Fiscal Policies
Monetary Policies
Inflation
National Income
Exchange Rates
Interest Rate
GDP/GNP and Growth rate
Pricing Strategies
Production efficiencies
Market Structure
Cost Management
Demand & Supply conditions
Micro Economic Factors
Financing decisions reflected in WACC through D:E ratio
Financing decisions to fund long term capital funding requirements are ignored
Business’ perspective, not just equity owners’. Hence, firm’s FCF (FCFF), rather than equity holders’ FCF (FCFE)
Portor' Five Forces
GE‘s Nine Grid Matrix
PEST Analysis
SWOT Analysis
Concentration
Industry lifecycle
BCG Matrix
Tools for Industry Analysis
MD & A
Periodic Regulatory Filings
Annual Reports
Ratio Analysis- Vertical
Financial Statements
Company Analysis
Ratio Analysis- Horizontal
Interest Exclusion Principle
8.4%. since 12% (1-30%) = 8.4%
Explicit Forecast Period

CFs are projected for an explicit forecast period, based on
Past experience and performance
Future industry outlook
Specific plans
Depending on business/industry, and the state of business, forecast period may range between 5 to 15 years
DCF – Future Projections
We have two classes of forecasters: Those who don’t know and those who don’t know they don’t know. –-John K Galbraith
However good our futures research may be, we shall never be able to escape from the ultimate dilemma that all our knowledge is about the past, and all our decisions are about the future. --Ian Wilson
Explicit Forecast Period Test?
Should cover at least one cycle of boom and doom
Business should attain steady state of operations by end of forecast period
DCF – Future Projections
14%. since 6% + 2 (10% - 6%) = 14%
6867, being 1000*1.03 / (0.18-0.03)
Increase by 7%, its beta is 1.4
Decrease by 9%, its beta is -1.8
Price is what you pay. Value is what you get. --Warren Buffett
Projections - P&L
Projections - Balance Sheet
FCFF
WACC
Valuation
Most important ingredient!
Valuation - Art or a Science
Bradford Cornell, in ‘Corporate Valuation: Tools for Effective Appraisal and Decision Making’:
“Valuation is neither an Art nor a Science, but an odd combination of both. There is enough Science that appraisers are not left to rely solely on experience, but there is enough Art, that without experience and judgments, failure is assured.”
If you can keep your head when everyone around is losing theirs, then yours is the Earth and everything that’s in it. --Rudyard Kipling
Valuation - Art or a Science
Valuation is all about judgment!
Benjamin Graham, in “The Intelligent Investor” quips:
“Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative the conclusions we draw therefrom
If you are wondering when to bank a profit, wait until all the brokers say buy and the stock is tipped in the Newspapers. -- Tom Winnifrith
Valuation Myths
Valuation techniques are quantitative, hence valuation is objective
Valuation is an art, not an exact science. Mathematical certainty is neither demanded, nor indeed is it possible
Influenced by perception of the buyer/ seller
Good valuation provides a ‘precise’ estimate of value
There is no ‘right’ value. Beyond number crunching, Valuation requires exercise of judicious discretion and judgment
Well-done valuation is timeless
Actual value depends on the needs, perceptions and negotiation power of the parties involved in the deal
Highly sensitive to changes in circumstances
“This time its different” is amongst the most costly four words in the market history. --Sir John Templeton
DCF – WACC issues
DCF – WACC issues
Things should be as simple as possible, but no simpler -- Albert Einstein
Concept of TVM can be used to
Compound all CFs over a period to a FV on a future date
Discount all CFs during a period to their PV today
You have an expected liability (cash outflow) of Rs. 100k in 5 years time, and you use a discount rate of 10%
Is it possible to calculate how much you would need
right now as savings to cover expected liability?
at the start of each year for next 5 years to cover the expected liability?
Discounted Cash flow (DCF)
Will your answer be different if the tenure to maturity is 5 years?
A Rs. 100 par value bond, bearing coupon rate of 10% will mature in exactly 2 years. What is the value of this bond if the desired rate of return is 12%. Ignore tax implications, if any.
Wait for the entire picture!!
Biggest test of Valuation
Common Sense??
Ratio Analysis
Value v/s Price
A tool is only as good as you put it to!!
Pitfalls in case of projections
Top down vs bottoms up approach
Mix up in fixed vs variable
Balance sheet not tallying. Yes, balance sheet not tallying!
Not taking impact of tax related issues
Depreciation of assets not in sync with life
Taking FS as is, without adjusting it for one-off/non-recurring items.
Increasing deposits along with revenues. If the deposits are rental office related?
Considering revaluation of fixed assets as cashflows
Seasonal companies – impact of seasonal stock or seasonal debt

Possible pitfalls
WC not being recovered in fixed life projects
Release of working capital towards the end in case of a growing company
Sustenance capex missing
Still growing co but projected financials ended
Growth rates to be tempered over a period of time. Use of geometric mean vs CAGR
In case of CAGR being different from latest growth rate
FCFE vs FCFF approach – wrong application
Possible pitfalls
Market share of over 35% in 5 years for a startup is scary! Not impossible (twitter facebook are eg), but be very careful
Broad ratio between TV and EV
Interest cost for WACC different from interest cost for projections
D:E ratio for WACC different from D:E ratio for projections. Possible!
Pre-money vs post-money conundrum
Full transcript