| Valuation – DCF | ||
| 1. Discounted Cash Flow Analysis | ||
| Discounted cash flow (DCF) analysis calculates the net present value of future free cash flow projections. Discounting is most often done using the weighted average cost of capital to arrive at a present value. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity is perceived to be a good one. DCF valuation method is based on the basic tenet of valuation that every asset derives value from its ability to generate cash flows. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions. DCF analysis can be done at two levels – firm or business level and equity level. The first will give the value of the core business excluding associates and joint ventures but including all forms capital (not just equity). The second gives the value of only the equity capital including stakes in associates and joint ventures. | ||
| 2. Business level valuation | ||
| This is obtained by discounting projected future free cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments and contributions from associates and joint ventures, at the weighted average cost of capital. | ||
| 3. Equity level valuation | ||
| The value of equity is obtained by discounting expected cash flows to equity shareholders, i.e., the firm level cash flows adjusted for debt payments and contributions from associates and joint ventures, at the cost of equity, i.e., the rate of return required by equity investors in the firm. | ||
| 4. Example of DCF valuation | ||
| Let us consider a simple example of a DCF at the firm level: Relevant estimates/assumptions: · Firm will yield cash flows of $1,000, $1200 and $1,500 for the first three years · Perpetual growth of 2% beyond 3 years · Cost of equity – 12% · Cost of debt – 8% · Debt to equity ratio is 1 WACC = 0.08*1/2 + 0.12*1/2 = 10% | ||
| Year | Cash flow | Present Value |
| 1 | $1,000 | 1000/(1.1)^1 = $909 |
| 2 | $1,200 | 1200/(1.1)^2 = $992 |
| 3 | $1,500 | 1500/(1.1)^3 = $1,127 |
| Terminal value | (1500*1.02)/(0.1-0.02) = $19,125 | 19125/(1.1)^3 = $14,369 |
| DCF Valuation |
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| 5. Points to Ponder | ||
| 1) What will be the equity level valuation for the above example? | ||
Monday, 27 October 2014
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