How to do dcf valuation

DISCOUNTED CASHFLOW MODELS: WHAT THEY ARE AND HOW TO CHOOSE THE RIGHT ONE..

THE FUNDAMENTAL CHOICES FOR DCF VALUATION

  • Cashflows to Discount
    • Dividends
    • Free Cash Flows to Equity
    • Free Cash Flows to Firm
  • Expected Growth
    • Stable Growth
    • Two Stages of Growth: High Growth -> Stable Growth
    • Three Stages of Growth: High Growth -> Transition Period -> Stable Growth
  • Discount Rate
    • Cost of Equity
    • Cost of Capital
  • Base Year Numbers
    • Current Earnings / Cash Flows
    • Normalized Earnings / Cash Flows

WHICH CASH FLOW TO DISCOUNT.

  • The Discount Rate should be consistent with the cash flow being discounted
    • Cash Flow to Equity -> Cost of Equity
    • Cash Flow to Firm -> Cost of Capital
  • Should you discount Cash Flow to Equity or Cash Flow to Firm?
    • Use Equity Valuation
      • (a) for firms which have stable leverage, whether high or not, and
      • (b) if equity (stock) is being valued
    • Use Firm Valuation
      • (a) for firms which have high leverage, and expect to lower the leverage over time, because
        • debt payments do not have to be factored in
        • the discount rate (cost of capital) does not change dramatically over time.
      • (b) for firms for which you have partial information on leverage (eg: interest expenses are missing..)
      • (c) in all other cases, where you are more interested in valuing the firm than the equity. (Value Consulting?)
  • Given that you discount cash flow to equity, should you discount dividends or Free Cash Flow to Equity?
    • Use the Dividend Discount Model
      • (a) For firms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to Equity (over a extended period)
      • (b)For firms where FCFE are difficult

        to estimate (Example: Banks and Financial Service companies)

    • Use the FCFE Model
      • (a) For firms which pay dividends which are significantly higher or lower than the Free Cash Flow to Equity. (What is significant. As a rule of thumb, if dividends are less than 75% of FCFE or dividends are greater than FCFE)
      • (b) For firms where dividends are not available (Example: Private Companies, IPOs)

WHAT IS THE RIGHT GROWTH PATTERN.

THE PRESENT VALUE FORMULAE

  • For Stable Firm:

  • For two stage growth:

  • For three stage growth:

Definitions of Terms

V0 = Value of Equity (if cash flows to equity are discounted) or Firm (if cash flows to firm are discounted)

CFt = Cash Flow in period t; Dividends or FCFE if valuing equity or FCFF if valuing firm.

r = Cost of Equity (if discounting Dividends or FCFE) or Cost of Capital (if discounting FCFF)

g = Expected growth rate in Cash Flow being discounted

ga = Expected growth in Cash Flow being discounted in first stage of three stage growth model

gn = Expected growth in Cash Flow being discounted in stable period

n = Length of the high growth period in two-stage model

n2 - n1 = Transition period in three-stage model

  • Use the growth model only if cash flows are positive
  • Use the stable growth model, if
    • the firm is growing at a rate which is below or close (within 1-2% ) to the growth rate of the economy
  • Use the two-stage growth model if
    • the firm is growing at a moderate rate (. within 8% of the stable growth rate)
  • Use the three-stage growth model if
    • the firm is growing at a high rate (. more than 8% higher than the stable growth rate)

SUMMARIZING THE MODEL CHOICES

Source: pages.stern.nyu.edu

Category: Taxes

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