# 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?)

- (a) for firms which have high leverage, and expect to lower the leverage over time, because

**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**

V_{0} = Value of Equity (if cash flows to equity are discounted) or Firm (if cash flows to firm are discounted)

CF_{t} = 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

g_{a} = Expected growth in Cash Flow being discounted in first stage of three stage growth model

g_{n} = 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