Demystifying Valuation: A Comprehensive Guide to the Discounted Cash Flow (DCF) Approach

15th edition ( Last Edition)

Is there an alternative approach to value equity directly rather than deriving it from firm value under the DCF method?

Answer: Equity can be valued directly using the Free Cash Flow to Equity (FCFE) model. This method estimates the cash flows available specifically to equity shareholders after accounting for operating expenses, taxes, working capital requirements, and debt payments. These free cash flows are then discounted at the cost of equity to derive the equity value.

For example, if a company projects free cash flows to equity of ?1,00,000 for the next year and the cost of equity is 10 percent, with a perpetual growth rate of 3 percent, the value of equity can be calculated as:

Equity value = Free Cash Flow to Equity divided by (Cost of Equity minus Growth Rate)

Substituting the given values:

Equity value = ?1,00,000 divided by (0.10 minus 0.03) Equity value = ?1,00,000 divided by 0.07 Equity value = ?14,28,571.43

This model provides a direct estimate of the equity value, bypassing the need to calculate the overall firm value and then deduct debt. As long as the assumptions regarding growth rates, discount rates, and cash flows are consistent, the valuation obtained using the FCFE model will be the same as when calculating the equity value by first estimating the firm value under the Discounted Cash Flow (DCF) approach.

How do you compute Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)?

The computation of Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) can be expressed as follows:

Free Cash Flow to Firm (FCFF): FCFF is calculated by starting with the Net Operating Profit After Taxes (NOPAT), adding back depreciation, and subtracting capital expenditures and the change in non-cash working capital.

FCFF = NOPAT + Depreciation - Capital Expenditure - Change in Non-Cash Working Capital

Example: Suppose a company has a NOPAT of ?5,00,000, depreciation of ?50,000, capital expenditure of ?1,00,000, and a change in non-cash working capital of ?20,000. Then:

FCFF = ?5,00,000 + ?50,000 - ?1,00,000 - ?20,000 FCFF = ?4,30,000

Free Cash Flow to Equity (FCFE): FCFE is calculated by starting with net income, adding back depreciation, subtracting capital expenditures, subtracting changes in non-cash working capital, and adjusting for net debt transactions (i.e., deducting debt repayments and adding new debt issued).

FCFE = Net Income + Depreciation - Capital Expenditure - Change in Non-Cash Working Capital - Repayment of Debt + New Debt Issued

Example: Assume a company has a net income of ?4,00,000, depreciation of ?50,000, capital expenditure of ?1,00,000, change in non-cash working capital of ?20,000, debt repayment of ?30,000, and new debt issued of ?70,000. Then:

FCFE = ?4,00,000 + ?50,000 - ?1,00,000 - ?20,000 - ?30,000 + ?70,000 FCFE = ?3,70,000

These formulas provide a clear method to calculate the cash flows available to all capital providers (FCFF) and, specifically, to equity holders (FCFE).

How do you compute the expected growth rate in equity?

The expected growth rate in equity, also known as the sustainable growth rate, is computed by multiplying the retention ratio by the return on equity. The retention ratio represents the proportion of net income retained by the firm rather than paid out as dividends. At the same time, the return on equity measures the profitability generated for each unit of shareholder equity.

Expected Growth Rate = Retention Ratio * Return on Equity

This formula estimates the growth rate the company can sustain internally without needing external financing. A higher retention ratio and return on equity imply a higher expected growth rate.

Example: Assume a company has a return on equity of 15%, meaning it generates a profit of ?0.15 for each rupee of shareholder equity. If the company retains 60% of its net income (i.e., pays out 40% as dividends), the expected growth rate can be calculated as:

Expected Growth Rate = 0.60 * 0.15 Expected Growth Rate = 0.09, or 9%

Assuming constant profitability and reinvestment, the company's equity earnings are expected to grow at an annual rate of 9%. This growth rate is achievable through internal resources without additional external equity or debt.

Does equity earnings also experience a high and stable growth period?

Answer: Yes, equity earnings may grow at a higher rate for a certain period, known as the high growth phase, but ultimately, they tend to stabilize and grow at a more consistent rate in the stable growth period. Therefore, similar to a firm's valuation, the value of equity is calculated as the sum of the present value of cash flows during the high growth phase plus the terminal value of the equity during the stable growth period.

Example: Assume a company is expected to experience a high growth rate of 20% for the next 5 years, after which the growth rate stabilizes to 5% indefinitely. To determine the value of equity, we need to calculate:

1. Present Value of Cash Flows During High Growth Phase: Calculate the cash flows for the first 5 years, discounting them back to the present value using the cost of equity.
2. Terminal Value During Stable Growth Period: Estimate the terminal value of the equity at the end of year 5, using the formula for perpetuity with growth:

The value of equity is then the sum of the present value of cash flows from the high growth phase + the discounted terminal value from the stable growth phase. This approach captures both the initial high returns and the subsequent stable growth potential of equity earnings.

If you cannot estimate the free cash flows, what alternative way is to calculate the equity value?

If financial statements do not provide sufficient information to compute free cash flows to equity, an alternative approach is to use the Dividend Discount Model (DDM). The DDM estimates the equity value by discounting the expected future dividends at the cost of equity.

However, the Dividend Discount Model may only sometimes yield accurate results because it is based on the implicit assumption that the firm pays out its entire available cash flows as dividends. This assumption may not hold, particularly for growth firms, which tend to retain a significant portion of their earnings for reinvestment rather than distribute it all as dividends.

When a firm retains earnings instead of paying them out as dividends, the DDM approach may underestimate the equity value because the model needs to account for the retained earnings used to generate future growth. Consequently, the value of the firm may also be underestimated.

Example: Suppose a company has a dividend per share of ?5, and the cost of equity is 10%, with an expected dividend growth rate of 3%. The value of equity using the DDM can be calculated as:

Value of Equity = Dividend per Share / (Cost of Equity - Growth Rate) Value of Equity = ?5 / (0.10 - 0.03) Value of Equity = ?5 / 0.07 Value of Equity = ?71.43

If the company retains a portion of its earnings for reinvestment, which the DDM does not capture, the actual value of equity could be higher than ?71.43. Thus, the DDM tends to underestimate the value for firms that do not distribute all their earnings as dividends.

Epilogue on the Discounted Cash Flow (DCF) Approach to Valuation

The Discounted Cash Flow (DCF) approach is one of two primary methods to value a firm or equity. This approach is rooted in the present value principle, which estimates the value of a firm or its equity as the present value of expected future cash flows. The DCF approach requires two key inputs: free cash flows and the cost of capital. These inputs are derived based on assumptions and subjective judgments concerning future estimates of capital expenditures, reinvestment rates, tax rates, growth rates, non-cash working capital, cost of capital, return on capital, and terminal value, among others.

This LinkedIn newsletter, presented in 15 editions, aims to provide a comprehensive theoretical framework for understanding the DCF approach to valuation. This 15th edition serves as the concluding part of the series. It is important to note that while the discussions throughout these editions offer theoretical guidance, real-world valuation is far more intricate. A valuation professional must navigate numerous complexities, exercise sound judgment, and make informed decisions based on well-grounded estimates. The practical application of the DCF method thus requires a thorough understanding of the underlying assumptions and the broader economic context in which the valuation occurs.