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

Part-2

This article continues the series presented on 6th September 2024 in the form of frequently asked questions. The previous article introduced various business valuation methods and explored key concepts of the Discounted Cash Flow (DCF) approach, such as Assets-in-Place, growth rate, and cost of capital.

In this installment, we move forward to elucidate the computation of business value using the DCF approach. The focus is on the practical application of DCF, providing clear steps and insights into the valuation process, supported by both theoretical and real-world considerations.

11.?? Explain the equation used in computation of value of the Business under DCF approach

As mentioned earlier, the Discounted Cash Flow (DCF) method determines the value of a firm as the present value of its future expected cash flows. Symbolically, this can be expressed as:

Value of the firm = Summation of future cash flows divided by (1 + WACC) raised to the power of the time period.

In this equation, the value of the firm is represented as the present value of future expected cash flows.

• FCF refers to the expected future cash flows.
• WACC stands for the Weighted Average Cost of Capital.
• t represents the time period over which the cash flows are expected

12. How do you measure Free Cash Flows for the purpose of business valuation? There are two alternative methods to measure free cash flows.

Alternative 1: Free cash flows are measured as Net Operating Profit After Tax (NOPAT), adjusted for capital expenditure, depreciation, and changes in non-cash working capital. Symbolically, free cash flows estimation is presented as follows: Free cash flows = Earnings Before Interest and Tax (EBIT) multiplied by (1 minus tax rate) minus capital expenditure minus depreciation minus changes in non-cash working capital.

Where:

• EBIT is Earnings Before Interest and Tax.
• (1 - t) refers to the tax rate, and EBIT (1 - t) is the Net Operating Profit After Tax (NOPAT).
• C refers to the capital expenditure incurred by the firm.
• D stands for depreciation.
• The excess of capital expenditure over depreciation is termed as net capital expenditure.
• ΔWC refers to the change in non-cash working capital.

Alternative 2: Free cash flows = EBIT multiplied by (1 minus tax rate) multiplied by (1 minus reinvestment rate).

Where:

• r refers to the reinvestment rate, which is computed as capital expenditure minus depreciation plus changes in working capital, divided by Net Operating Profit After Tax (NOPAT).

13. Explain Net Operating Profit After Tax (NOPAT).

Net Operating Profit After Tax (NOPAT) is widely regarded as a more accurate measure of a firm's operating performance. While net income is commonly used to assess business performance, it is influenced by the effects of financial leverage, particularly through tax savings. Since tax savings do not stem from a firm's operational efficiency, relying on net income to gauge operating performance introduces a positive bias, potentially distorting the true picture of operational effectiveness.

NOPAT mitigates this limitation by excluding the impact of leverage, providing a clearer representation of a firm's core operational profitability. By focusing solely on operating income after tax, without the influence of financial structuring, NOPAT serves as a more appropriate and unbiased metric for evaluating the operating performance of a business.

14. In the computation of NOPAT, EBIT is adjusted using (1 minus the tax rate), which means there is no distinction between interest expense and dividend payments. However, for tax purposes, interest is deductible while dividends are not. What is the rationale behind this indifference towards interest and dividends in the computation of NOPAT?

In the computation of Net Operating Profit After Tax (NOPAT), Earnings Before Interest and Tax (EBIT) is adjusted by (1 minus the tax rate), effectively disregarding the distinction between interest expense and dividend payments. Although interest is tax-deductible, whereas dividends are not, NOPAT intentionally ignores this differentiation.

The rationale for this indifference stems from the core objective of NOPAT, which is to evaluate the firm’s operating performance independent of its financial structure. The tax savings resulting from interest payments are a function of leverage, not operational efficiency. By calculating tax based on EBIT, inclusive of interest, NOPAT eliminates the impact of financing decisions, focusing solely on the firm's ability to generate profits from its operations. This ensures that the measure remains unbiased by financial strategies, making it a more accurate reflection of the firm’s true operating performance.

15. Explain 'Net Capital Expenditure'.

Net Capital Expenditure refers to the portion of capital expenditure that exceeds the amount accounted for by depreciation. In the calculation of Free Cash Flow (FCF), net capital expenditure is subtracted from NOPAT. The rationale behind this adjustment is that depreciation, a non-cash expense, has already been deducted in the calculation of NOPAT. Since depreciation is a component of capital expenditure, only the portion of capital expenditure beyond depreciation needs to be subtracted to avoid double-counting.

For example, if a firm has capital expenditures of ?10,00,000 and has already deducted ?3,00,000 in depreciation from NOPAT, the net capital expenditure would be ?7,00,000. This remaining amount is deducted from NOPAT to reflect the non-depreciated portion of the firm's capital investments.

Conclusion

That concludes today's edition of my series on the Discounted Cash Flow (DCF) approach to valuation. In this article, we further explored key concepts such as Net Operating Profit After Tax (NOPAT) and Net Capital Expenditure. Stay tuned for the next edition, which will be released tomorrow, 8th September 2024, where we will delve deeper into more advanced aspects of the DCF method. See you tomorrow!