Valuation: Different DCF & WACC techniques

Valuation: Different DCF & WACC techniques

Right now I am writing several blogs on the so called “Cost of Capital” that is used in business valuation.

I got inspired to do this after reading the book: “The real cost of capital: A business field guide to better financial decisions” (2004). The book is written by Tim Ogier & John Rugman & Lucinda Spicer.

I really recommend any Corporate Finance professional to read this book, since it is so practical and well-grounded in theory!

In this sequence of blogs I have written 8 blogs already. You can find the link to the precedent blogs at the end of this one.

In this ninth one in the sequence “the cost of capital” I will talk about: Different discounted cash flow (DCF) and weighted average cost of capital (WACC) techniques.

And last summer I have written 6 blogs on business valuation (e.g. topics: Multiples, DCF, LBO analysis, M&A analysis) and financial modelling.

These blogs are also still available, you can find the links to these blogs also at the very end of this blog.

Blog author: Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East). This at (investment) banks, corporates and universities.

Also I provide inhouse training on request and I have open training programs in business valuation in The Netherlands and all over the world.

Training agenda Joris Kersten:

• Financial Modelling in Excel (5 days): 2, 3, 4, 5, 6 February 2020. Location: Riyadh/ Saudi Arabia;
• Business Valuation & Deal Structuring (6 days): 18, 19, 20, 21 and 23, 24 March 2020. Location: Uden/ The Netherlands;
• Financial Modelling in Excel (4 days): 20, 21, 22, 23 April 2020. Location: Uden/ The Netherlands;
• Business Valuation & Deal Structuring (5 days): 22, 23, 24, 25, 26 June 2020. Location: New York City/ United States.

All info on these open training sessions can be found on: www.kerstencf.nl/training

And 130 references on my training sessions can be found on: www.kerstencf.nl/referenties

Different DCF techniques

Most people who use the cost of capital are interested in valuing businesses or shares in a business. And by far the most robust and frequently used technique is the discounted cash flow valuation (DCF).

Concerning DCF there are three widely used methods to calculate the present value of a company:

1.     The standard WACC approach;

2.     The flows to equity method;

3.     The adjusted present value approach.

Let’s now take a look at these methods in more depth.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Standard WACC approach

The most commonly used method in the world of corporate finance is the standard WACC method. The first step of the WACC approach is to estimate the operating cash flows that would be available to the providers of capital to the business after corporate taxes are paid.

These cash flows are also called “free cash flows”, a term you might have heard before. But be careful, these cash flows do NOT take into account any reductions coming from the “tax shields” from interest payments.

So we refer to the tax in the free cash flow calculation as: “Unlevered tax”. This because the tax is estimated on the same basis as if the business was unlevered, so in this case the corporate tax is not reduced by any tax relief on interest payments.

It is necessary to asses the cash flows on this unlevered tax basis, because our standard WACC formula already includes an adjustment to the cost of debt. So this approach does not ignore the implications of debt financing.

This since all of the debt implications to the equity holders of the business are reflected in:

1.     The gearing adjustment to equity betas. These capture the increased risk from the presence of debt;

2.     The reflection of the tax benefit in the WACC (tax adjustment to cost of debt in WACC);

3.     The impact of debt on the overall discount rate, where the cost of debt is weighted in the capital structure;

4.     The deduction of debt (at its market value) from enterprise value to calculate the equity value.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Characteristics of a standard WACC approach

The approach assumes that the company adopts a single capital structure for the projection period and terminal value.

This assumption on the long-term capital structure is made with reference to actual data on both the company and peer group industry norms. I have discussed this in more detail in the previous blogs.

The approach typically uses the CAPM (capital asset pricing model) for the cost of equity calculation. I have discussed this before, but it means that equity providers require a premium above the risk free rate that reflect the “systematic risk” (also called market risk) associated with the investment.

Also a “leveraged equity beta” is used and this beta reflects the riskiness of shareholders returns that arise as a result of fixed “debt service” commitments.

The conventional formula that is used to lever an asset beta (unlevered beta) to a levered equity beta is: Beta equity = Beta Asset * ( 1 + debt/ equity ). This formula is called the: “Harris Pringle Beta Formula”.

At last, a terminal value is most often calculated as a perpetuity. This is calculated as the annual free cash flow at the end of the projection period. And then plus one year’s growth divided by the estimated long term WACC less the growth rate.

This growth rate is that for the sector in which the company or division operates. And normally it would expected to be the same as the economy growth rate to which the company is exposed (GDP).

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Flows to equity approach

A second DCF approach is the “Flows to equity” (FTE) approach. The FTE approach gets an estimate of the present value of the equity (market value of equity).

This based on a post-interest and post corporate tax cash flow of a business. So here you can notice that there is no debt component in the discount rate.

The cash flows are discounted using a “leveraged cost of equity”, the same cost of equity that is used in a standard WACC. So the beta is here adjusted for the financial risk of debt.

This method does not require practitioners to deduct a market value of debt from the calculated present value. And this method is useful for valuing financial services firms where the company’s funding structure is there to make money.

These companies make money on the spread between borrowing and lending, so debt financing is not a financial engineering decision, but becomes part of normal day-to-day business decisions.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Adjusted present value approach

A third approach to DCF valuation is the adjusted present value (APV) approach. It basically claims that the value of an asset is dependent on two factors:

-The fundamental value from the operation of the asset;

-The value associated with the finance structure (basically interest tax shields).

The method treats a company like it is debt free in order to calculate the fundamental value of the business. And then it looks at the value that comes from the debt financing in a separate calculation.

For the value of the operations, post-tax unlevered cash flows are discounted using an unlevered cost of equity. This implies that the assumption is made that there is no debt.

And then there is the value from the interest tax shield. The discount rate that should be used to calculate the present value of the interest tax shield, should reflect the risk associated with obtaining the tax deductions.

Fixed level of debt financing (irrespective of enterprise value)

If a company is able to maintain a fixed level of debt financing, which will never need to vary in response to changes in the market value of equity (and enterprise value), then the risk to the interest tax shield arises from the risk to the company's tax rate and the risk to the company’s existence.

These risk factors are probably the best reflected in the “cost of debt”, as they are similar to the risk that bond holders in a company face.

So with this assumption (begin able to maintain a fixed level of debt, irrespective of enterprise value) the “cost of debt” is probably the right discount rate for the present value of the interest tax shield.

Constant gearing ratio (depending on enterprise value)

When a company needs a constant gearing ratio then the level of debt financing will vary to the variation in enterprise value.

As we know, the "unlevered cost of equity" estimates the discount rate that investors use to calculate enterprise value, when the company is entirely financed with equity.

But as the interest tax shield will vary in line with enterprise value (when there is a constant gearing ration assumption), this suggests that the unlevered cost of equity is the right discount rate to use to value the interest tax deductions for such a business.

In practice …

The freedom of a company to control its capital structure will lie between the two extremes mentioned above: fixed level of debt and constant gearing ratio.

For example, let's assume a company faces pressure to maintain the gearing ratio broadly in line with the “target ratio”. But it does not need to change it's gearing ratio instantly in response to a change in enterprise value.

Then the appropriate discount rate would lie in between the "unlevered cost of equity" and "cost of debt".

And judgement is still needed from the practitioner!

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Sources used for this blog

·       The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer. 9780273688747.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! ??

Next blog next week

In hope you liked this blog on the different DCF & WACC techniques. ??

In my next blog, next week, I will talk about how to conduct “International Valuations”.

And when you have any questions in the meantime do not hesitate to contact me on: [email protected]

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Trainer & Consultant: J.J.P. (Joris) Kersten, MSc BSc RAB

·     130 recommendations on his training can be found on: www.kerstencf.nl/referenties

·     His full profile can be found on: www.dhirubhai.net/in/joriskersten

J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium sized companies. 

Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/ or sellers, organises financing for takeovers and negotiates M&A transactions in a LOI and later in a share purchase agreement (in cooperation with (tax) lawyers).

Moreover, Joris is associated to ‘AMT Training London’ for which he provides training as a trainer and assistant-trainer in Corporate Finance/ Financial Modelling at leading investment banks in New York, London and Hong Kong.

And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf.

In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney. 

Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam and Mongolia. And at partner Universities of SP Jain in Dubai, Mumbai and Singapore.

Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. And Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.

Currently Joris is doing the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV). This title will enable Joris to give out business valuation judgements in for example court cases.

J.J.P. (Joris) Kersten, MSc BSc RAB. Email: [email protected]. Phone: +31 6 8364 0527