Discounted Cash Flow Analysis
Discounted Cash Flow (DCF) analysis is one of two ways of calculating the fair value of an investment, the other being relative valuation. It says that the fair value of any investment is the present value of its future cash flows. For instance, a bond’s fair value will be present value of the coupons as well as the principals. For a stock investment, the fair value will be the present value of any cash flow received by the stockholder such as dividends or in rarer instances, liquidation value.
DCF analysis has two parts. First we calculate the cash flows we will be discounting and second is the calculation of the discount rate on which we will be discounting the cash flows. Assuming we are already done the above two parts, let us proceed with an example to see how they fit together for calculation of fair value. Let us assume there is an investment that yields a cash flows of $100 an year after investment and then grows 12% thereafter for ten consecutive years. Also let us assume the discount rate is 10%. The fair value of the investment then would be calculated as per the following model:
From the above model, we find that the fair value of such an investment would be approximately $774 in today’s terms. Note that the discount rate becomes the discount factor when we raise it to the appropriate power. Also, if you play around with the model a bit, you will find that if you increase the discount rate, the fair value falls, and vice versa.
You can download the fully functional Excel version of the model here: DCF Model
Common DCF Applications
There are many ways the DCF model is applied, but we’ll talk about two of the most common.
- The most popular DCF application is the FCF analysis where the fair value of the whole firm (inclusive of both debt and equity) is calculated. The discount factor is the Weighted Average Cost of Capital (WACC) and the cash flows are those that belong to both the debt as well as equity holders of the firm.
- Another common application is the Dividend Discount Model (DDM). In the DDM, the future cash flows are simply the dividends. If the dividends are expected to grow at a constant rate, the DDM becomes the Gordon Growth Model (GGM). According to the GGM, if a company is expected to give out a dividend of D next year, which is expected to grow at the rate of g and the discount rate is r, then the fair value of that stock would be:
Fair Value = D/(r-g)
Industry analysis is a vital part in the investment process. Companies hire consultants to do a lot of industry analysis work in order to make sure that money is spent on the right place. If we want to invest in certain stocks or companies, we need to be sure that the overall industry is growing rather than declining.
Starting with a Macro economic analysis, the primary goal is to identify what are the opportunities and threats to the industry. One method to use is called the PEST analysis:
- Political: This is the first factor in the industry analysis process. Government policy has significant effects on certain industries such as natural resources, telecommunication etc. In those industries, government policy could have huge impact on industry players, influencing strategic planning, financial performance and stock price of those companies. The effect of government policy is the most obvious in Emerging Markets. For instance, in China, foreign investors could not hold controlling interest in financial institutions, on the other hand, government encourages foreign investors to invest in retail chain business. If you want to dig deeper, you could check Carlyle’s acquisition of XuZhou Construction Materials case to see how government policy could influence M&A transactions in Emerging Markets.
- Economic: Economic factors generally include economic growth, interest rates, exchange rates, tax policy and the inflation rate. Some industries will be more influenced by certain factors, for instance, financial services industry is pretty sensitive to change in interest rates and companies have tremendous overseas exposure will pay special attention to exchange rate movement. As a comparison, economic growth and inflation rate actually could be used to gauge the overall health of a country’s economic status. A high growth economy with stable inflation rate could be an attractive place to invest in.
- Social: Social factors include health consciousness, population growth rate, age distribution, career attitudes and emphasis on safety. These are important demographic features for investor to evaluate the characteristics of consumers and those factors help identify the promising industries to invest into. For example, if the country is with an aging population structure, then healthcare industry will benefit from the trend. Similarly, a relatively ‘young’ country indicates that consumer product companies will have promising prospects.
- Technology: Technology factors include technological aspects of specific country, such as R&D activity, automation, technology incentives and the rate of technological change. Technology factors help identify potential markets and build up competitive advantage. Compared with the U.S., Brazil has weak technological infrastructure base and also the level of technology investment. Therefore, it is much easy for a tech company to succeed in Brazil than in the US, because of lower level of technology investment and stronger demand. Another example is mobile apps. The penetration rate of mobile device in the US is much higher than that of Brazil, and consumers in the US are more selective in using mobile apps due to the variety of choices. So a mobile app developer will find Brazil market more attractive because of less competition and more potential customers.
Industry analysis is not only important but also fundamental in the investment process. However, many people are confused about where to start and what to focus when conducting industry analysis. We will write several blog posts about how do an effective industry analysis, which includes Macro-economic analysis, industry analysis and company analysis, which is in effect a top down approach to evaluate an industry and a company.
We will start with PEST macro-economic analysis and work out way down.
Let us know in the comments if you have any questions.
Applying the multiple to your target
- Calculated the average or mean of the multiples – see Precedent Transaction Comps or Public Trading Comps
- Apply discount or premium to your multiple – see Precedent Transaction Comps or Public Trading Comps
- Apply premium to your target
Assuming the mean revenue multiple is 1x, and the target had $20m in revenue, then the value of the target is $20m.
Assuming the mean EBITDA multiple is 7x, and the target had $5m in EBITDA, the value would be $35m.
So based on these two multiples, the value of the company would range from $20m to $35m.
Be sure to the timing of your multiples and your targets numbers are correct. For example, using forward looking multiples and LTM revenue will give you misleading numbers.
Variation within the range
There would be more variation as you consider where the target’s multiples should fall within the range of the compset. If it has a higher EBITDA margin than it’s peers, then it deserves a higher EBITDA multiple.
Again this is where the art of valuation comes in to play.
In addition to the public trading multiples comparables, the other common multiples valuation methodology is the M&A multiples compset. M&A multiples uses mergers and acquisition transactions to value the target. One can use the value that others that have put on a company to help determine the valuation of the target.
The example below, taken from the Oracle/Autonomy deck shows recent precedent transactions in the enterprise software space.
The list would be shorter and more varied than the trading multiples compset.
With most acquisitions, there is a premium paid for the target. There is value to controlling the company rather than just investing in the target. There is potential for operational synergies (top-line growth, decreased overhead, decreased financial risk, funding cost etc.)
That premium is included in the price of the acquisition and hence baked into the M&A multiple, so you would need to discount the M&A multiple to get to a fair trading multiple. I’ve seen discounts ranging from 15% to 50%.
After coming up with the the multiples, you apply them to your target.
There are numerous ways to value a company. Each method has its pros and cons and are usually used in combination to triangulate a value. Of course, the value is ultimately set by the buyer.
This post will give an example of public comparables methodology. A public compset is a select set of publicly traded companies where price metrics and operating metrics are laid out in a table for comparison with the target company. The example below is a quick compset I threw together of internet companies with Apple and RIMM thrown in for comparison.
What companies to include
Ideally, there are direct competitors and pure plays, meaning they only focus on that one product/service. You can also include companies that offer similar services. In our example compset below, most are internet/tech companies. But there is a sub-segment of pure internet companies if you remove Apple and RIMM.
You can also segment the list based on size or other outliers.
In my experience, the ideal list size is 7-10 companies.
Continue reading “Valuation Methods – Public Comparables”
Capital Expenditures aka CapEx is the spending of money to buy or fix assets. CapEx is typically related to buildings, property, equipment. Many financial models are built to help determine growth and expansion plans that require spending money on equipment and other assets. Understanding the relationship between CapEx, deprecation, and the financial statement is a very important aspect of financial modeling.
In the current sample financial model, deprecation and CapEx are not forecasted to change. However as the business grows, additional equipment is needed.
In the new model, we CapEx spending in Years 5,6 and 8.
Days Sales Outstanding (DSO), Days Payable Outstanding (DPO), and Inventory Turns are some key metrics for company analysis. While they are just some simple calculations, they tell are story about how a company is doing.
In the balance sheet assumptions section of the model, see below, we calculate each metric and then make assumptions about the forecast values.
Continue reading “Days Sales Outstanding, Days Payable Outstanding, and Days Sales Inventory”
What is a circular reference?
A circular reference is when a cell refers to itself directly or indirectly.
Are circular references bad?
In most cases, a circular reference should and can be avoided with some planning. However, in a complex financial, I found it easier to just use circular references in certain areas.
Circular References in Financial Models
Circular references are used to help calculate cash balances. Let’s walk through two typical cases.
The cash sitting in the bank generates interest. The interest income is taxed and lowers the net income. More cash -> more interest -> more tax -> lowers net income -> effects cash.
See the example below. To determine the amount of interst, we use an average of the forecasted beginning and ending cash balances. It’s not fair to use just the beginning or the ending cash balances to calculate interest because over the time period that balance will change. Continue reading “Circular References in Financial Models”
One of the hardest parts of building a financial model is getting the balance sheet to balance, meaning the basic equation of Assets = Liabilities + Shareholder’s Equity is true.
The balance sheet itself is not the problem, it is usually the cash flow statement that introduces the error.
Here are some tips to make sure your cash flow statement is correct to ensure you calculate the correct ending cash balance.
For a working model, start with the basic financial model.
Make sure you rebuild the historical cash flow statement with formulas, that’s the only way to ensure you’ve accounted for all numbers and everything will flow going forward.
All line items on the balance sheet must be used in the cash flow statement. Continue reading “How to Balance Your Balance Sheet”