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)
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”