COPORATE VALUATION

Chap.3 – Valuation Methods

Chapter 3.1- Valuation by the DCF Methods & derivative

By Gérard CHAPALAIN
2020 - 2021

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Introduction
• The valuation by the DCF method is probably the method which requires the most
studies and which takes into consideration a significant number of financial
parameters;

• This is a so-called "intrinsec" valuation method because it is essentially based on

elements relating to the company under study;

• We must therefore first define the financial parameters that can be used…

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Chapter 3.1- Valuation by the DCF Method
• 1 – Cash Flow definition & calculation (CF;FCF;FCE;FFCF)
• 2 - What is the DCF Method
• 2.1 – Definition
• 2.2 – Appliyng the Model
• 2.3 – FCFF or FCFE in the Model
• 2.4 – The great impact of the growth rate scenario
• 2.5 – Question on the Model
• 3 – Intrinsec value per share vs…market value
• 4 – Sensitivity
• 5 – A derivative Model from DCF …DDM (Dividend Discount Model)

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1 – Cash Flow definition & calculation (CF;FCF;FCE;FFCF)

• The cash flow & drivers of Business Valuation

This first definition of

cash flow is the most
direct and easiest to
obtain from the income
statement.

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1 – Cash Flow definition & calculation (CF;FCF;FCE;FFCF)

• CF = Cash Flow / It’s the Cash Flow from operations

This first definition of cash flow is the most direct and easiest to obtain from the income statement.

Formula :

• CF = Net Income + Depreciation & Amortization – Change in NWC

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1 – Cash Flow definition & calculation (CF;FCF;FCE;FFCF)

• FCF = Free Cash Flow : the Cash Flow from operations & Investment

In this cash flow reading we integrate the balance of investments which can be
positive in cash if the disposals are greater than the investments

Formula :
• FCF = CF + Cash sold from Investment

The most often, the cash from investment is a cash out…so it’s a negative amount when
you see more investments than disposals

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1 – Cash Flow definition & calculation (CF;FCF;FCFE;FFCF)

• FCFE = Free Cash Flow to Equity : It’s the sum of all cash flow
• Cash flow from operations
• Cash flow from investment
• Cash flow from financing
It’s explain the Net change in cash

If you add up all the categorized cash flow lines you get the final cash flow
remaining from the financial year therefore relating to Equity

Formula :
• FCFE = FCF + Cash sold from Financing
• The most often, after issuance of debt you have to repay …
so it’s the cash flow from financing is the most often a negative amount

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1 – Cash Flow definition & calculation (CF;FCF;FCFE;FFCF)

• FCFE = Free Cash Flow to Equity : The sum of all cash flow

• What Does FCFE Tell You?

The FCFE metric is often used by analysts in an attempt to determine the value of a company. This method of valuation gained
popularity as an alternative to the dividend discount model (DDM), especially if a company does not pay a dividend (See
paragraph 5) .
Although FCFE may calculate the amount available to shareholders, it does not necessarily equate to the amount paid out to
shareholders.

Nota :
Net Borrowing can be found on the cash flow statement in the cash flows from financing section. It is important to remember
that interest expense is already included in net income so you do not need to add back interest expense.

For this you must remember the cash flow table

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1 – Cash Flow definition & calculation – Exercize - (CF;FCF;FCE;FFCF)

Red Case - Model – FAS Value

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• 2 – What is the DCF Method

2.1 - Définitions
In the DCF method, the underlying idea is that the value corresponds to the discounted future flows generated
by the company the DCF method

Formula :
EV Dcf = Σ CFt / (1+k%)^t + TV * 1 / (1+k%)^n
t = 1..n

Discounted CF during Terminal Value discounted

The forecast period

Cash Flow line CF1 CF2 CF3 CF4 CFn CFn+1 CFn+2 CFN+3……………
t= 1…n n=5

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• 2 – What is the DCF Method
2.1 – Definition & global view on the method
In the DCF method, the underlying idea is that the value corresponds to the discounted future flows generated
by the company the DCF method
Impact of gearing & β Impact of g%

Part A Part B

Formula : EV Dcf = Σ CFt / (1+k%)^t + TV * 1 / (1+k%)^n

t = 1..n

Impact of forecast assumptions

Discounted CF during Terminal Value discounted
The forecast period

If the calculation formula finally seems simple enough to integrate, the fact remains that the value that will be thus estimated
will depend largely on the assumptions that you will have defined formula can be easily :

• The CFt….depend on your assumption on the futur growth of the Cy & the positionning
• The k% : discount rate is coming from the financial parameters like define (chapter 2)
• The period : t…n – the most often we are using a forecast of 5 years
• The infinity growth : g% is a rate that impact the TV : TV = CFn * (1+g%) / (k% - g%)

Valuation Methods
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 • 2 – What is the DCF Method
2.1 – Definition – Focus on the Terminal Value
The Formula EV dcf = Σ (t=1..n) CFt / (1+k%)^t + TV / (1+k%)^n
You can, but you don't have to absolutly mix the 2
methods, because it makes them "unclean". It’s not
What is the Terminal Value ? incorrect to choose.

Indeed, if we admit that other methods will be

based on multiples, then avoid mixing the results
before having obtained the results by anoyehr
method don’t seem to correct

The calculation of the terminal value is based on the simplification TVgs = CFn * (1+g%) / (k% - g%) GS solution
of infinity sequences by the Gordon method - Shapiro theorem TVgsd = TVgs * 1/(1+k%)^n

For reasons of facilitation, certain financial analysts also sometimes TVm = Multiple (EV/EBITDA) X EBITDA n
Multiple solution
use multiples of EBITDA to consider the terminal value TVmd = TVm * 1/(1+k%)^n

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2 – What is the DCF Method
2.2 – Modeling the DCF method
Part A / The DCF on the forecast period

Red Case - Model – FAS Value

?
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2 – What is the DCF Method
2.2 – Modeling the DCF method

Modeling the DCF method – Part B / The Terminal Value

You can, but you don't have to absolutly mix the 2

The Formula EV dcf = Σ (t=1..n) CFt / (1+k%)^t + TV / (1+k%)^n methods, because it makes them "unclean". It’s not
incorrect to choose.

Calculate the discount TV by mixing the 2 methods…..OR NOT

GS solution

Multiple solution

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 2 – What is the DCF Method
2.2 – Modeling the DCF method
You can, but you don't have to absolutly mix the 2
The Formula EV dcf = Σ (t=1..n) CFt / (1+k%)^t + TV / (1+k%)^n methods, because it makes them "unclean". It’s not
incorrect to choose.

What is the Terminal Value ?

Modeling the DCF method – Part B / The Terminal Value…………………………………...Solution

GS solution

Multiple solution

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2 – What is the DCF Method
2.2 – Modeling the DCF method
The Formula EV dcf = Σ (t=1..n) CFt / (1+k%)^t + TV / (1+k%)^n
Part A + Part B

Part A

Part B

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2 – What is the DCF Method DCF by FCFF vs DCF by FCFE / 2 different paths give us the same answer
1 - Cost of Equity & Wacc%

2.3 – Using FCFF or FCFE in the DCF method

Wacc% calculation From gearing ratio Rate Net rate
NFD 0,30 3,00000% 0,90%
EQ 1,00 8,64485% 8,64%
Total 1,30 7,34219% 9,54%

Price Value of EQUITY

The Formula Market Value of Net Debt -

Cost of EQ = Rj% 8,64485%

Wacc% 7,34219%
Inf. Growth Rate 1,50000%

2 - Applying DCF on FCFF & FCFE with different Discount rate

2.1 - DCF Value on FCFF

Time period 0 1 2 3 4 5
Y0 Y1 Y2 Y3 Y4 Y5
EBIT 2 520 2 671 2 805 2 917 3 004
- Income Tax 706 748 785 817 841
+D&A 630 668 701 729 751
- Change in NWC 205 259 229 192 150

k% = Wacc% - Capex
Unlevered Free Cash Flow (FCFF)
1 050
1 189
1 113
1 219
1 169
1 323
1 215
1 422
1 252
1 513
(1+k%)^t 7,34% 1,07 1,15 1,24 1,33 1,43
FCFF / (1+k%)^t 1 108 1 058 1 070 1 071 1 061

TV 26 280
TVd 18 440

Σ CFt/(1+k%)^t 5 368
TVd 18 440
EV dcf (FCFF) 23 808

EQ value (FCFF)

2.2 - DCF Value on FCFE

FCFF 1 189 1 219 1 323 1 422 1 513
- Interest cost * (1-Tx r%) 224 232 241 251 260
FCFE (before dividends) 965 987 1 082 1 171 1 253
(1+k%)^t 8,64%
FCFE / (1+k%)^t

TV

k% = Cost of Equity (Rj%) TVd

Σ CFt/(1+k%)^t
TVd
EQ Value (FCFE)

Minority Interest Included

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 2 – What is the DCF Method
2.4 – Different growth assumptions

EV dcf (Bull) = ?
Nota 1:

Consequently, the determination of growth vectors and the

appreciation of activity and expense forecasts are
fundamental, which have an essential impact on the
estimation of future cash flows.

EV dcf (Medium) = ?
Question :

What happens when you change the turnovers growth in

The forecast period ?

Use the model to propose 3 scenarii and results

EV dcf (Bear) = ?

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 2 – What is the DCF Method
2.5 – Questions on the DCF method

[TV * 1 / (1+k%)^n ] / [ Σ CFt / (1+k%)^t ]

Nota 2 :
As in our example in modeling, most often the weight of the terminal value is very
[ 16 547 / 5 292 ] = 3,12
important in the overall value obtained.
The weight of the terminal value is 3,12 X higher
than the DCF value on the forecast period !
Question : Is it normal………………..?

• Probably « YES » because in our reasoning, the underlying of the notion of

infinity period logically incorporates more value.

• However a problem remains because in the model we consider the maximum

value over the most distant time space and therefore the most uncertain in cash flow production.

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Valuation Methods
 2 – What is the DCF Method
2.5 – Questions on the DCF method

[TV * 1 / (1+k%)^n ] / [ Σ CFt / (1+k%)^t ]

[ 18 440 / 5 368 ] = 3,12

Nota 3 : The weight of the terminal value is 3,43 X higher

All along the periods (forecast period and infinity period) the used discount rate than the DCF value on the forecast period !
Is the same… even if the view on the cash flow production, between the end of the
forecast period (n) period and the the infinity period, is very low … You can, but you don't have to absolutly mix the 2
methods, because it makes them "unclean". It’s not
incorrect to choose.
Question : Is it normal to use same discount rate (k) in the TV calculation………..?
k’% = 5%

• TV/(1+k%)^n = [ CFn*(1+g%) / (k% - g%) ] * 1 / (1+k%)^n

• If the economic and financial visibility is less beyond the nth period, then we
could imagine being able to add a risk premium to the discount rate within the If we choose to calculate the terminal value by retaining the
formula of multiple
Gordon-Shapiro formula :

• It is possible to add an arbitrary risk premium of 5% which corrects too many

discrepancies between the 2 terms of the equation of value by DCF

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 3 – Intrinsec value per share… vs Market Value
In order to make the value of listed capital (Market Capitalisation) comparable to the value of equity thus obtained
by the DCF method, it remains to subtract net financial debt and minority interests

You recommend investing or buying the stock, because it costs less

on the financial market than your intinces valuation

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4 – Sentitivity Analysis & Financial Modeling
• Sensitivity analysis adds credibility to any type of financial model by testing the model across a
wide set of possibilities.Financial Sensitivity Analysis allows the analyst to be flexible with the
boundaries within which to test the sensitivity of the dependent variables to the independent
variables. Thus, the analyst can be helpful in deriving tangible conclusions and be instrumental in
making optimal decisions.

• For example, it would be very interesting to be able to read instantly on a table the impact of a
change in the discount rate coupled with a change in the growth rate to infinity.

• These 2 variables are decisive in the calculation of the value by the DCF method and sometimes
subject to discussion

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4 – Sentitivity Analysis & Financial Modeling

After having constructed your DCF value calculation

model, you can both differentiate the scenarios and
change certain fundamental assumptions.

So you can measure the impact of these variations and

have more detailed information to understand the
results obtained and your risk.

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4 – Sentitivity Analysis & Financial Modeling
The Method

In the « Medium Central case »

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 5 – A derivative Model from DCF…DDM
What Is the Dividend Discount Model?

• The dividend discount model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its
present-day price is worth the sum of all of its future dividend payments when discounted back to their present value.

• The most common and straightforward calculation of a DDM is known as the Gordon – Shapiro growth model , which assumes a stable dividend
growth rate and was named in the 1960s after American economist Myron J. Gordon. This model assumes a stable growth in dividends year
after year. To find the price of a dividend-paying stock, the GGM takes into account three variables:

DDM Formula : EV Eq = D / (k% - g%)

D : Dividend expected
k% : Rj% that is the cost of Equity & not the wacc%
g% : The expected dividend Growth rate

It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout
factors and the market expected returns.

If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice
versa.

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 5 – A derivative Model from DCF…DDM
The DDM can be open to some variation like :
- Zero growth
- Constant growth
- Variable growth

But this model is better to be used for very « mature » Cy.

CEO Warren Buffett mentions that dividends are almost a last resort for corporate management, suggesting companies should prefer to reinvest in
their businesses and seek “projects to become more efficient, expand territorially, extend and improve product lines, or to otherwise widen the
economic moat separating the company from its competitors.” By holding onto every dollar of cash possible, Berkshire has been able to reinvest it
at better returns than most shareholders would have earned on their own.

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5 – A derivative Model from DCF…DDM
Exercize Nber 1

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5 – A derivative Model from DCF…DDM
Exercize Nber 2

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5 – A derivative Model from DCF…DDM
Exercize Nber 3

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The DDM apply to Red CAse

l ue
Va
AS
e l –F
o d
e -M
a s
d C
Re
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These results come from an
intrinsic analysis resulting
from an in-depth financial
analysis and cash flow
forecast.

These results come from an

intrinsic analysis, but
It’s a Discounted Model depending on dividend
But not on the same policy.
variables It’s seems to be a return
projection for shareholders.

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