Discounted Cash Flow Approach

Equity shareholders have a claim on the future cash flows.

Based on this insight, Discounted Cash flow models have
been developed.

Intrinsic value of a share is the present value of its expected

future cash flows.

Types of DCF Models

1.Enterprise DCF - FCFF
2.Equity DCF – FCFE or Dividend Discount Model
Dividend Discount Model

Value from Investors perspective

Accounts for reinvestments

Generally mature companies operating profitably

tend to have a set dividend policy, hence DDM is
suitable for such companies.

If the dividend payout reflects changes in

profitability, DDM model can be used for valuation.
Inputs

Company’s growth rate

Economy’s nominal growth rate ( real GDP
growth rate + expected inflation rate )
Forecasted earnings
Forecasted Dividends
Financial Determinants of Growth rates (Drivers of growth)
1. Retention ratio
2. ROE
g = b*ROE
If a company’s ROE is 25%, dividend payout is 40%, then g =
(1-0.40) * 25% = 15%
Say the company has a equity share capital of 10,00,000 and
it earned 2,50,000 as return for equity
Capital Return on Dividend paid Retained Total Capital
Equity earnings
1000000 250000 100000 150000 1150000
1150000 287500 115000 (15%) 172500 1322500
1322500 330625 132250 (15%) 198375 1520875
g= retention ratio * ROE

Net Income – Dividend * Net Income * Sales * Total Assets

Net Income Sales Total Assets Equity

Dividend Discount Model

The value of an equity share is determined by capitalising the future

dividend stream at the opportunity cost of capital.

n
DIVt Pn
P0   
t 1 (1  ke ) (1  ke )
t n
- Zero Growth Model
- Constant Growth Model
- Two stage/Three Stage growth Model
- H Model
 Two Stage Model

1+g1 n
P0 = D1 1 - 1+r + Pn
r-g1 (1+r) n
 
 H- Model
H Model for valuing share

V0 = D0(1+gL) + D0*H*(gS-gL)
r- gL r-gL

= D0(1+g) + D0*H*(gS-gL)
r-gL

H= half life in years of high growth period (2H)

gS = initial short term dividend growth rate
gL = normal long term dividend growth rate after year 2H
Current dividend of Ace Ltd is 2.00. Growth
expectation for next 10 years – 20%, thereafter –
10% . Equity investor’s expectations – 15%.
Determine Value per share

If in the above case it is assumed that the decline in

abnormal growth rate to a stable growth rate is
linear then what is the value per share?
Justified P/E based on Gordon’s model

Forward P/E = P0 = D1/ r-g = (1-b)

E1 E1 r-g

Trailing P/E = P0 = D0(1+g) / r-g = (1-b)(1+g)

E0 E0 r-g
HT assembles the following information to value X Ltd.

Current MPS : Rs.23.84/share

Trailing EPS : Rs.1.81/share
Current dividends : Rs.0.58/share
Dividend growth rate : 3.5%
Risk free rate : 2.8%, risk premium : 4%, beta : 0.80

1. Required rate of return using CAPM : 6%

2. Dividend payout : 0.58/1.81 = 0.32
3. Trailing P/E : 23.84/1.81 = 13.2
4. Forward P/E : 23.84/1.81(1+0.035) = 12.8

Is the market price justified ?

You are the portfolio manager of diversified Equity Fund
researching the value of V Ltd. Although during the past 5
years it has been paying interim and final dividends with a
average growth of 3% p.a., faster future growth is
forecasted. The following information is collected by you:

1. Current share price : Rs.41.70/share

2. Current dividend : Rs.1.77/share
3. Growth rate in dividend : 7% declining linearly for the
next 10 years and 4% thereafter.
4. Expected return on equity : 9.5%.
Is the share fairly valued ?
FCFF / FCFE model

Applicability

The company does not pay dividends

Dividends are not aligned to company’s
earning capacity
The investor takes a ‘control’ perspective
 Free Cash Flow is the cash flow arising after
providing for fixed assets and working capital to
sustain the growth of the firm.

• Free Cash Flow to Firm (FCFF) – Free Cash available

to all suppliers of capital
• Free Cash Flow to Equity (FCFE) – Free Cash
available to equity shareholders
Roe - 20% - Industry avg / investors exp / opportunity cost

IT sector - 18% ECONOMIC PROFIT – SURPLUS

PROFIT

Cost of equity – 13.5% VALUE OF 6.5%

CFO == REVENUES LESS OP EXPENSES --- 1000 CRS --

REINVESTMENT – WORKING CAPITAL + CAPEX

FCFF - ALL SUPPLIERS

FCFE – FCFF LESS ( INTEREST / PREF DIVIDEND/ DEBT REAPYMENT/REDEMPTION OF

PREF SHARES) ADD: DEBT/PREF CAPITAL ISSUED
As per DCF – FCFF approach,

Value of the firm = Present Values of all free

cash flows expected to be generated by the
firm over its life time
Determining FCFF

FCFF = Cash Flow from Operations Less Net Investments in

Fixed Assets and Working Capital

Cash Flow from Operations = PAT+ Interest(1-tax rate) +

noncash charges

Investments in fixed assets = Fixed Assets at the end of the

year – fixed assets at the beginning of the year + Depreciation

Investments in working capital = Working capital at the end

of the year – Working capital at the beginning of the year
Op NB -----250
CL NB ------450

DEPN ------ 125

CAPEX ------200 450-250+125 = 325

OP NB 250
ADD: PURCHASES 325
LESS: SALES
ASSETS AT THE EOY 575
DEPN 125
CL NB 450
Non cash charges

Depreciation, amortisation, gains from sale of

assets, losses from sale of assets, expenses
written off, deferred taxes
Determining FCFF from Cash flow statement

FCFF = CFO +Interest (1-t) – Investment in Fixed

Assets
What drives FCFF ?

FCF = NOPAT – Net Investment

= NOPAT * (1- Net Investment )
NOPAT
= Invested capital * NOPAT * (1- Net Investment/ Invested Capital)
Invested Capital NOPAT/ Invested Capital

= Invested capital * ROCE * 1- Growth rate

ROCE
Value of Firm = Value of Operations + Value of non
operating assets

a) Value of Operations = PV of FCFF

b) Non Operating Assets = Excess cash / Marketable

securities/ Investments in Associate and Subsidiary
companies/ Excess real estate/ Unutilised assets
Value of Equity = Value of firm – Value of non equity claims

Value of non equity claims = Debt/ Preference shares/

Debentures

CY - 2021
FORECAST - 2025
PERPETUITY -
FCFE
Free Cash flow to equity means the cash available
to equity shareholders

FCFE = FCFF +/- Net increase/decrease in Debt/ Pref.

capital – Interest (1-tax rate ) – Preference dividend
Compute FCFF and FCFE
2020 2019
Rs. lacs
Net sales 3300 3000
Depreciation 80 80
Interest 35 40
PBIT 477 470
PAT 350 320
Capital employed 1830 1620
Net worth 1370 1070
Net block 1330 1300
Current assets 800 600
Current liabilities 300 280
Determine FCFF and FCFE from the following data
  Amt Rs.lacs
A. Net Sales 545
Other income 55
COGS 345
Admin & selling 50
Depreciation 35
Interest 24
 B. Balance Sheet 2020 2019
  Equity Capital 150 130
Reserves & Surplus 120 90
Debt 180 150
Total 450 370
Fixed Assets 300 250
Investments 70 60
Net current Assets 80 60
Total 450 370
With the data given below determine FCFF
Rs.
EBIT 5000000
Interest 2500000
Depreciation 1200000
Income tax rate 30%
Investment in working capital 500000
Investment in fixed capital 4000000
Forecasting performance

1. Length of the forecast period - The period by the end of which the company is
expected to achieve a stable growth ( profit margins/ turnover/ ROCE/
reinvestment rate / capital structure )

2. Develop a growth story based on industry analysis, customer base, technology

used etc.

3. Develop Financial forecasts –

a) Sales forecast
b) Forecasted P/L A/c
c) Forecasted Balance Sheet ( Start with asset side and then liabilities )
d) Determine ROCE and FCF
e) Check reasonability of the above values.
Forecasting Profit and Loss A/c

1. Estimate the historical ratio of each line item w.r.t driver e.g COGS w.r.t Sales,
Interest w.r.t debt, Expenses
2. Forecast the line item applying the ratio to forecasted sales.

General Guideline for forecast

3. COGS - Sales
4. Selling/ Admin/ General expenses - Sales/ yoy growth
5. Depreciation - Net Block ( PY)
6. Non operating income - relevant non operating assets
7. Interest expense - Total Debt ( PY)
8. Interest income - relevant investments
9. Tax - Avg tax rate on EBT
10. Dividend - Policy decision
11. RE - Policy decision
Forecasting Balance Sheet

Net Fixed Assets Sales NFA/Sales

Investments - Growth in investments
Inventories COGS/Sales Inventories /COGS
Debtors Sales Debtors/Sales
Loans and advances - Growth in loans and advances
Sundry creditors COGS/Sales Sundry creditors/ COGS
Advances from customers - Growth in Advances from customers
Accrued employee benefits - Growth in Accrued employee benefit
 Basic guidelines for selecting the forecast
period

1. If the company’s growth is slow and it

operates in a highly competitive industry
and has a low margin – 1-3 years
2. If the company’s growth rate is quite high
and it is a company known for its brand and
has strong distribution channels - 5 -7 years
3. If the company’s growth rate is very high and
it is more or less a monopoly in the industry
– 10 years
Forecasting revenue growth – Forecasting revenue is
one of the most important and most difficult aspects
in firm valuation.

Factors which help a company determine revenue

growth

- Market growth and Market share

- Relative to GDP growth
- Historical growth
 Forecasting operating expenses – COGS, Admin
expenses, selling expenses based on historical trend
and w.r.t Sales

Forecasting Financing charges – Average percentage

of interest on debt at the beginning of the year.

Forecasting Capex – As a percentage of Sales based

on historical data

Forecasting Working Capital – As a percentage of

sales based on historical trend and ratios
Points to be kept while forecasting

1. Projected revenue growth should be

consistent with industry growth
2. ROCE should be consistent with the industry
returns
3. Impact on growth due to technological
changes
4. Prospects of raising capital and managing
the proposed investments should be
analysed
Determining WACC to be used for discounting free cash
flows

1. Cost of debt:

Estimated Interest rate = Interest cost

long term +short term borrowings

Note : Ensure the reasonability of the rate so arrived

with the average prevalent interest rate and the type of
loans taken by the company.

Post tax cost of debt to be taken for determining WACC

Cost of equity

a) CAPM model:

Required return on investment = current expected risk free return +

beta* equity risk premium

1.Risk free return = 10 year Indian Government bond yield

2.beta = covariance ( return on security , return on market portfolio )
variance of the return on market portfolio *
( using slope formula in excel )
3.Risk premium = average historical market returns in relation to 10 year
Government bond yield.

* Proxy for market portfolio is market index ( NIFTY/ Sensex)

Points to note

1. To calculate market risk premium ,if using historical return

on long term bonds, use historical returns on market index .

Else use current expected return on long term bonds and

current expected return on market index.

2. Use historical rate of interest as a reference point. Relate

the same to current rate of interest on borrowings ( more
relevant in case of debentures than bank loans )
Implied risk premium ( forward looking )

Similar to bond yield calculation :

Current market Index = FCF1/(1+ke) + FCF2/(1+ke)2 + .. +
FCFT/(1+ke)n

FCF = Weighted average cash-flows from companies

constituting the index for year n
K = discount rate

Ke is the expected market return

Expected market return less expected long term government
bond yield = Equity risk premium
Alternative methods

1. DDM : ke = D1 + g
P0
2. Earning- price approach : E1
P0
3. Bond yield + risk premium:
Yield on long term Government bonds + risk premium

4. Fama-Fench Model

5. Arbitrage pricing Theory

Determining WACC

Use market weights of equity and debt or

target Debt Equity ratio for determining WACC
Estimating Continuing Value

Continuing value is a function of Last forecasted FCFF,

estimated long term growth rate and WACC

Guidelines

1. Nominal growth rate of the economy

2. Risk free rate

As the company achieves stable growth rate, its target debt

equity is in alignment to industry average and the
reinvestment should sustain assumed growth rate.
Post Valuation checks

1. Does the pattern of financial ratios conform to the industry

average.
2. Does the company really achieve stable growth after the
forecasted period ? If not extend the forecasting period.
3. Compare the value determined with market price. If the
value is very different from market price, don’t assume
that market price is undervalued. Have reasons to believe
that the market is undervaluing the company due to
illiquidity / small float etc.
4. Compare the important multiples with peer companies.
Major deviations should have a reason.
Guidelines for corporate valuation

1. Understand the various approaches to valuation

2. Use more than one valuation model
3. Cross check the validity of the assumptions by
studying financial ratio changes during the
forecast period
4. Use theory along with judgement. It is often said
that valuing a company is a combination of art and
science
•Calculating
  beta
Year/Month Return on Return on Re - Rm- (Re - )(Rm- ) (
/Date equity share market
(%) Re index(%) Rm

Covariance ( cov) = ∑ (Re - )(Rm- )/ n-1

Variance (σ²) = ∑ ( / n-1

beta = cov/ σ²