Chapter 4 DCF

CHAPTER 4
DISCOUNTED CASH FLOWS METHOD

• The Net Cash Flows refer to the amount of cash
available for distribution to both debt and equity
claims of the business or asset. This is calculated from
the net cash generated from operations and for
investment over time. For GCBO, the net cash flows
generated will be based on the cash flows from
operating and investing activities, since this represents
already the amount earned or will be earned from the
business and the amount that is required to be infused
in the operations to generate more profit.
Net Cash Flows is preferred as basis of valuation if any of the
following conditions are present:
• Company does not pay dividends
• Company pays dividends but the amount paid out
significantly differs from its capacity to pay dividends
• Net Cash Flows and profits are aligned within a reasonable
forecast period
• Investor has a control perspective. If an investor can exert
control over a company, dividends can be adjusted based
on the decision of the controlling investor.
Using net cash flows over other cash flow concepts is
more advantageous in a valuation activity since this
metric can be directly used as input to a DCF model. This
is not the case for other cash flow or earnings measure
such as EBITDA, EBIT, net income and cash flow from
operations since these metrics might have missed or
double an item.
• EBITDA and EBIT are both metrics that are before taxes;
cash flows that are available to investors should be after
satisfying tax requirements of the government.
• EBITDA and EBIT also do not consider differences in capital
structures since it does not capture interest payments,
dividends for preference shares and funds sourced from
bondholders to fund additional investments
• All these measures also do not consider reinvestment of
cash flows made into the firm for additional working
capital and fixed assets investment that are necessary to
maximize long-term stability of the business.
In valuation, analysts find analyzing cash flows and its
sources helpful in understanding the following:
• Source of financing for needed investments – The best
case for firms is to fund its investments wholly or partly
through cash from operations.
• Reliance on debt financing – Debt financing is an excellent
financing strategy especially for expanding companies.
• Quality of earnings – Significant disparities between cash
flows and income may indicate earnings does not get
converted to cash easily suggesting low quality.
There are two levels of Net Cash Flows:
(1) Net Cash Flows to the Firm – the amount made available
to both debt and equity claims against the company.
(2) Net Cash Flows to Equity – represents the amount of
cash flows made available to the equity stockholders
after deducting the net debt or the outstanding liabilities
to the creditors less available cash balance of the
company.
The net cash flows can be determined by referring to the
financial statements of the company.
NET CASH FLOW TO THE FIRM
Net cash flow to the firm refers to the cash flow
available to the parties who supplied capital (i.e. lenders
and shareholders) after paying all operating expenses,
including taxes, and investing in capital expenditures
and working capital as required by business needs. NCF
to the firm is cash flows generated from operating
activities of the business which is intended to pay
required return of fund providers. Valuation models
based on enterprise value encompass cash flows
available to all investors – whether debt or equity.
Enterprise value of a company refers to the theoretical
value of its core business activities as reflected by its net
cash flows. This is the basic premise of most corporate
valuation methodologies.
Net cash flows only capture items that are directly
related to the operating and investing activities of the
business. Consequently, net cash flow excludes items
associated with financing activities. Net cash flows to
the firm can be computed or derived using the following
approaches.
A. BASED FROM NET INCOME (OR INDIRECT APPROACH)
Net Income Available to Common shareholders Php xxx
Add: Non Cash Charges (net) xxx
Add: Interest Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital xxx
(Purchases – Sales of Fixed Capital Investment)
Net Cash Flows to the Firm Php xxx
• Net Income Available to Common Shareholders
Basic measure of a firm’s profitability which refers to the bottom
line figure in an income statement. This is the amount left for
the common shareholders after deducting all costs, expenses,
depreciation, amortization, interest, taxes and dividends to
preferred shareholders. This is an accounting measure, meaning
that non-cash items like depreciation and amortization is also
included as a deduction to arrive at net income. However, this
measure does not include changes in working capital nor capital
investments made during the specific period which significantly
affects a firm’s cash flows.
• Non-Cash Charges (Net)
Pertains to non-cash items that are included in the
computation of net income. Analyst usually look at the
statement of cash flows to validate potential non-cash
charges. If amount in the income statement does not match
amount reflected in the cash flows statement, it can be
indicative that a portion of that expense is non-cash.
NET CASH FLOW TO THE
FIRM
The common non-cash items are the following:
oDepreciation and amortization
When a firm acquires a fixed asset like equipment or
intangible asset, the initial cash outflow is made at point of
acquisition and is presented in the balance sheet. In
succeeding periods, a portion of the initial cash outflow is
recorded as depreciation and amortization which reduces net
income, despise not having an actual cash outflow. As a
result, this should be added back to arrive at the real cash
flow.
FIRM
oRestructuring charges
Restructuring refers to the change in the organizational
structure or business model of a company adapt to changing
economic climate or business needs. Most restructuring
involves involuntary separation of employees. As a result, the
restructuring requires the company to pay them severance
pay. Severance pay should comply with the minimum
requirements set in the Labor Code of the Philippines.
Severance pays are normally outright cash outflows.
FIRM
oRestructuring charges (continuation)
The company may also need to record write-down in value of
pension assets (or reversal of previous accruals) as a result of
the restructuring activity. This is usually recorded as part of
the restructuring expenses (income) in the income statement.
However, since there are no cash outlays involved in write-
downs (reversal gains), this should be added back to
(deducted from ) net income to get NCF.
FIRM
oProvisions for Doubtful Accounts
These are estimated amount to be incurred for the customers
inability to pay on time which is cumulatively accounted
under the statement of financial position reported against the
accounts receivable. Since these amounts represent the value
that may have high profitability of collection but not yet
written off, meaning there is a positive chance that it can still
be collected then it should be added back to the net income
attributable to common.
FIRM
• After-Tax Interest Expense (net of any tax savings)
This interest expense is a cash flow intended for the debt
providers. In the Philippines, interest expense is a tax-deductible
expense for the company. This means that when the company
pays interest, it reduces tax to be paid. Hence, the cash outflow
is the amount of interest expense less any tax savings.
After-tax interest expense is added back to net income since the
objective of NCF is to measure the cash flows associated with
the operating activity of the business. The impact of financing
should be neutralized to arrive at the real business value based
on its operations.
• Working Capital Adjustment
Also known as working capital, this item represents the net
investment in current asset such as receivables and
inventory reduced by current liabilities like payables. The
amount captured is based on the movements in these
accounts from prior year.
• Working Capital Adjustment (continuation)
Required investment in current assets tend to increase when
a firm’s sales grow consistently year on year. Higher
receivables and inventories are needed in order to support
rising revenues. The company also needs higher financing
through payable or taxes payable to fund these receivables
and inventories. Increase in current assets means cash
outflow while higher current liabilities are cash inflows.
Otherwise, the company may miss out on sales growth if
they lack the current assets and liabilities to support it.
Fast growing firms engaged in industries with high working
capital needs like retailing and manufacturing tend to have
substantial rise in working capital. Companies do not need
to pay for taxes when they are investing in their operating
capital. On the other hand, if current assets requirement
decline, this means that more cash is available to debt and
equity providers, thus, added back.
For NCF and valuation purposes, movements in cash,
marketable securities short-term notes payable and current
portion of long-term debt is excluded in the computation.
Cash is excluded since the purpose of the NCF exercise is to
identify what is the real cash flow of the business.
Marketable securities are also excluded since these are not
directly linked to operations. On the other hand, notes
payable and current portion of long-term debt are excluded
since they are associated with the financing side of the
business.
• Investment in Fixed Capital
Pertains to cash outflows made to purchase or pay for
capital expenditures that are required to support existing
and future operating needs. Capital expenditures range from
property plant and equipment necessary for production
requirements to intangible assets like trademark, patent and
copyrights. Firms expect that they will reap benefits for
more than one year as a result of these investments. The
investment in fixed capital assumes that the projects
financed acceptable and has positive net present value.
• Investment in Fixed Capital
Increases in fixed capital investments use cash, hence, a
reduction to Net Cash Flow. This is captures in the year that
the cash outflow is made. Information related to these can
be found in the balance sheet and statement of cash flows.
Once initial cash payment is made, this is charged to
succeeding year’s income statement as depreciation and
amortization. Treatment for depreciation and amortization
applies.
• When gaps exist between amount of capital investment
and depreciation (called as net capital expenditures), this is
usual related to the growth profile of the company.
Company expecting high growth tend to report high net
capital expenditures compared to earnings while low-
growth companies usually have negative net capital
expenditures.
• Cash paid for acquisition of a new business also falls into
this category. The full purchase amount reduces the Net
Cash Flow in the year of acquisition. If the acquisition
involves non-cash settlement, analysts should be careful in
capturing only portion denominated in cash as reduction to
Net Cash Flows.
FIRM
• On the other hand, if there are sale of capital expenditures that
occurred, this should be added back to the Net Cash Flow. This
sales increase the cash inflow which consequently reduces the
investment in fixed capital for that period. For example, if a
property is sold for Php 1,000,000, then this should reduce the
amount of investment in fixed capital (i.e. ultimately, an
addition to net cash flows).
• Hence, net investments in fixed capital is deducted to arrive at
Net Cash Flow computation. A negative net investment
signifies that firm received cash since it sold more assets than it
purchased for the year.
• Analyst should use the statement of cash flows to analyze
cash flows related to fixed capital investments. There are
instances when companies may obtain fixed capital in
exchange of shares which doesn’t necessarily have impact
to cash flows. Even though transactions might be non-cash
for the current year, analysts should be careful in
forecasting future fixed capital investments especially if it
will require cash outlays.
B. FROM STATEMENT OF CASH FLOWS
NCF can also be computed using cash flows from operating
activities (in the statement of cash flows) as the starting
point. Analysts usually start from this item since it already
considers adjustment for noncash expenses and working
capital investments.
As refresher, the statement of cash flows classifies cash flow
into three major sections: cash flow from operating
activities, cash flow from investing activities and cash flow
from financing activities.
Cash Flows from Operating Activities Php xxx
Add: Interest Expense (net of Taxes)* xxx
Less: Cash Flows from Investing Activities xxx
*only if deducted from the operations
• Cash flow from operating activities
This represents how much cash the company generated
from its operations. This shows how much cash is
received from customers and how much cash outflows
are paid to vendors. This also captures changes in current
assets and current liabilities. Normally, this is computed
from net income by considering non-cash items and
working capital changes. This is considered in computing
for NCFF.
• Cash flow from investing activities
This represents how much cash is disbursed (received) for
investments in (sale of) long-term assets like property,
plant and equipment and strategic investments in other
companies. This is considered in computing for NCFF. If
this section reflects transactions involving financial assets,
this should be excluded.
• Cash flow from financing activities
This represents how much cash was raised (or repaid) to
finance the company. This is not considered when
computing NCFF. This is simply because these figures will
be accounted for in the calculation of the Net Cash Flows
to the Equity.
Analysts should be mindful how interest and dividends are
classified in the statement of cash flows. IFRS allows interest
and dividends received to be classified under operating or
investing activities while interest and dividends paid out is
placed under operating or financing activities. One-time or
extraordinary items should also be eliminated from the
computation.
C. FROM EARNINGS BEFORE INTEREST, TAXES,
DEPRECIATION AND AMORTIZATION (EBITDA)
EBITDA, net of Taxes Php xxx
Add: Tax Savings on Noncash Charges xxx
Add/Less: Working Capital Adjustments xxx
Less: Investment in Fixed Capital xxx
• EBITDA or Earnings Before Interest , Taxes,
Depreciation
and Amortization pertains to income before deducting
interest, taxes, depreciation and amortization expenses,
net of taxes.
Since the basis of the computation for the NCFF is already
the earnings after excluding the financing costs, taxes and
other non cash charges, the NCFF should only consider
the amount net of the applicable taxes to be paid. This is
to conservatively show the EBITDA at the amount net to
be realized by the investor.
• Tax Savings on Non-cash Changes
Non-cash charges are not typically adjusted if NCFF starts
with EBITDA. However, it is important that analyst should
check whether non-cash charges were already deducted
in computing for EBITDA or not. If deducted, then there is
a need to add the item back. If non-cash charges are not
deducted from EBITDA, there is no need to add it back to
compute for NCFF.
• Tax Savings on Non-cash Changes (continuation)
Instead of adjusting for the full amount, analyst should
add back the corresponding tax savings related to this
non-cash charges to EBITDA. Several non-cash charges
such as depreciation and amortization are tax-deductible.
This means that occurrence of these expenses reduces
the taxes that the company should pay, thus, reducing
cash outflow. This is added back to EBITDA to capture this
impact.
Concepts on investments in fixed and working capital is
same as previous discussion.
NET CASH FLOW TO EQUITY
Net Cash Flow to Equity or NCFE refers to cash available for
common equity participants or shareholders only after
paying operating expense, satisfying operating and fixed
capital requirements and settling cash flow transactions
involving debt providers and preferred shareholders. NCFE
can be computed from NCFF by considering items related to
lenders and preferred shareholders.
NCFE signifies the level of available cash that a business can
freely declare as dividends to its common shareholders. This
may still differ significantly from the dividends actually
declared and paid out since this decision is made upon the
discretion of a company’s board of directors. Companies
tend to manage their dividends policy: some slowly increase
dividends over time while some maintain current dividends
despite actual profitability. As a result, dividend trend is
seen as less volatile compared to earnings as this is
managed by the board of directors.
Add: Proceeds from Borrowings xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxx
• Proceeds from borrowing
This refers to the amount of cash received by the
company as a result of borrowing of long-term debt.
Since NCFF did not include items related to financing, it
did not capture cash received by the company from
lenders. Since the cash from borrowing is with the
company already, it is added back to NCFF and forms part
of the cash flow available to common shareholders.
• Debt Service
Debt Service is the total amount used to service the loans
or debt financing. This is the total amount of loan
repayment and the interest expenses, net of income tax
benefit.
The interest expense is considered as part of the
financing activities and hence deducted from Net Cash
Flow since this is associated with long-term debt of the
company. The amount to be included must exclude the
equivalent tax benefits from the interest.
• Proceeds from Issuance of Preferred Shares
Same with the debt , preferred shares as another form of
financing, other than the issuance of ordinary equity,
must also be factored in the calculation of the net cash
flows available to equity.
• Dividends on Preferred Shares
Since payments made to preferential shareholders in the
form of dividends are outflows. This must be
incorporated in the calculation as a reduction of the net
cash flows to equity.
Similarly, given the above formula as guiding principle, NCFE

can be determined under the following approaches on the
next three slides:
Net Income Available to Common shareholders Php xxx
Add: Non Cash Charges (net) xxx
Add: Interest Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital xxx
(Purchases – Sales of Fixed Capital Investment)
Net Cash Flows to the Firm xxx
Add: Proceeds from Borrowing xxx
NET CASH FLOW
TO EQUITY
Cash Flows From Operating Activities Php xxx
Add: Interest Expense (net of Taxes)* xxx
Less: Cash Flows from Investing Activities xxx
Department of Accountancy – ELEC2 –Valuation Concepts and Methods
Source: Valuation Concepts and Methodologies
By: Marvin V. Lascano, Herbert C. Baron and Andrew Timothy L. Cachero
C. FROM EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION
AND AMORTIZATION (EBITDA)
EBITDA, net of Taxes Php xxx
Add: Tax Savings on Noncash Charges xxx
Add/Less: Working Capital Adjustments xxx
Less: Investment in Fixed Capital xxx
TERMINAL VALUE
Since GCBOs is assumed to operate in a long period of time to
almost perpetuity, the risk and returns are inherent to the
opportunity at the end of the projection period should also be
quantified. Furthermore, the economic value that will be
generated by the assets is expected to be stable after some point
in time since the projections are reliant on certain assumptions
made. The challenge for the determination of the value of the
asset is to also account for the economic returns that it will
generate in perpetuity. This is addressed by the Terminal Value.
Terminal Value represents the value of the company in
perpetuity or in a going concern environment. In practice, there
are several ways on how to determine the terminal value.
TERMINAL VALUE – BASIS OF TERMINAL VALUE
1. Liquidation Value
Some analysts find that the terminal value be based on
the estimated salvage value of the assets. Methodologies
on how to determine the salvage or liquidation value was
discussed in Chapter 3.
TERMINAL VALUE – BASIS OF
TERMINAL VALUE
2. Estimated Perpetual Value
Another way to determine the terminal value is by using the
farthest cash flows you can estimate divided by the cost of
capital less the growth rate
𝐶𝐹𝑛+1
TV =
𝑟 −𝑔
TV = Terminal Value
CFn+1 = Farthest net cash flows
r = cost of capital
g = growth rate
For example, a Filipino company is expecting for 15%
returns for a venture and assumes that their net cash
flows for the next five years are as follows:
Year Net Cash Flows (in million Php)
1 5.00
2 5.50
3 6.05
4 6.66
5 7.32
TERMINAL VALUE
In the given illustration, you may note that the net cash
flows are growing annually. Assuming this is a GCBO, and
it is expected that the net cash flows will behave on a
normal trend. The growth rate (g) is computed using
compounded annual growth rate formula:
𝑁𝐶𝐹𝑛 1
𝑔 = [( )𝑛−1] − 1 𝑥 100%
𝑁𝐶𝐹0
NCF0 = net cash flows at the beginning
NCFn = latest net cash flows
n = latest time
TERMINAL VALUE
Substituting the given figures, the growth is computed as
1
7.32 5−1
𝑔={ } − 1 𝑥 100%
5.00
g = (1.10 – 1) x 100%
g = 10%
Since the growth rate is 10%, it will be applied on the
farthest cash flows i.e. on the 5th year equivalent to
Php7.32, thus the farthest cash flows is now Php8.05 or
will substitute the CFn+1. It is now assumed that the cash
flows will continuously growth at the rate of 10% per
annum. Thus, the formula can now be applied (on the
next slide).
TERMINAL VALUE – BASIS OF TERMINAL
VALUE
2. Estimated Perpetual Value 𝐶𝐹
𝑛+1
TV =
𝑟 −𝑔
𝑃ℎ𝑝 8.05
TV =
15%
𝑃ℎ𝑝− 10%
8.05
TV =
5%
TV = Php161
In some cases, that the historical growth pattern is
undetermined, some analysts only consider the cost of
capital or their required return to determine the terminal
value. In the given illustration , you may note that
difference on the terminal value: (on the next slide)
TERMINAL VALUE
𝐶𝐹𝑛+1
TV =
𝑟 −𝑔
𝑃ℎ𝑝 8.05
TV =
15% − 0%
𝑃ℎ𝑝 8.05
TV =
15%
TV = Php53.66
You may observe that the terminal value in this case is more
conservative by about Php107.
3. Constant Growth
Challenges for some valuators is to determine that
amount of required return for a specific type of asset or
investment. In lieu of the required return, they use the
growth rate as the proxy especially if the growth is
constant and significant.
4. Scientific Estimates
Other valuators especially those with vast experience
already in some types of investments uses other basis for
them to determine the reasonable terminal value. Using
guesstimates is not prevented because in the end, equity
values will still be based on negotiation.
There is no perfect approach to determine the terminal
value. Actually, some risk averse investors don’t consider the
terminal value in their value. The differences in their
appreciation on the determination or even the inclusion of
the terminal value is dependent on their risk appetite. Then
again, the valuation method will only serve as a reference to
determine the reasonable value for the equity or the asset
being purchased. This is why negotiation plays a key role in
finalizing the determined value.
OTHER INPUTS IN THE NET CASH FLOWS
The present value of the Net Cash Flows represents the
value of the assets. It may be recalled further that the assets
are financed by debt and equity. Hence, these are the claims
which are presented at the right side of the Statement of
Financial Position, under an account form of reporting.
The discounted cash flows analysis factors in all the
projected stream of cash flows that the project, opportunity
or investment and valuing it in present time to determine
whether the investment made on this year would be less
than the value it will generate in the future, that means the
investment yielded an amount sufficient to cover the
investment and allowing the investors to earn more. Same
principle applies that the best opportunity is the one that
will yield the highest present value or solely if the
opportunity will result into a positive amount it should be
accepted.
OTHER INPUTS IN THE NET CASH
FLOWS
Conservatively, the total outstanding liabilities mustbe
considered and deducted versus the asset value
determine the amount appropriated to theto equity
shareholders. This is called the equity value. The
opportunity that will result in the highest equity value is
considered.
DCF Analysis is most applicable to use when the
following are available:
• Validated Operational and Financial Information
• Reasonable appropriated cost of capital or required rate of
return
• New quantifiable information
ILLUSTRATIVE EXAMPLE NO. 1
Bagets Corporation has projected to generate revenues,
cash operating expenses, and the corresponding tax
payments for the next five years:
Revenue Cash Operating Taxes Working Capital
Expenses Adjustments
1 92.88 65.02 45.57 18.58
2 97.52 68.26 48.23 19.50
3 102.40 71.68 51.04 20.48
4 107.52 75.26 54.01 21.50
5 112.90 79.03 57.15 22.58
The investment in fixed capital that was purchased and invested
in the company amounted to Php100 Million. To be financed by:
• 60% from loan borrowing with an annual interest of
10%
payable equally in five years. First payment will be due after 1
year; and
•If 10%
youpreferred shares
are going to with 8% coupon
purchase 50% rate.
of Bagets Corporation,
assuming 15% required return, how much would you be willing
to pay?
Based on the foregoing information, the value of Bagets
Corporation equity is Php22.90 Million. If the amount at stake is
only 50% then the amount to be paid is Php11.45 Million
(Php22.90x 50%)
Bagets Corporation
Discounted Cash Flows Analysis
Notes to Analysis
/1 Terminal Value Calculation
𝐶𝐹𝑛+1 45.86 𝑥 (1+5%) 48.15
TV = = = = Php
481.50
𝑟 −𝑔 15% −5% 10%
/2 Proceeds from Borrowings and Debt Service
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
Financial Modeling is a sophisticated and confidential
activity in a company or for an analyst. Information is can
also be considered as competitive advantage of a company
or a person. Most of the companies hire financial modelers
to assist them in determining the value of GCBOs or other
opportunities. They also ask them to validate ballpark
estimates and may also be used to determine impairments.
Most financial modelers have extensive financial acumen
and vast knowledge and experience.
ANALYSIS
Financial modelers normally are economists, financial
managers, and accountants. Management accountants are
good candidate for this role given their ability to understand
operational models and design long term financial
strategies.
In order to develop financial models, the following steps
needs to be observed: (in the next following slides)
ANALYSIS
1. Gather historical information and references
Historical information must be made available before the
financial model is to be constructed. Historical information
may be generated from, but not limited to the following:
audited financial statements, corporate disclosures,
contracts, and peer information.
ANALYSIS
Audited Financial Statements are the most ideal reference for the
historical performance of the company. The components of the
Audited Financial Statements enable the analyst or the financial
modeler to assess the future of the company based on its past
performance. Statement of Income are used to determine the
historical financial performance, Statement of Financial Position is
used to determine the book value of the assets and the disclosed
stakes of the debt and equity financiers, Statement of Cash Flows
illustrate how the company historically financing its operations
and investments.
ANALYSIS
Statement of Changes in Stockholder’s Equity provides the
information on how much is the claim and dividend background
of the company. One of the most important components of the
financial statements are the Notes to the Financial Statements. It
provides the summary of important disclosure that should be
considered in the valuation. The financial modeler must be able
to quantify these disclosures and more importantly the risks
involved.
ANALYSIS
Corporate disclosures are also key in developing the
financial model. Corporate disclosures provide more context
for the future plans and strategies of the company. This will
enable the analysts or the financial modelers to identify the
risks about the GCBO and quantify them accordingly. Since
these are available to the public, it is the same information
that is known to others.
ANALYSIS
Contracts are formal agreements between parties. In valuing
the GCBOs, it is important for modeler to also know the
existing contracts and the covenants contained in it. Large
accounting firms offer transaction advisory services to assist
their clients who enter into new ventures. Due diligence is
necessary to verify any contingent liability and other legal
risks surrounding that opportunity and quantify it
accordingly to have a more conservative value.
ANALYSIS
Peer information and other public information are also
essential inputs to the financial model. Peer information
provides more context and even supports the risks identified
or will be assumed in the valuation process. Peers may be
other analysts, industry experts and other consultants.
Internal members of the organization may also be
considered as peers.
ANALYSIS
Collectively, the financial model must be able to filter the
information that would be necessary for the valuation.
Relevance and reliability of information are important. Not
all information should be given consideration.
Materiality is another consideration. Even if there are
additional information gathered, there should be a sense of
materiality assessment involved. Note that projections
remain to be estimates. Therefore, only relevant items
should be considered in the valuation.
ANALYSIS
2. Establish drivers for growth and assumptions
Once all relevant information was gathered and validated,
drivers and assumptions can be established by conducting
financial analysis. Drivers are suggested to be those validated
and is represented by authorities like government or experts.
Growth drivers are normally based on population, since most
of the businesses are consumer goods. If services, industry
growth may be used as a driver. In the Philippines, information
is available from the Philippine Statistics Authority.
ANALYSIS
For other economic factors, drivers, and estimates, Bangko
Sentral ng Pilipinas and National Economic and
Development Authority are also other agencies that can be
relied with. Certain statistical information can also be found
from the websites or research centers of the Local
Government Units and National Government Agencies.
Research organizations may also be used, however, strong
validation and evaluation needs to be done to isolate any
form of biases that may affect value.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
The usual growth indicators used are: inflation, population
growth, GNP or GDP growth. In economics, the inflation is the
result of the movement of prices from a year to another. This is
calculated by comparing the movement of the price of the
basket of commodities from a year to another or a period to
another. Inflation is computed using this formula:
𝐶𝑃𝐼𝑛
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = − 1 𝑥 100%
𝐶𝑃𝐼𝑜
CPIn = consumer price index – current year
CPIo = consumer price index – base year
ANALYSIS
The consumer price index represents the price of the basket
of commodities for a particular period. In financial
modelling, you need the inflation to be used as driver for
certain operating and capital expenditures. There are two
ways to calculate the value: (1) nominal and (2) real.
ANALYSIS
Nominal financial models are already in current prices,
meaning, the prices stated in the model already assumes
that the prices grew or decline, in the case of inflation or
deflation respectively. Some uses the headline inflation to
determine the current price. Real financial model, on the
other hand, does not include the effect of changes in prices,
but rather preserve the price of operating expenses and
capital expenditures, as if no changes in prices occur. If the
financial model is in real prices, the cost of capital should
also excludes the effect of inflation.
CASH FLOWS ANALYSIS
With the given equation, to illustrate, that in year 2019 the CPI is
151 meaning the cost of the basket is Php151. In year 2020, the
CPI published is Php155. Obviously, the price of the basket grew,
hence, inflation is expected to be 2.64% [(155/151)-1 x 100%].
On the other hand, if the CPI published for 2020 is Php 149, then
it will be a deflation or decrease in prices at 1.32% [(149/151)-1
x 100%].
To illustrate its application, supposed you are projecting for how
much is the communication costs for 2021 when the cost
in
2020 is Php5 Million. Given the calculated inflation of 2.64%, the
communication costs to be incorporated in the financial model is
Php5.132 Million.
CASH FLOWS ANALYSIS
Other indicator is population growth rate. Population growth
rate is factored in to serve as a growth driver for the demand of
the product, particularly for the merchandising or manufacturing
business. The services sector may use the growth rate in the
businesses or the industry or sector that they are going to serve.
The formula to calculate for the population growth rate is similar
with the inflation, except that the input is the population count
of a particular segment in a particular year. To illustrate, suppose
that in Barangay A in 2019 the population is 25,200. The survey
is conducted in 2020 and the population is 26,460.
ANALYSIS
Using the formula of inflation to calculate for
population growth rate:
26,460
𝑔= − 1 𝑥 100%
25,200
𝑔 = 5%
ANALYSIS
To illustrate the application, assuming that the estimated
consumption of pan de sal in Barangay A is 5 pcs average per
head. If you are going to project the number of pande sal to
be sold in 2021, it will be 138,915 units computed as
follows:
Current pan de sal sold (26,460 x 5) 132,300
Increase in pan de sal (26,460 x 5% x 5)
6,615
Total estimated pan de sal 138,915
ANALYSIS
Financial ratios may be used as tools to determine the
growth drivers and assumptions. Trend analysis will also
help you establish the trajectory of growth pattern. The
financial modeler must assess whether the company can
sustain the pattern otherwise it is conservative to assume a
less aggressive growth. Normally the weighted growth
pattern will be consideredin the long-term financial
perspective. It must be assessed whether the average year
on year growth will be sustained or may be surpassed.
ANALYSIS
To illustrate, PUP Company’s historical production grows
10% per year. It is expected that in the next five years the
probability are as follows:
Scenario Rate Probability
A 5% 10%
B 10% 40%
C 15% 50%
ANALYSIS
With the given information, the weighted average
growth rate to be used is 12% computed as follows:
Scenario Rate Probability Weighted
(1) (2) (3)
A 5% 10% 0.5%
B 10% 40% 4.0%
C 15% 50% 7.5%
Total 12.0%
ANALYSIS
In this situation, the financial modeler can safely use the
12.0% for projecting sales moving forward. Hence, if the
sales for this year was reported to 8,500 units then under
the average sales computed will result to 9,520 units sold.
ANALYSIS
3. Determine the reasonable cost of capital
In determining the reasonable cost of capital, the financial
modeler must be able to use the appropriate parameters for
the company. Generally, cost of debt and cost of equity are
weighted to determine the cost of capital reasonable for the
valuation.
ANALYSIS
4. Apply the formulae to compute for the value
Normally in Financial Modelling, DCF is used to calculate for
the value. Since most information are already available in
Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Return,
Profitability Index etc.
ANALYSIS
For example, Delight Bakery Inc. projected volume of pan de
sal to be sold in Year 1 is 138,915 units, assuming 5% growth
every year, and the estimated required return of 10%. The
pan de sal is sold at Php15 per unit with a cash net income
margin of 20%. Delight’s equipment is capable of producing
the volume required for 10 years. It was noted that the
company has outstanding debt of Php500,000.
ANALYSIS
Using the inputs, the financial model may be presented
through:
CASH FLOWS ANALYSIS
Observe that the enterprise value is calculated by getting the sum of all
discounted net cash flows. Alternatively, NPV function can be used in electronic
spreadsheets. Below is an illustration where both should arrive at the same
results.
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
The advantage of having a financial model is that you can
easily tweak the given information and get the results
immediately. For instance, in the previous illustration the
cost of capital used is 10%. How about if you find that cost
of capital will be 12% or 15%, what will be the Enterprise
Value?
If this is the case, we need to design the financial model to
accommodate this through the use of Data Table feature in
Microsoft Excel. First, design a table where the values will be
inputted.
CASH FLOWS ANALYSIS
Next, select the table we prepared by highlighting cells C17
to D19 and you go to DATA Tab and go to “What if” Analysis
then select ‘Data Table’.
CASH FLOWS ANALYSIS
Data Table Dialogue box will appear and will ask you to enter
the inputs. Since the table we are doing provides for a
columnar input. Then we’ll input C17 in the COLUMN INPUT
and click OK.
CASH FLOWS ANALYSIS
Then the results will now be shown to you in the table.
CASH FLOWS ANALYSIS
It will be easier for you to determine which value to use.
Since, in our example the outstanding debt is Php500,000
then you have to play in the range of Php1.2 Million to
Php1.02 Million.
The scenarios will be developed based on the set of possible
occurrences like level of operating expense, mode of
operations, capital expenditure development period etc.
Emerging trend is having a Risk Based Valuation, wherein
major systematic risk is incorporate such as climate change,
war, economic sabotage, pandemic etc.
CASH FLOWS ANALYSIS
Sensitivity Analysis is almost similar with Scenario
Modelling. The difference is that sensitivity analysis will have
to select a driver or few drivers, ceteris paribus, and check
the degree of change it will cause to the results. Sensitivity
analysis is a useful exercise in developing ballpark estimates.
COMPONENTS OF FINANCIAL MODEL
As described in the earlier part of this chapter, a financial
model should be understandable, printable and auditable.
The financial model should be designed in a way that the
investor or the client of the analysis or the proponent
themselves can understand the dynamics and follow the
drivers to enable them to have a better appreciation and
sound judgment of the results. Please bear in mind that the
results of the financial models are just guide for the
investors or even sellers of investment to determine the
reasonable value.
As a quick guide in developing a financial model the
following components are recommended, particularly when
using Microsoft Excel:
• Title Page
This provides an overview and the project being valued or
assessed. This includes also necessary information to
secure the proprietary rights of the modeler or the firm
he or she is working with. It may also include data cut-off
to serve as a guide to the readers.
• Data Key Results
This sheet summarizes the results of the study. This will
serve as the dashboard to enable the modelers to analyze
the results and to facilitate the readers’ appreciation on
the results of the project. This also facilitate preparation
of pertinent reports.
This also contains the valuation results, scenarios, and
sensitivity analysis. Graphs can also be found in this
sheet.
• Assumption Sheet
This sheet summarizes the assumptions used in the
model. This is normally an input sheet where all inputs
should be made. The information that can be found in
this sheet must be linked to all the output sheets like Pro-
forma Financial Statements, Supporting Schedules and
Data Key Results.
• Pro-forma Financial Statements
This presents the 3 components of the financial
statements namely: Statement of Income, Statement of
Financial Position and Statement of Cash Flows. In this
sheet, you can also find some key financial ratios
particularly those that has to do the with financial
performance and efficiency ratios.
Some modelers also find it convenient to have their
valuation computation be done in this sheet since the
inputs of cash flows are already available here.
• Supporting Schedules
This is like a subsidiary ledger which provides supporting
computation to the components of the pro forma
financial statements. There is no limit for the supporting
schedules the only challenge is that the electronic
financial models consume large amount of data because
of the supporting schedules.

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Chapter 4 DCF

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CHAPTER 4

DISCOUNTED CASH FLOWS METHOD

Similarly, given the above formula as guiding principle, NCFE

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