DCF and WACC calculation: Theory meets practice

Transcription

1 DCF and WACC calculation: Theory meets practice

2 Table of contents Section 1. Fair value and company valuation page 3 Section 2. The DCF model: Basic assumptions and the expected cash flows page 6 Section 3. And what about the discount rate? page 12 Slide 2

3 Section 1 Fair value and company valuation Slide 3

4 Let s have a look on the different kinds of value Market value (Tax and general; objective/standalone basis) Fair value (Accounting) Economic value Market value (Price/M&A) Fair value (Legal issues) Value in use (Accounting) or Investment Value (particular investor's subjective view) Slide 4

5 There are different valuation methods within two common approaches that are used for determining the value of a company Income approach Market approach (Multiples) Gross value (Enterprise Value) Net value (Equity Value) Gross value (Enterprise Value) Net value (Equity Value) DCF methods: DCF methods: Discounted dividends EBIT multiple WACCapproach APVapproach Equityapproach EBITDAmultiple Sales- Multiple Price-Book- Multiple Price- Earnings- Multiple Slide 5

6 Section 2 The DCF model: Basic assumptions and the expected cash flows Slide 6

7 In the WACC approach expected cash flows are discounted with a risk adjusted discount rate Future business cash flows (CFs) are uncertain. Therefore expected cash flows are discounted (E(CF)). Present Value t n 0 E( CF) (1 k) t t The discount rate (k) contains a risk premium. Commonly the WACC is used as an estimate of k and thus "Gross Value" is determined Slide 7

8 The equivalence principle: In the DCF method expected cash flows and the discount rate shall fit together These two sets of cash flows have the same expected value (mean), but different risks. The way a standard DCF model obtains different values is to assign them different discount rates. Risk-adjusted discount rate: In a standard DCF model, the discount rate consists of the risk-free interest rate and a risk premium. It is most likely that the (future) cash flows do not necessarily equal the expected cash flows. Riskier Less risky Probability distributions for risky future cash flows Slide 8

9 Theory meets practice (1/2): Are the cash flows reasonably symmetrical? Judgment call: What to do if the cash flows are not reasonably symmetrical... How certain are my expected cash flows: Discuss the process of creating cash flows and the purpose for which they are prepared, e.g. budgets, management bonus, accounting, bank financing, etc. Consider thoroughness of preparation Consider likely bias of preparation Consider market-specific and entity-specific factors Assess sustainability of corporate strategy/structure Slide 9

10 Theory meets practice (2/2): What to do if the cash flows are not realistic? Adjusting cash flows is normally the preferred approach. Two alternatives if cash flow projections are not realistic: 1. Adjust discount rate Subjective quick fix But how do you determine the discount rate adjustment...? 2. Adjust cash flows Discuss and agree on sensible adjustments Consider market and economic data Consider ranges and sensitivity analysis Slide 10

11 Note: Thinking about cash flows starts with the business involved, not with the accounting figures. Trying to understand the underlying business 1. Strategic issues Competitive advantages: interdependencies Value chain/market forces : basic needs 2. Value flexibility Timing issues/decisions on scale Interactions/Technology/Innovation Learning effects/choice of scope Slide 11

12 Section 3 And what about the discount rate? Slide 12

13 Remember: The DCF method is based on the equivalence principle Denomination of the discount rate in the cash flow currency The discount rate should meet applied future economic income measure (Cash Flow), i.e. WACC is applied to Cash Flow to Firm and Cost of Equity is applied to Cash Flow to Equity (CFE) CF r UAH UAH OR CF r EUR EUR CF r UAH EUR OR CF r EUR UAH Note: A mix of currencies is not possible... Slide 13

14 The weighted average cost of capital take the cost of equity and the cost of debt into consideration wacc E re rd (1- TC ) E D D Where: r E Cost of Equity r D Cost of Debt E Market value of Equity D Market value of Debt TC Corporate Tax Rate Slide 14

15 E re rd (1- TC ) In the CAPM the cost of equity is based on the risk free rate and a risk premium wacc D r EUR E EUR EUR r rf Stock, Index MRP EUR Index Risk free rate determined by currency (e.g. EUR) and AAA rated countries General comments Comparable company or peer group companies Market portfolio: Reflects the investment opportunity of the investor (e.g. local vs. global) CAPM widely accepted in theory and practice (although empirical power has been challenged) Interest rate / cost of capital is always related to a certain currency, e.g. UAH risk free interest rate EUR risk free interest rate or USD risk free interest rate EUR risk free interest rate in general In the long run any difference should be explained by the differential in expected inflation rate. Slide 15

16 The risk free interest rate should always be risk free also in times like today wacc E re rd (1- TC ) D General comments Denomination of risk free interest rate in the cash flow currency (remember the equivalence principle) Related to AAA rated countries (risk free!?) If a risk free interest rate in the valuation currency is not available, conversion into the valuation currency through estimation of long term inflation differential Maturity linked to valuation object (in general long term interest rate, duration of the project/business) Possible sources: Bloomberg, Thomson Financial, Datastream etc. ECB etc. Slide 16

17 E re rd (1- TC ) In case that the business plan is in UAH a risk free rate should be used considering future inflation rate differentials wacc D According to practice, even if the business plan would be given in UAH we would not use a UAH interest rate without any further considerations as we would expect the yield to account for certain default risk as Ukraine is not AAA rated. Supposed solution would rather be to adjust the EUR risk free rate by an estimation for the inflation rate differential and a country risk premium or to use UAH sovereign rate and be aware of certain default risks already included there = country risk premium. Slide 17

18 In case that the business plan is in EUR a EUR risk free rate should be used and country risk should be added Apply a EUR interest rate due to equivalence reasons, i.e. if the cash flow is in EUR it has to be discounted by a EUR discount rate and vice versa. In addition, we can assume that this rate is (quasi) risk free. Standard approach is to apply risk free rate derived from sovereign bonds having a maturity correspondent to the duration of cash flows taking into account liquidity aspects of the underlying bond market ( 10y up to 20 or 30 years). Svensson-Method is rarely applied due to complexity and is only available for some countries, however most accurate. Note: Country risk should be added, e.g. it can be estimated by the yield differential (spread) between (EUR) USDdenominated sovereign bonds and (German) US government bonds wacc E re rd (1- TC ) D Slide 18

19 The currency of the business plan also determines the setting of the beta The Bloomberg currency default setting should always be taken into consideration as different currency settings lead to different betas. Moreover, we assume that the investor can diversify globally. Thus, we would recommend to use a global market index (e.g. MSCI World). Data: total return indices (however, use of price indices may have little impact on beta estimation as dividends only influence single data points) Frequency: monthly data, period: five years (three years) Unlevering / relevering: Harris & Pringle wacc E re rd (1- TC ) D Slide 19

20 Different currency exposures may lead to (significantly) different beta values Foreign currency Euro Slide 20

21 E wacc re rd (1- TC ) And what about the data points of the beta? D Slide 21

22 E re rd (1- TC ) There are many market risk premia all over the world... wacc D Source: experience and research Slide 22

23 Regarding the debt component in the WACC there is a big variety of instruments What is debt: A promise to make regular interest payments and to repay the principal (i.e the original amount borrowed) according to an agreed schedule. Plain vanilla debt is paid before equity, but does not share in the upside potential of equity returns. wacc E re rd (1- TC ) D Money market debt Bank debt Leases Bond market Commercial papers Short term (Overdraft) loans Financial lease Fixed coupon, variable coupon, callable Long term Slide 23

24 Based on the debt mixture the cost of debt is calculated We suggest to estimate the cost of debt as the weighted average cost of the portfolio of interest bearing debt instruments used by the firm. Companies often don t have sufficient long-term borrowings to be consistent with long-term debt finance in gearing assumption. Therefore they will need to roll over the short term borrowings. This assumption can be benchmarked against the forward interest rates, which give an indication of the market rate for the follow-up funding conditions. Theoretically, we will end up with an interest rate according to the spot rate with company s asset duration Or: Refinancing / prolongation risk may be considered as part of beta Slide 24

25 In the end we get the WACC... wacc E re rd (1- TC ) D Parameter 20XX 20XY Comments Risk-free rate, USD 2,66% 2,66% Yield to maturity for US Treasury papers with maturity in 20 years as of Valuation Date Equity risk premium 5,00% 5,00% Best practice Unlevered Beta 1,00 1,00 Relevered Beta 1,39 1,42 YTM for US Treasury papers 1,92% 1,92% YTM for Ukrainian eurobonds 9,40% 9,40% Sovereign risk of Ukraine 7,34% 7,34% Cost of equity, for USD-denominated CFs 16,92% 17,10% Yield to maturity for US Treasury papers with maturity in 10 years as of Valuation Date Yield to maturity for Ukrainian USD eurobonds with maturity in 2021 Forecasted long-term inflaiton in the USA 1,9% 1,90% US CPI for 2020 Forecasted long-term inflation in Ukraine 3,4% 3,40% Ukraine CPI for 2020 Cost of equity, for UAH-denominated CFs 18,65% 18,82% Debt-to-Equity ratio 50,00% 50,00% Research data Weight of Equity 66,7% 66,7% Weight of Debt 33,3% 33,3% Cost of debt, for UAH-denominated CFs 12,00% 12,00% Weigted average effective interest rate for the company's loans and bonds Effective tax rate 23,0% 16,0% Corporate tax rate Weighted average cost of capital 15,51% 15,91% Slide 25

26 We will be glad to answer your questions and to discuss any further issues. Andreas Pfeil Senior Manager Corporate Finance - Valuation & Strategy Kyiv Ukraine andreas.pfeil@ua.pwc.com Mobile This publication has been prepared for general guidance on matters of interest only, and does not constitute professional adv ice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, [insert legal name of the firm], its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or any one else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it Limited liability company «PricewaterhouseCoopers». All rights reserved. In this document and «PricewaterhouseCoopers» refer to Limited liability company «PricewaterhouseCoopers», which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.