Discounted Cash Flow. Alessandro Macrì. Legal Counsel, GMAC Financial Services

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1 Discounted Cash Flow Alessandro Macrì Legal Counsel, GMAC Financial Services

2 History The idea that the value of an asset is the present value of the cash flows that you expect to generate by holding it is very OLD. Discounted cash flow calculations have been used since money was lent at interest.

3 History Francesco Balducci Pegolotti, a merchant from Firenze, developed interest rate tables in 1340.

4 History In 19 th century railroads grew incredibly in the US. This required models to analyze long-term investments with significant cash outflows in the earlier years being offset by positive cash flows in the later years.

5 History The principles of modern valuation were developed by Irving Fisher in the 30s. Even Keynes claimed that the marginal efficiency of capital can be calculated as the discount rate that makes the present value of returns on an assets = to its current price

6 History In the last 50 years discounted cash flow models have been applied to securities and business valuation.

7 Definition Discounted cash flow ( DCF ) valuation relates the value of an asset to the present value of expected future cash flows on that asset, discounted back at a rate that reflect the riskiness of these cash flows.

8 A simpler definition A 1 today is * worth more than 1 you might receive in the future. * generally (e.g., Italian government bonds during the Euro crisis ).

9 Key concepts Cash flow Cash generated by an asset. Terminal value Value at the end of the cash flow projection period (horizon period).

10 Key concepts Discount rate The rate used to discount projected cash flows and terminal value to their present values. Net Present Value It is the total discounted value for a series of cash flows across a time period extending into the future.

11 Impress your CFO The value of an asset is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset A. Damodaran

12 Impress him even more! The Benninga and Sarig model (1997): VTS = PV [Kd (1- TPD); D Kd [(1- TPD)- (1-T) (1- TPA)]] They claim that if there are personal taxes, the tax benefits of the debt should be discounted with after-personal-tax discount rates. Keywords: value of tax shields (VTS), required return to debt is Kd, debt is D, present value (PV), required return to equity, corporate income tax is T, the personal tax rate on shares is TPA and the personal tax rate on debt is TPD.

13 Discount rate: elements to consider Discount rate = BASE RATE + RISK PREMIUM The base rate is intended to express the normal (riskfree) return that can be realized by the company, while the risk premium represents estimating various risks over the long-term. Some typical components of the base rate and risk premium are:

14 Discount rate: elements to consider BASE RATE or Risk Free Rate: the national central bank s base rate inflation rate national GDP growth normal return in the industry Etc.

15 Discount rate: elements to consider RISK PREMIUM: country risk company-specific risk force majeure; Etc.

16 DCF: the 4 main variants 1. You can discount expected cash flows on an asset at a risk-adjusted discount RATE to arrive at the value of the asset. 2. You can adjust the expected cash flows for risk to arrive at what are termed risk-adjusted CASH FLOWS which you discount at the RISK FREE RATE to estimate the value of a risky asset.

17 DCF: the 4 main variants 3. You can value a business as a function of the EXCESS RETURNS you expect it to generate on its investments. 4. You can value a business first, without the effects of debt, and then consider the marginal effects on value, positive and negative, of borrowing money. This approach is termed the adjusted present value approach.

18 1. Risk-Adjusted Discount Rate Basic principle: you use higher discount rates to discount expected cash flows when valuing RISKIER assets.. and lower discount rates when valuing SAFER assets.

19 1. Risk-Adjusted Discount Rate Two models: You value just the EQUITY in the business You value the FIRM valuation

20 1. Risk-Adjusted Discount Rate A) Equity Valuations In equity valuation models, we focus our attention on the EQUITY of investors in a business and value their STAKE by discounting the expected cash flows to these investors at a rate of return that is appropriate for the equity risk in the company.

21 1. Risk-Adjusted Discount Rate A) Equity Valuations The cash flows AFTER debt payments and reinvestment needs are called FREE CASH FLOWS TO EQUITY, and the discount rate that reflects just the cost of equity financing is the cost of equity. Two forms: equity and extended equity

22 1. Risk-Adjusted Discount Rate > A) Equity Valuation > i) Dividend Discount Model There are two basic inputs to the model - expected dividends and the cost on equity. To obtain the expected dividends, we make assumptions about expected future growth rates in earnings and payout ratios.

23 1. Risk-Adjusted Discount Rate > A) Equity Valuation > i) Dividend Discount Model The required rate of return on a stock is determined by its riskiness, measured differently in different models.

24 1. Risk-Adjusted Discount Rate > A) Equity Valuation > i) Dividend Discount Model Main limits of this model: some companies hold back cash that they can pay. Therefore the cash flows to equity exceed dividends; other firms pay more in dividends than they have available in cash flows, often funding the difference with new debt or equity issues.

25 1. Risk-Adjusted Discount Rate > A. Equity Valuation > ii) Extended Equity Model Extended equity valuation models try to capture this cash build-up in value by considering the cash that COULD have been paid out in dividends rather than the actual dividends.

26 1. Risk-Adjusted Discount Rate > A. Equity Valuation > ii) Extended Equity Model So, the dividend discount model has been slowly abandoned.

27 1. Risk-Adjusted Discount Rate > A. Equity Valuation > ii) Extended Equity Model How do we best estimate potential dividends? A common method is the WARREN BUFFET way: investors should judge companies based upon what he called owner s earnings, which he defined to be cash flows left over after capital expenditures and working capital needs. But this assumes a strong corporate governance, i.e., the remaining cash should not be wasted.

28 1. Risk-Adjusted Discount Rate > A. Equity Valuation > ii) Extended Equity Model Another way is to extend the definition of cash returned to stockholders to STOCK BUYBACKS, thus implicitly assuming that firms that accumulate cash by not paying dividends return use them to buy back stock. However, stock buy backs are more and more common, they do not happen so regularly.

29 Aswath Damodaran Using discounted cash flow models is in some sense an act of faith

30 1. Risk-Adjusted Discount Rate > B) Firm Model In the cost of capital approach, you begin by valuing the firm, rather than the equity. The cash flows BEFORE debt payments and AFTER reinvestment needs are termed FREE CASH FLOWS TO THE FIRM, and the discount rate that reflects the composite cost of financing from all sources of capital is the cost of capital, i.e., WACC.

31 1. Risk-Adjusted Discount Rate > B) Firm Model WACC - weighted average cost of capital in simple terms is the rate representing the return requirements of both groups of capital providers (shareholders and creditors).

32 1. Risk-Adjusted Discount Rate > B) Firm Model Embedded in this value are the tax benefits of debt (in the use of the after-tax cost of debt in the cost of capital) and expected additional risk associated with debt (in the form of higher costs of equity and debt at higher debt ratios).

33 1. Risk-Adjusted Discount Rate > B) Firm Model The most revolutionary idea behind this model is the notion that equity investors and lenders are ultimately partners who supply capital to the firm.

34 1. Risk-Adjusted Discount Rate > B) Firm Model In essence, this is a cash flow after taxes and reinvestment needs but before any debt payments, thus providing a contrast to cash flows to equity that are after interest payments and debt cash flows.

35 1. Risk-Adjusted Discount Rate > B) Firm Model The difficulty is that the firm valuation approach requires information about debt ratios and interest rates to estimate the WACC.

36 2. Risk-adjusted Cash Flows You replace the uncertain expected cash flows with the certainty equivalent cash flows, using a risk adjustment process akin to the one used to adjust discount rates.

37 2. Risk-adjusted Cash Flows Three main steps: 1. Select a coefficient between zero and one that reflects the riskiness of each cash flow. A coefficient of zero indicates that you do not expect to receive the cash flow at all, and a coefficient of one indicates full confidence that you will receive the cash flow.

38 2. Risk-adjusted Cash Flows 2. Multiply each cash flow by its corresponding certainty equivalent coefficient. 3. Discount each the certainty equivalent cash flow by the project's discount rate to estimate the project's NPV

39 2. Risk Adjusted Discount Rate or Risk Adjusted Cash Flow? They are alternative approaches to adjusting for risk. No model is better than the other

40 3. Excess Return Models In the excess return valuation approach, you separate the cash flows into excess return cash flows and normal return cash flows.

41 3. Excess Return Models An investment adds value to a business only if it has positive net present value, no matter how profitable it may seem on the surface. This would also imply that earnings and cash flow growth have value only when it is accompanied by excess returns, i.e., returns on equity (capital) that exceed the cost of equity (capital).

42 3. Excess Return Models The most common variant is economic value added (EVA) which is a measure of the surplus value created by an investment or a portfolio of investments.

43 3. Excess Return Models Economic value added is an extension of the net present value rule. It is computed as the product of the excess return made on an investment or investments and the capital invested in that investment or investments

44 4. Adjusted Present Value Models In the APV approach, you begin with the value of the firm without debt. As you add debt to the firm, you consider the net effect on value by considering both the benefits and the costs of borrowing.

45 4. Adjusted Present Value Models In general, using debt to fund a firm s operations creates tax benefits (because interest expenses are tax deductible) on the plus side and increases bankruptcy risk (and expected bankruptcy costs) on the minus side.

46 Main Pros of DCF It is forward-looking and does not depend on historical results. It is inward-looking, relying on the fundamental expectations of the business or asset It is focused on cash flow generation and less affected by accounting practices and assumptions.

47 Main Cons of DCF It estimate too many numbers: it is highly dependent on the quality of the assumptions regarding cash flows and discount rate. This is why DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs.

48 Albert Einstein You do not really understand something unless you can explain it to your grandmother.

49 Acknowledgement This presentation has been made possible thanks to all the materials kindly made available by Aswath Damodaran Professor at NYU, Stern School of Business, on

50 Suggested readings by Damodaran s website Depending on your company/sector: Valuing Financial Service Firms Valuing Private Businesses Valuing Acquisitions Valuing Distressed Firms Valuing commodity and cyclical companies Valuing companies with intangible assets Valuing emerging market companies Valuing multi-business, multinational enterprises

51 One more suggestion... Valuation, Measuring and managing the value of companies, Second edition, Copeland, Koller, Murrin

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