In a previous article on the logic behind changes to a firm’s value, we explained that the current value of a firm is determined by:
- Their future earnings potential
- The associated risks of the business in their pursuit of profits.
This concept is the building block behind the science of firm valuation known as the Discounted Cash Flow (DCF). However, valuation is as much an art as it is a science because the usefulness of DCF is largely determined by the quality of the assumptions that go into it. In this article, we will guide you through these basic assumptions.
The Science of DCF
DCF is a quantitative representation of the above relationship, by first estimating the value of the firm for each period (annually in the following example) and summing up this string of values to arrive at a dollars and cents figure.
Free cash flow (FCF) refers to the cash generated by the firm and required return is the combined interest costs (in %) demanded by equity holders and debt holders in exchange for financing the company.
You might wonder why we use FCFs instead of net profits since the latter is a mandatory disclosed figure that is readily available. The reason is that net profits can be distorted by varying treatments of accounting rules, whereas free cash flows represent the company’s ability to generate cash and economic value. FCF is typically calculated by removing taxes, interests, non-cash items, and changes to working capital from net profit.
In most cases, required return is calculated as the weighted average cost of capital (WACC). This figure is derived by summing up the interest costs of equity and debt proportionately. We typically reference the cost of equity by applying a mathematical model to the company’s historical stock prices, and cost of debt by the interest costs of the debt held by the company. These figures are generally reported by the company in their annual reports, and you can obtain these figures from analyst reports as well.
We present an example of the FCF and WACC of a Singapore listed company in the table below:
*FCF (U) = Unlevered free cash flow; WACC = Weighted average cost of capital
We could use this data to help us estimate the current value of the firm through the following 3 steps:
- Extrapolate the annual free cash flow into the future (not more than 10 years).
- Take an average of the WACC and assume that this rate applies to future years.
- Estimate the terminal value of the company.
What is terminal value? Listed firms are expected to operate indefinitely. To resolve the impossible task of building a DCF with infinite terms, we capture all the remaining years of the firm’s value into 1 figure known as the terminal value. There are 2 main approaches to this:
- Use a multiple method, such as price-earnings ratio. For example, if a comparable company’s share price is trading at 10 times earnings per share, then we multiply the FCF in the last year of our DCF model by the same multiple for our terminal value.
- Use the Gordon Growth model, and multiply the FCF in the last year of the DCF model by a long-term growth rate, before dividing it by the difference between WACC and this rate.
You can now derive the value of the firm per share ($ per share) by plugging the above components into the DCF equation, deducting the net debt from the computed value, and dividing the result by the total number of shares outstanding. If the DCF value per share is higher than the existing stock price, it means that the firm is performing better than what the market believes, and you may want to buy this undervalued stock. If the DCF value per share is lower, then you may want to do the reverse.
The Art of DCF
The astute reader may realize that we have made a couple of unrealistic assumptions, such as extrapolating cash flows and assuming that the future WACC is the same as the historical average. DCF is extremely sensitive to cash flow assumptions, growth rates, and terminal value. Small changes to growth rates can cause large fluctuations in project cash flows and terminal value, making valuation models susceptible to way-off-the-mark errors and manipulation.
In this section, we present some quality improvements for you to consider when working on the assumptions of your DCF models.
a. Estimating future streams of Free Cash Flow
Future streams of free cash flow should be estimated by at least considering:
- The historical growth rates
- Existing pipelines that the company has a good chance of securing
- Expected changes to the economics, politics, and regulatory environment of the company’s major markets
- Expected changes to the competition and market power of the company
- Expected changes to the company’s management and their abilities
- Expected changes to the company’s business model
b. Estimating the weighted cost of capital
Historical weighted cost of capital is valid if we do not expect drastic changes to the business model or environment. However, we may want to adjust the WACC by increasing it in those years that we think that the company may face more risks, and decreasing it when the opposite occurs.
c. Evaluating valuation models
Always assume that all models are wrong (especially the ones not built by you). However, models can be made useful by questioning the assumptions as rigorously as possible. You should be as prudent as you can, assume more risks than expected, and perform what-if assessments by checking the economic impacts to the models when certain assumed values (especially revenue growth rates) change.