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Estimate Cashflows
2.
Estimate Growth Profile (1 stage, 2 stage, 3 stage etc) & Growth Rates
3.
4.
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represent its potential dividends but this will typically over estimate the value of the equity in the firm. Earnings
are not cash flows, since there are both non-cash revenues and expenses in the earnings calculation. This also
fails to take into account the need for a firm to invest in new assets in order to grow.
For that reason, the best option is to focus on free cash flow - there are two main such definitions:
i) Free Cash Flow to the Firm (FCFF). This is the cash available to bond holders and stock holders after all
expense and investments have taken place. It is defined as:
EBIT * ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital.
ii) Free Cash Flow to the Equity (FCFE). This is the cash is available to pay to a company's equity
shareholders after accounting for all expenses, reinvestment, and debt repayment. It is defined as:
Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal
Repayments - New Debt Issues) OR alternatively Cash From Operations - (Capital Expenditures Depreciation) + Net Borrowing.
If we are looking to value the equity, then the most obvious option is to use FCFE. FCFF is preferred if the
company is unstable or has huge amount of debt because the FCFE might be very low or negative in this case.
Basically, the drawback of FCFE is that it will change if the capital structure changes. That is, FCFE will go up if
the company replaces debt with equity (an action that reduces interest paid and therefore increases CFO) and
vice versa.
suggests that analysts are very poor forecasters, especially over the long-term. Work by James Montier found
that the average 24-month forecast error is around 94%, and the average 12-month forecast error is around 45%.
iii) Fundamental Determinants - With both historical and analyst estimates, growth is treated as an exogenous
variable that affects value but is divorced from the operating details of the firm. As Professor Damodaran
notes, the alternative way of incorporating growth into value is to make it endogenous, i.e., to make it a function
of how much a firm reinvests for future growth and the quality of its reinvestment. When a firm has a stable return
on capital, its expected growth in operating income (and therefore cashflow) is a product of the reinvestment rate,
i.e., the proportion of the after-tax operating income that is invested in net capital expenditures and non-cash
working capital, and the quality of these reinvestments, measured as the return on the capital invested. The
formula is:
Reinvestment Rate * Return on Capital where Reinvestment Rate = Capital Expenditure Depreciation + Change in Non-cash WC and Return on Capital = EBIT (1-t) / Capital Invested
Option iii) is probably the best option but may feel a bit involved. A simpler approach would be to look at historic
growth over the past several years, take an average, and then reduce that in stages. A three-stage model might
take the last 3-years' growth rate, apply it to the next five years, chop it in half for the next five years, and then
reduce it to 3% (the long term rate of inflation, e.g. no "real" growth) from then on.
Cost of Equity
Equity shareholders expect to obtain a certain return on their equity investment in a company. From the
company's perspective, the equity holders' required rate of return is a cost. However, unlike the cost of debt
which is relatively easy to determine from observation of interest rates in the capital markets, a company's
current cost of equity is unobservable and must be estimated.
CAPM
There are various models for doing so, the most commonly accepted of which is the Capital Asset Pricing Model,
or CAPM where:
Cost of Equity (Re) = Risk Free Rate (Rf) + Beta * Equity Risk Premium.
To explain these terms:
i) Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such
as US government bonds.
ii) - Beta - This measures how much a company's share price moves against the market as a whole. A beta of
one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the
share is amplifying the market's movements; less than one means the share is more stable.
iii) Equity Market Risk Premium - The equity market risk premium represents the returns investors expect, over
and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other
words, it is the difference between the risk-free rate and the market rate. Practitioners never seem to agree on
the premium; it is sensitive to how far back you go in history, what bonds you use as a reference point, and
whether you use geometric or arithmetic averages.
While widely used, CAPM has been widely criticised as being empirically flawed - according to Montier, "CAPM
woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta
stocks. Over the long run there has been essentially no relationship between beta and return" - as well as being
based on a highly unrealistic set of assumptions. For that reason, it may be better to just adopt a discount rate
that seems intuitively consistent with both the riskiness and the type of cashflow being discounted.
Interestingly, Buffett uses something like the thirty-year U.S. treasury bond rate but without a risk premium on the
basis that he avoids risks. "I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't
make any sense to me. Risk comes from not knowing what you're doing." (although, presumably, as a value
investor, he builds a significant margin of safety elsewhere).
Conclusions
Although Montier argues that DCF "should be consigned to the dustbin of theory, alongside the efficient markets
hypothesis, and CAPM", this seem a little harsh. It is a useful tool, provided that its constraints are clearly
understood (e.g. the sensitivity to inputs), and it is best used with other tools such as Earnings Power Value and
Relative Value techniques as a sense check. In order to use DCF most effectively, the target company should
generally have positive and predictable free cash flows (i.e. typically it's best with mature firms that are past the
growth stages). DCF works less well when a company's operations lack "visibility" - i.e, when it's difficult to
predict revenue and cost trends with much certainty. DCF analysis also demands vigilance so if Company X
delivers disappointing quarterly results, or if interest rates change dramatically, you may need to adjust your
assumptions.
- See more at: http://www.stockopedia.com/content/valuation-101-how-to-do-a-discounted-cashflow-analysis63489/#sthash.n47s0UaO.dpuf