BIBLIOGRAPHY AND REFERENCES
7. Relever or regear ßa with the private company’s debt to equity ratio in order to find its ße
5.6 DCF SUMMARY – ENTERPRISE VALUE ADJUSTMENTS
This is the final step of a DCF valuation where we will gather the workings of the previous steps together. We see in Exhibit 5.8 the free cash flows of the 5-year explicit forecast period as well as the terminal value of SteelCo. The discount rate has been set to 7.2%. Then the discount factor of each period is calculated based on the following equation:
Discount factor of period n =
( )
1 1+r n, or Discount factor of period 1
1 0.93,
1 7.2%
= =
+ Discount factor of period
( )
22 1 0.87
1 7.2%
= =
+
and so on. Finally, the present value of each of the free cash flow streams is given by multiply-ing the FCF with the relevant discount factor.
The sum of the present values of the free cash flows of period 1 to period 5 plus the present value of the terminal value gives the enterprise value of SteelCo.
1 2 3 4 5
5
€30.7m €10.6m €8.2m €3.8m €4.7m
EV of SteelCo =
(1+7.2%) (1+7.2%) (1+7.2%) (1+7.2%) (1+7.2%)
€91.9m (1+7.2%)
+ + + +
+ or
EV of SteelCo = €115.5m
Please note that apart from SteelCo’s free cash flows, we present just below them its cumulative cash deposits [Cells (E17:J17) of Exhibit 5.8]. It is typical to present in similar valuation engagements a combined graph of the evolution of free cash flows and the cumu-lative cash deposits over time. The graph of the cumucumu-lative cash flows in cases of new com-panies and start-ups sometimes takes the form of the letter J and thus is known as the J-curve graph (see Exhibit 5.9).
Exhibit 5.9 shows a typical J-curve divided into 3 phases (initial period, growth period, and maturity period). These phases appear discrete, but this is purely to make the diagram easier to read. The timing of each stage depends largely on the characteristics of each com-pany and the environment in which it operates. In the early stage of the J-curve the free cash flows of the firm are negative. Gradually they become positive at an increasing rate and finally they stabilize. Any valuation arising from the above cash flows will be determined on one
EXHIBIT 5.8 DCF valuation model for SteelCo
EXHIBIT 5.9 Typical J-curve for start-ups
Maturity Period Time
Cumulative Cash Flows
Initial Period 2–3 years
Growth Period 4–5 years
hand by the depth and duration of the trough and on the other by the trajectory and extent of the upswing. SteelCo is not a start-up and its cumulative cash deposits graph looks like the one in Exhibit 5.10.
Another point of concern is that the terminal value was discounted by the discount factor of the last period of the explicit forecast period, that is, the fifth period and not the next one. We have also kept the discount rate constant for both the explicit forecast period and the terminal value. In this way we have assumed that SteelCo’s leverage and the other WACC parameters (risk-free rate, market premium, etc.) stay fairly constant during that period. We could have used different discount rates for each year if we had to value a company with significant changes in its leverage ratio or if it operated in an environment where changes in risk-free rates and country risk premiums were expected.
Returning to SteelCo, if we want to find its equity value (shareholder value) or the so-called “intrinsic” value per share we need to make some adjustments to the enterprise value according to the following equation:
Enterprise Value = Value of equity − Value of Cash and Cash Equivalents + Value of Debt or if we solve for the value of equity, the equation can be rewritten as:
Value of Equity = Enterprise Value + Value of Cash and Cash Equivalents − Value of Debt SteelCo is a public company and its equity value or market capitalization is derived after subtracting from its total value all senior claims such as debt and preferred stock. It is calcu-lated as the current share price multiplied by the number of shares outstanding. To find the number of shares outstanding, you need first to find the number of basic shares on the front of the latest company SEC filing in case of a US listed company (e.g. 10-K, 10-Q, 20-F) or a similar one in case of another stock exchange. If, let us say, SteelCo has 4.6 million shares out-standing then its intrinsic value per share is estimated to be €3.88, as shown in Exhibit 5.11.
We start with SteelCo’s enterprise value of €115,505k as calculated above and we then subtract its total debt which equals €104,663k. When calculating total debt, be sure to include both the long-term debt and the short-term debt. The market value of debt should be used in the
14,549
30,711
10,552
8,175
3,767 4,707
7,000
37,711 48,262
56,437 60,204 64,911
-10,000 20,000 30,000 40,000 50,000 60,000 70,000
2013 2014 2015 2016 2017 2018
Free Cash Flow Cash Deposits Evolution of Discounted Cash Flows ('000 Euros)
EXHIBIT 5.10 Evolution of discounted cash flows for SteelCo
calculation of enterprise value. However, in practice we can usually use the book value of the debt by assuming that the debt trades at par. The figure of debt we subtracted corresponds to the total debt of the company at the time the valuation takes place. We consider that the valuation takes place at the end of 2013 so the debt that we subtract is the one as at 31 December 2013.
Then we add up cash and equivalents. SteelCo holds €7,000k in cash as at 31 December 2013. If there were any balance sheet items such as property, plant, and equipment available for sale then we should add them up as well. Since there is no such information about SteelCo we leave the other adjustments line empty. The shareholders value then equals €17,841k.
Value of Equity (Shareholders Value) = €115.5m + €7.0m – €104.7m = €17.8m And if we divide shareholders value by the number of shares outstanding (4.6m):
Price per Share= Shareholders Value = Number of SharesOutstanding
17 841 4,600, k 3.88
k =
€ €
This price is at a discount of almost 50% compared to SteelCo’s book value per share which is €6.97 as of 31 December 2013:
Book Value per Share Book Value of Equity Number of Shares
= OOutstanding= 32,030k=
k 6.97
4 600,
€ €
We can invoke many reasons for a discrepancy between the book value (accounting value) per share and its intrinsic value. As far as SteelCo’s case is concerned, the most obvious one is that the book value reflects the past performance of the company whereas the intrinsic value reflects the future performance. In particular, in contrast to book value, the intrinsic value as estimated by the DCF method reflects the absence of future growth potential of the company at least in the short term. The intrinsic value derived by the DCF can come closer to the book value by adjusting the growth potential of SteelCo during the explicit forecast period in terms of both sales and profits.
As a final note to this chapter I would like to warn the user of the DCF method about its drawbacks. Although the concept of DCF valuation is simple, is less exposed to market perceptions and forces you to think about the underlying business model of the company, it is very sensitive to its inputs (which are sometimes difficult to estimate). For example, small changes in the discount rate may have a big impact on the value of a company. Apart from the discount rate, DCF is very sensitive in estimating the value of a company to changes in the growth rate of the terminal value. Moreover it can easily be manipulated by a savvy modeller in order to provide the conclusion he or she wants. In order to make the above crystal clear let us examine the following situation.
Company Worth in Euro '000 115,505
− Debt
+ Cash Deposits +/− Other adjustments
= Shareholders Value Shares Outstanding Price per Share
–104,663 7,000 17,841
-4,600,000 3.88
EXHIBIT 5.11 The intrinsic value per share of SteelCo
Part of the calculation of the free cash flow for 2018 was the working capital difference between years 2018 and 2017. To estimate the working capital for 2018 we made the authori-tative assumption that it would be 26% of 2018 sales. Before we proceed further with our thinking keep in mind that 2018 is the last year of the explicit forecast period. Moreover the free cash flow for 2018, after being increased by the perpetual growth rate, is the main con-stituent of the terminal value which in our case represents 80% of SteelCo’s total value. Let us see what would be the value of SteelCo had we assumed that the working capital of 2018, given the sales we have already forecast, was 27% instead of 26%. The working capital of 2018 would be €25,869k instead of €24,911k and the difference between the working capital of 2018 and the working capital of 2017 would be €1,701k instead of €2,659k. Then the free cash flow of 2018 would be €3,749 instead of €4,707k and the terminal value, keeping all other parameters the same, would be €73,229k instead of €91,945k. Finally, the total value of SteelCo would be €101,622k instead of €115,505k and its intrinsic value per share would be just €0.86 instead of €3.88. That is, for a slight increase in working capital requirements of 3.85% {(27% − 26%)/26%} the intrinsic value per share of SteelCo plummeted by 77.8%.
The interested reader can play with the assumptions of the DCF valuation model on the web-site accompanying the book and see their impact on the company’s value.
BIBLIOGRAPHY AND REFERENCES
1. Professor Aswath Damodaran’s web site. Probably the best valuation source you can find online, http://www.damodaran.com.
2. Statistical data warehouse of the European Central Bank (ECB), http://sdw.ecb.europa.eu/quick-view.do?SERIES_KEY=143.FM.M.U2.EUR.4F.BB.U2_10Y.YLD.
3. Bloomberg site, http://www.bloomberg.com/markets/rates-bonds/.
4. Investopedia web site, http://www.investopedia.com/terms/c/covariance.asp.
5. Barra Integrated Model, http://www.msci.com/products/risk_management_analytics/barra_
integrated_model/.
6. Ibbotson Associates, http://www.ibbotson.com.
7. Reinhart, C. M. and Rogoff, K. S., “The Aftermath of Financial Crises” (May 2009) 99(2) American Economic Review, American Economic Association, 466–472, http://www.nber.org/
papers/w14656.
8. Duff & Phelps, http://www.duffandphelps.com/Pages/default.aspx.