DCF Valuation Flashcards
Fundamental Trends
Asset Value Increases if
1) Discount Rate decreases
2) Future cash flows increase
3) life of asset increase
negative cash flows can still be valuable if disproportionately large cash flows in the future, normal for young growth companies
DCF valuation
intrinsic value approach = value attached to an asset by looking at its fundamentals
to value an asset by forecasting future cash flows based on riskiness
A longer time period of risk rates covers more possible outcomes
Enterprise Value
Value of the core business operations to all investors
Equity Value
View is only for equity investors. Only two ways to raise $ debt or equity.
Enterprise Value Fundamental Rules
1) is there long-term funding? ADD such as debt, preferred stock, non-controlling capital leases
2) will this cost the acquirer and will not be paid back of the company’s normal cash flow? ADD (debt, preferred stock) - bc will need to raise debt to pay that back
3) if not an operating asset? SUBTRACT ex. cash, cash equivalents, net operating losses, assets from discontinued operations
Valuation Framework
Assets: Existing investments (short-term, long-term), expected value to be created
Liabilities: Debt, Equity (only two ways to fund a business)
Valuation
Sound principal of investing = investor does not pay more for an asset than it is worth, in terms of finance buy assets for the cashflows we expect to receive from them
General Principals of Estimating Cash Flow
Need to match cash flows to discount rates:
ex. equity cash flows to cost of equity firm cash flows to cost of capital pre-tax cash flows to pre-tax rates post-tax cash flows to post-tax rates nominal cash flows to nominal rates real cash flows to real rates
FCF Equity
Post-Debt = cashflows from assets, after debt payments, and after making reinvestments for future growth
Discount rate that reflects just the cost of equity financing only = Cost of Equity
= Net Income - (capex - depreciation) - change in non-cash working capital) - (principal repaid - new debt issues) - preferred dividend
FCF Business
Pre-Debt = cashflows from assets, prior to debt payments, but after the firm has reinvested in growth assets.
Discount rate that reflects the composite cost of financing via debt and equity in proportion to their use = Cost of Capital
=EBIT (1-tax rate) - (capex - depreciation) - change in non-cash working capital
If negative, firm is raising fresh capital with the mix of debt and equity
LTM
last 10K - first 3 QTRs prior year + first 3 QTRs current year
Red Flags in Accounting
1) Income from unspecified sources
2) Income from asset sales or financial transactions for a non-financial firm
3) sudden changes in standard expense (SG&A or R&D)
4) Frequent restatements
How to Analyze Companies with Low Earnings
Factors:
1) temporary / cyclical industry
2) life cycle
> Normalize earnings by looking at Average Dollar earnings if size consistent
> Normalize earnings by looking at average ROE (valuing equity) or ROC (valuing firm)
3) leverage too much debt
> Normalize with DCF. If leverage, use industry average or its own optimal debt ratio. If structural, use operating margins of stable firms in the sector
4) long term operating problems (significant production or cost problems)
> Normalize with DCF. If operating use industry-average operating margin
Right Tax Rate to Use
Marginal tax rate for the country in which the company operates in safest
Characteristics of a Declining Company
1) Stagnant or declining revenue even when economy is normal
2) Shrinking or negative margins = negative operating income with occasional spikes from one-time asset sales. Existing assets earn less than the cost of capital
3) Big payouts = dividend or stock buy backs which then skews debt, equity and capital if not repaid proportionally, cost of debt may increase as default risk rises, ratings can drop to junk (BB or lower)
4) High Leverage = Liabilities carry high debt
