Session 3&4 Intro to DCF Flashcards
What is the structure by which we arrive to the transaction price used in M&A deals?
What are the two “sides” of a valuation
- Asset-side valuation (Enterprise Value)
* From enterprise value
* to Cash flow generated by operating activities
* to Asset value
* Minus the Market Value of Net Financial Debts - Equity-side
* From Equity
* to Cash flow to equity holder
* to Equity value
Both methods lead to equity value in the end
What is the bridge between enterprise and equity value?
Enterprise Value
(-) Net financial debt = Financial debt - cash & equivalents
* It is common practice to use book value of debt when compting the net debt of the company
* However, think about market value of debt when applicable, if all or part of debt is listed or traded over the counter or by discounting future debt flows at market cost of debt
(-) Pension provisions = (Projected Benefit Obligation - Fair Value of plan Assets) x (1 - Tax rate)
* For Defind Benefit regimes only
(-) Other debt-like items = Debt-like provisions x (1- Tax rate)
(+) Non-operating Assets
* Include financial stakes in associates, financial stakes in JVs (if not related to the Company’s business and not in cash flows), other non-operational financial assets, other non-operating assets (land, buildings)
(-) Minority Interests
* Minority interests may be valued at fair value, at least by applying a P/B ratio to the Equity Value of the company, or at book value
Equity Value
When do we use Equity-side Valuation in DCF?
- For firms which have stable leverage, whether high or not
- If equity (stock) is being valued
When do we use Asset Valuation in DCF?
- For firms which have leverage which is too high or too low, and expect to change the leverage over time, because debt payments and issues do not have to be factored in the cash flows
- Where you are more interested in valuing the firm than the equity
What is the general DCF formula?
What are the three primary categories within the DCF approach and what makes them different?
- FCFO (Free Cash Flow from Operations)
* Discounted at WACC
* Result in EV
*Considered Asset-side Valuation - FCFE (Free Cash Flow to Equity)
* Discounted at Ke (cost of equity)
* Result in Equity Value
* Considered Equity-side valuation - Dividend (Dividend Discount Model)
* Discounted at Ke (calculation may slightly differ from previous case)
* Result in Equity Value
* Considered Equity-side valuation
What is the main formula for the DDM (dividend discount model) approach?
The model starts from a simple expectation of an investor. In particular, for investors with a 1 year horizon the cash flows of a stock are:
* Expected dividends (if paid by the company)
* Expected price at the end of the holding period. Price itself can be seen as a function of future expected dividends in perpetuity.
What is the main formula for the Gordon Model (a derivative of the dividend discount model) approach?
The Gordon model can be used to value a “steady state” firm with dividend growing at rate that can be sustained forever.
Limitations: it is extremely (exponentially) sensitive to assumptions about “g”.
DDM Model works best for:
1. Firms growing at a rate less than or equal to the nominal growth rate in the economy
2. Firms with well-established dividend pay-out policies that they intend to continue in the future
How do we account for stock buybacks in the dividend discount model?
- Over time, firms have increasingly turned stock buybacks as a way of returning cash to stockholders (also for taxation
of capital gain lower than dividends). - In using DDM, if we focus only on dividends we may miss an important portion of cash returnd to stockholders
through share repurchases. We need thus to estimate an augumented dividend pay-out ratio
How do we account for cases where debt issuance was used to finance share buybacks when considering the dividend discount model?
If share buybacks have been financed by debt issuance to increase the financial leverage, the **modified augumented
dividend pay-out ratio is:
How to decide whether firms are returning too much or too little to their stockholders?
FCFE: Free Cash Flow to Equity
Measure how much cash is available to be paid out to stockholders after meeting reinvestment needs
What are the underlying principles and consequences of the FCFE model?
Principles:
* With FCFE model we discount potential dividends rather than actual dividends (as done with the traditional DDM). →
FCFE models are simple variant on DDM models, with one significant change the FCFE replace dividends.
Consequences:
* Cash. no future cash build-up since the available cash after debt payments and reinvestment needs is assumed to be
paid out to stockholders each period.
* Growth. Expected growth in FCFE will include growth in income from operating assets.
What is the main formula for the FCFE approach to valuation?
Limitations: it is extremely (exponentially) sensitive to assumptions about “g”
Firms model works best for: (i) firm growing at a rate comparable to or lower than the nominal growth in the
economy; (ii) it is better than DDM for stable firms that pay out dividends that are unsustainably high or are
significantly lower than the FCFE.
What is the main formula for the FCFO approach to valuation if the company is expected to reach steady state at a certain point in the future?
What is the main formula for the FCFO approach for a stable company?
What is the process behind using historical growth for estimating valuation growth rates, as well as the potential pitfalls of the method?
What is the process behind using analysts’ estimates for growth for estimating valuation growth rates, as well as the benefits of the method?
What is the process behind using analysts’ estimates for growth for estimating valuation growth rates, as well as the benefits of the method?
