IMPORTANT INPUTS FOR THE DISCOUNTED CASH FLOW
1. Cash flows
1. Cash flows: –
Cash Flow (CF) represents the net cash payments an investor receives in a given period for owning a given security (bonds, shares, etc.). When building a financial model of a company, the CF is typically what’s known as unlevered free cash flow. When valuing a bond, the CF would be interest and or principal payments.
- In most cases, the projections shall comprise the statement of profit & loss, balance sheet, cash flow statement, along with the underlying key assumptions. However, in certain cases, if balance sheet and cash flow statement are not available, details of future capital expenditure and working capital requirements may also suffice.
- The projections reflect the accrual based accounting income and expenses. For arriving at the cash flows, non-cash expenses, such as depreciation and amortisation, shall be added back. Further, cash outflows relating to capital expenditure and incremental working capital requirements, if any shall be deducted.
- Generally, historical financial statements are used as the base for preparation of projections. If in future, changes in circumstances are anticipated the assumptions underlying the projections shall reflect differences on account of such differences vis-à-vis the historical financial statements.
- The length of the period of projections (explicit forecast period) shall be determined based on the following factors:
- Nature of the asset- where the business is of cyclical nature, explicit forecast period should ordinarily consider one entire cycle (for example cement business).
- Life of the asset- In case of asset with definite life, explicit period should be for the entire life of the asset (for example, debt instruments, Build Operate Transfer (BOT) road projects).
- Sufficient period- The forecast period should have a length of time that is sufficient for the asset to achieve stable levels of operating performance.
- Reliable data- The data that are used for projecting the cash flows, should be reliable.
5. The following are the cash flows which are used for the projections:
- Free Cash Flows to Firm (FCFF): FCFF refers to cash flows that are available to all the providers of capital, i.e. equity shareholders, preference shareholders and lenders. Therefore, cash flows required to service lenders and preference shareholders such as interest, dividend, repayment of principal amount and even additional fund raising are not considered in the calculation of FCFF.
- Free Cash Flows to Equity (FCFE): FCFE refers to cash flows available to equity shareholders and therefore, cash flows after interest, dividend to preference shareholders, principal repayment and additional funds raised from lenders / preference shareholders are considered.
2. Discount rate: –
The discount rate is the interest rate charged to commercial banks and other financial institutions for short-term loans they take from the Federal Reserve Bank.The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The term discount rate can refer to either the interest rate that the Federal Reserve charges banks for short-term loans or the rate used to discount future cash flows in discounted cash flow (DCF) analysis.
- Discount Rate is the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.
- Different methods are used for determining the discount rate. The most commonly used methods are as follows:
- Capital Asset Pricing Model (CAPM) for determining the cost of equity.
- Weighted Average Cost of Capital (WACC) is the combination of cost of equity and cost of debt weighted for their relative funding in the asset.
- Build-up method (generally used only in absence of market inputs).
- A valuer may consider the following factors while determining the discount rate:
- cash flows used for the projections as FCFE needs to be discounted by Cost of Equity whereas FCFF to be discounted using WACC;
- pre-tax cash flows need to be discounted by pre-tax discount rate and post-tax cash flows to be discounted by post-tax discount rate.
3. Terminal value
Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value. Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the financial model, as it typically makes up a large percentage of the total value of a business.
- Terminal value represents the present value at the end of explicit forecast period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.
- In case of assets having indefinite or very long useful life, it is not practical to project the cash flows for such indefinite or long periods. Therefore, the valuer needs to determine the terminal value to capture the value of the asset at the end of explicit forecast period.
- There are different methods for estimating the terminal value. The commonly used methods are:
- Gordon (Constant) Growth Model: The terminal value under this method is computed by dividing the perpetuity maintainable cash flows with the discount rate as reduced by the stable growth rate. The estimation of stable growth rate is of great significance because even a minor change in stable growth rate can have an impact on the terminal value and the value of the asset too.
- Variable Growth Model: The Constant Growth Model assumes that the asset grows (or declines) at a constant rate beyond the explicit forecast period whereas the Variable Growth Model assumes that the asset grows (or declines) at variable rate beyond the explicit forecast period.
- Exit Multiple: The estimation of terminal value under this method involves application of a market-evidence based capitalisation factor or a market multiple (for example, Enterprise Value (EV) / Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA), EV / Sales) to the perpetuity earnings / income.
- Salvage / Liquidation value: In some cases, such as mine or oil fields, the terminal value has limited or no relationship with the cash flows projected for the explicit forecast period. For such assets, the terminal value is calculated as the salvage or realisable value less costs to be incurred for disposing of such asset.