Corporate Finance I

DCF Valuation

Ernst Maug
University of Mannheim
http://cf.bwl.uni-mannheim.de
maug@corporate-finance-mannheim.de
Tel: +49 (621) 181-1951
 Overview

→ Market value balance sheets

→ The dividend discount model
→ Simple discounting models:
- Perpetuity models
- Two-stage models
- Three-stage models
→ Why DCF?
→ DCF-WACC versus Flow to equity (FTE)

© 2021 Ernst Maug Corporate Finance I 2

 The objective of DCF valuation
Constructing a market value balance sheet

→ Construct a balance sheet:

- Use same principles as in financial accounting
- Assess all assets and liabilities at market values

Market value of existing assets Equity

Non-operating cash Pension obligations

Other non-operating assets Debt

NPV of future investments

© 2021 Ernst Maug Corporate Finance I 3

 DCF value of the company

→ DCF values operating assets of the company as

- present value of future cash flows from operations.
- Do not include other cash flows, e.g. interest earned on financial investments.
→ DCF does not separate assets in place from NPVs from future investments.
→ Value company as:
DCF-value of operating assets
+ market value of non-operating (financial) assets
+ non-operating cash

© 2021 Ernst Maug Corporate Finance I 4

 DCF value of equity

→ Value equity as:

value of the company
– market value of debt
– market value of pension obligations
– market value of other liabilities
→ This equals:
DCF value of operating assets
+ market value of non-operating assets (e.g., financial assets)
– net debt (= debt – cash)
– market value of pension obligations
– market value of other liabilities
→ Note: Taxes are not included
- already included in DCF-value of operating assets (accounts for taxes).
- otherwise included as separate asset (tax shield) and liabilities

© 2021 Ernst Maug Corporate Finance I 5

 Dividend discount model

→ Discount future expected payments with the appropriate discount rate:

E (D1) E (D2 ) E ( D3 ) E (Dt )

Equity 0 ...
(1 rE ) (1 rE ) 2 (1 rE )3 t 1 (1 rE ) t

Equity0 value of equity at time 0

Dt random dividend at time t
rE costs of equity
(return on an investment with similar risk)
P0 share price at time 0
N number of outstanding shares

→ Price of a single share: P0 = Equity0 /N.

© 2021 Ernst Maug Corporate Finance I 6

 Dividend discount model (2)

→ Market value of the firm: V0= Equity0 + Debt0

→ Value of debt can be calculated in the same way:

E ( interest t ( principal repayment )t )

Debt 0
t 1 (1 rD )t

→ Market value and book value of debt usually do not differ a lot:
- Approximate Debt0 by the book value of debt

© 2021 Ernst Maug Corporate Finance I 7

 Constant growth formula

2
E (D1) E (D1) 1 g E (D1) 1 g
Equity 0 ...
1 rE 1 rE 2
1 rE 3

E (D1) 1 g
D
rE g rE g 0

→ Notes on the application of this formula:

- g is the long-run growth rate.
▪ It cannot exceed the growth rate of the economy.
- This calculation can be done in real or nominal terms.
▪ r and g must both be either nominal or real (don’t mix!).
▪ D1 must be expressed in constant Euros (real) or in current Euros (nominal).

© 2021 Ernst Maug Corporate Finance I 8

 Modify the growth model

→ The formula for a T-year horizon can be written as:

t T E Dt E PT
P0 t 1 t T
1 rE 1 rE

→ Apply the growth model to the price in T:

E DT 1
PT
rE g

→ Then the current value of the share is:

t T E Dt 1 g E DT
P0 t 1
1 rE t
1 rE T rE g

© 2021 Ernst Maug Corporate Finance I 9

 Valuing a company: A primer
A two-stage model

→ Sometimes equity analysts have knowledge about the immediate, but not the
distant future:
- Dividend forecasts for immediate future (2-5 years)
- Assume constant growth for distant future (> 5 years)
- How do you apply the model now?

detailed planning: horizon:

year-by-year constant exponential growth
forecasts
Dividends

*
* *
*
*
Time
T
© 2021 Ernst Maug Corporate Finance I 10
 Discounting free cash flows

→ Discount free cash flows that are generated by the firm

- rather than payouts as in the dividend discount model.
→ Free cash flows differ from dividends:
- Firms retain and reinvest some of their cash flows.
▪ Generates higher cash flows in the future
→ Three versions of discounted (free) cash flows:
- DCF-WACC: unlevered (free) cash flows to the firm
- APV: levered (free) cash flows to the firm
- Flow To Equity (FTE): levered (free) cash flows to shareholders

© 2021 Ernst Maug Corporate Finance I 11

 → Free cash flows differ from earnings:
- Do not include:
▪ Depreciation or amortization of assets (add those back)
▪ Realized capital gains or losses
- Do subtract investments that are capitalized
→ Otherwise use same analytic approach as DDM:
- Discount FCF to all security holders to obtain value of the firm as a whole V0 (= debt +
equity)
t T FCFt 1 g FCFT
V0 t 1
1 r t
1 r Tr g

© 2021 Ernst Maug Corporate Finance I 12

 Valuing a company
A primer

→ Recall: The free cash flows to the unlevered firm are all cash flows the firm could
pay out if it had no debt.
- Combines cash flows to all security holders
- Does not include tax shields
- We refer to these shortly as free cash flows (unlevered) or FCFU:
→ Consider a company with cash flows from operations of €1 million for the most
recent year.
- The company’s cash flows are expected to grow at a rate of 20% for the next 5
years and at a constant rate of 5% thereafter.
- To generate this increase in cash flows, the company is required to reinvest 50% of
its cash flows for the first 5 years and 40% of its cash flows thereafter.
- Given the risk of the business, the required rate of return is 15%.
→ What is the value of the business?

© 2021 Ernst Maug Corporate Finance I 13

 A very simply DCF model

Period 1 2 3 4 5
EBITDA € 1.20 € 1.44 € 1.73 € 2.07 € 2.49
Investment € 0.60 € 0.72 € 0.86 € 1.04 € 1.24
Cash flow € 0.60 € 0.72 € 0.86 € 1.04 € 1.24
PV(FCF) (1-5) € 0.52 € 0.54 € 0.57 € 0.59 € 0.62

Present value = PV(FCF1 + ... + FCF5)

= € 0.52 + € 0.54 + € 0.57 + € 0.59 + € 0.62
= € 2.85
→ We use free cash flows (FCF) and company value (V)
→ Same as dividends (D) and value of equity (P)
- if company has no debt

For calculations see DCF Valuation.xls tab “Simple valuation model”.

© 2021 Ernst Maug Corporate Finance I 14

 A very simple DCF model (2)

→ Value of dividends over the first 5 years is € 2.85.

→ Value of business at the end of the 5th year:

FCF6 €2.49 1 0.4 1.05

V5 €15.68
rE g 0.15 0.05

→ Value of the business:

€15.68
V0 €2.85 €2.85 €7.79
1.155
€10.64

→ PV(years 1-5) = 27%, PV(years 6-) = 73%

- Most of the value comes from the distant future:
▪ Estimation problem!

© 2021 Ernst Maug Corporate Finance I 15

 A perpetuity model

→ Reconsider the example from lecture 2 (value drivers)

→ Assumptions and results:
- FCF2009: € 4.77
- Nominal growth rate: 4.55%
- Cost of capital (assumed): 7.00%
→ See spreadsheets on website:
- Value Drivers - PerpetuityModel.xls

FCF2009 €4.77
V2008 = = = €194.67
rU − G 0.07 − 0.0455

© 2021 Ernst Maug Corporate Finance I 16

 Three-stage models

→ Sometimes it is practical to extend the model to three stages:

- Detailed forecasts of cash flows, earnings, dividends for periods 1…T1
- Transition period where growth and margins from T1 to terminal values at T2
- Perpetuity model for periods after T2
→ Example:
- Growth from 2014 – 2019: 9%
- Growth from 2022 onwards: 3%
- Margin from 2014 – 2019: 20%
- Margin from 2022 onwards: 16%
- Interpolate values for 2020 and 2021:
▪ Growth is 7% (2020) and 5% (2021).
▪ Margin is 18.67% (2020) and 17.33% (2021).
→ Mechanics same as before, see spreadsheet „DCF Valuation -
ThreeStageModel.xls“

© 2021 Ernst Maug Corporate Finance I 17

 Why DCF?

→ We have used the general formula:

FCFt FCFt VT
V0 =  t =1 =  t =1
t = t =T
+
(1 + r ) (1 + r ) (1 + r )
t t T

→ Why is this formula right?

→ Investors compare:
- Price of the company (buy liabilities combined) V0
- Value of expected future cash flows FCF1, FCF2,...,FCFT,...
→ Consider strategy of a typical private equity investor:
- Buy company for some price X today, sell it after T years
- Compare this with an alternative investment that generates a return r

© 2021 Ernst Maug Corporate Finance I 18

 Why DCF?
Strategy 1: Buy company, sell after T years

→ Buy company, sell after T years:

- What is the portfolio worth in year T?
- Invest cash flow in year 1 for T-1 years at rate r:

= FCF1 (1 + r )
T −1

- Invest cash flow in year 2 for T-2 years at rate r:

+ FCF2 (1 + r )
T −2

- Continue until year T, then receive cash flow in year T, sell company:

... + FCFt (1 + r )
T −t
+ ... + FCFT + VT
- Account balance after T years:

= VT +  t =1 FCFt (1 + r )
T T −t

© 2021 Ernst Maug Corporate Finance I 19

 Why DCF?
Strategy 2: Invest in securities with the same risk

→ Invest price X0 in investment with expected return r

- What is this alternative portfolio worth in year T?

= X 0 (1 + r )
T

→ In a functioning asset market, both values have to be the same:

- As funds are always invested in assets with the same risk
- they should have the same return.
→ Set both equal:

X 0 (1 + r ) = VT +  t =1 FCFt (1 + r )
T T T −t

→ Then the result for X0 is:

X 0 = VT (1 + r ) +  t =1 FCFt (1 + r )
−T T −t

→ ...which is just the DCF-formula with X0 = V0!

© 2021 Ernst Maug Corporate Finance I 20

 A variant of DCF: Flow to equity

→ Recall: Flows to equity (FTE) are free cash flows that accrue to equity holders.
CFE = Free cash flow to the levered firm
+ Payments by debtholders to the firm (issues)
- Payments from the firm to debtholders (interest + principal)

→ These are discounted with the costs of equity, re:

E CFEt
Equity 0 t
t 1 (1 rE )

→ Get firm value as V0 = Equity0 + Debt0

→ Looks much easier than DCF-WACC
- but there are hidden problems...

© 2021 Ernst Maug Corporate Finance I 21

 FTE versus DCF-WACC (1)
An example

→ Assume that
- EBIT = 100 (million €)
- depreciation equals capital expenditure
- no working capital investment
- no capital gains or losses
- no taxes, no tax shields
- → FCFU = 100 (million €)
- debt is 266.7 (million €)
- rE = 20% and rD = 7.5%
- all these numbers are constant for all future years

For calculations see DCF Valuation.xls, tab “Flow to equity”.

© 2021 Ernst Maug Corporate Finance I 22

 FTE versus DCF-WACC (2)
An example

→ Use DCF with pre-tax weighted average cost of capital :

- Start the calculation by assuming that leverage is 40%
- Unlevered cash flow is 100.
- rOA = 40%  7.5% + 60%  20% = 15%

FCFU 100
V0 666.7
rOA 0.15
- Equity0 = 60%  666.7 = 400
- Debt0 = 40%  666.7 = 266.7
▪ So leverage of 40% is correct.

© 2021 Ernst Maug Corporate Finance I 23

 FTE versus DCF-WACC (3)
An example

→ Use Flow To Equity (FTE):

- Levered cash-flow is 100 – 7.5%  266.7 = 80
CFE 80
Equity 0 400
rE 0.2
V0 = Equity0 + Debt0 = 400 + 266.7 = 666.7

- Both approaches arrive at the same result.

© 2021 Ernst Maug Corporate Finance I 24

 FTE versus DCF-WACC (4)
An example

→ New assumption:
- EBIT grows with 2% per year.
- Leverage remains constant.
→ Use DCF with pre-tax weighted average cost of capital:
- Assume that leverage is 36%
- rOA = 36%  7.5% + 64%  20% = 15.5%.

FCFU 100
V0 740.7
rOA g 0.155 0.02
- Debt0 = 36%  740.74 = 266.7
▪ So leverage of 36% is correct.

© 2021 Ernst Maug Corporate Finance I 25

 FTE versus DCF-WACC (5)
An example

→ Use FTE:
- Levered cash-flow is 100 – 7.5%  266.7 = 80

E CFE 80
Equity 0 444.4
rE g 0.2 0.02
V0 = Equity0 + Debt0 = 444.4 + 266.7 = 711.1

→ Why do the two methods yield different results under identical assumptions?
- Flow to equity used incorrectly here!
- Does not take into account that equityholders receive cash from debtholders as
value grows with constant leverage.

© 2021 Ernst Maug Corporate Finance I 26

 FTE versus DCF-WACC (6)
An example

→ Use FTE correctly:

- Levered cash flow: 100 – 7.5%  266.7 + 2%  266.7 = 85.33

E CFE 85.33
Equity 0 474
rE g 0.2 0.02
V0 = Equity0 + Debt0 = 474 + 266.7 = 740.7

→ Consistent forecasts are easier for unlevered cash flows.

→ DCF-WACC is easier to apply than FTE.

© 2021 Ernst Maug Corporate Finance I 27

 DDM and payout policy

→ We have two models for the value of equity:

→ The dividend discount model:

E ( Dt )
Equity 0
t 1 (1 rE )t

→ The (cash) flow to equity model:

E (CFE t )
Equity 0
t 1 (1 rE )t

© 2021 Ernst Maug Corporate Finance I 28

 Modigliani-Miller dividend irrelevance

→ They are consistent only if:

E ( Dt CFE t )
0
t 1 (1 rE )t

→ This does not imply that Dt=CFEt.

- Equivalence is in expected present value terms.
→ If the firm pays out the present value of future cash flows, then payout policy is
irrelevant.
- Example 1: put retained cash flows into financial securities and other zero-NPV
investments:
▪ Value of firm increases by NPV of financial investments = 0.
▪ Cash flow valuation and dividend valuation are the same.
- Example 2: borrow against future cash flows to pay dividends today:
▪ Borrowing is also a zero-NPV transaction.

© 2021 Ernst Maug Corporate Finance I 29

 Conclusion

→ The value of a company‘s equity is the present discounted value of all future
dividends
- even if shareholders have short investment horizons.
→ The value of an (unlevered) company can be expressed as
- the present discounted value of all future free cash flows.
→ Flow to equity is equivalent
- if applied correctly.
→ Open Questions:
- What do you do if the tax system discriminates between dividends and interest
payments?
- How do you account for leverage?

© 2021 Ernst Maug Corporate Finance I 30