DCF Models

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Approaches to Valuation


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Approaches to ValuationValuation Models

Asset Based Valuation

Discounted Cashflow Models

Relative Valuation Contingent Claim Models

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capitalapproach

APVapproach

Excess ReturnModels

Stable

Two-stage

Three-stageor n-stage

Current

Normalized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option toliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Firm


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Valuation

Equity shareholders All stakeholders

Equity valuation Firm valuation


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Equity Valuation Models

Dividend discount modelFree cash flow to

equity model


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Equity Discounted Models

Dividend Discount Model(Actual Dividend Paid) Free Cash flow to Equity(Potential Dividend)

Single Stage Two Stage Three stage Single Stage Two Stage Three stag


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Dogs of Dow


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Dogs of Dow


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Dogs of Dow

• Buying the stocks with the highest dividend yield in the indexevery year

• CRISI and !laxoSmith"line have dou#led their dividend

rate in three years while maintaining a $ayout o% &' ( $lus


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imitations o% )*ogs o% *ow+

• But #uying stocks #ased only on their current dividend yield, without

looking into their #usiness $ros$ects, can #e %raught with risk

• Buying stocks $urely %or their current dividend yield can #ack%ire i% the

com$any ha$$ens to #e in a cyclical #usiness

• In A$ril -arun Shi$$ing. /ith a regular dividend $ayout o% Rs 0 $er share

on a market $rice o% Rs 0', *ividend yield 1 2' (

• Between 3''&4'5 and 3''642', the com$any7s dividend rate $lummeted

%rom 0' to 5 $er cent, as $ro%its dro$$ed #y 6' $er cent

• !E Shi$$ing, Excel Cro$ Care, 8rime Securities %alling victim to lower

dividend yield owing to the cyclical swings in their core #usiness

Buying stocks based on just their current dividend yield can be fraught with

risk. Focus on dividend potential instead


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• India Card Clothing

9 It was one o% the highest dividend yielding stocks in themarket %ive years ago, $aying out annual dividends o% 230

$er cent, translating into a yield o% nearly 5 $er cent in

3''&.

9 But the %luctuating %ortunes o% the textile industry have ledto high volatility in $ro%its o% this com$any too.

9 Its annual dividend $ayouts have declined %rom 230 $er

cent to :' $er cent over %ive years

9 India is today one o% the lowest dividend yielding marketsin the world. ;

$er cent?.

9 Average dividend $ayout ratios hover at 3> $er cent %or

=SE4listed com$anies.


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ingle tage Dividend Discount Model

! When should I use this model?

" #his $odel is applica%le when the dividend paid is &' or a%ove the Free cash flows to equity and theco$pany is in a sta%le growth category

! How do I find the value of the company under thismodel?

" #he value of the co$pany is calculated %y using*ordon Model of dividend policy

! What does Gordon odel say a!out the value of acompany? " +nder *ordon Model, the value of share depends on the

e-pected dividend and growth in dividend forever


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*ordon Model of Dividend Policy

"ost of #quity $alue of Share

%e & D'( ) g $alue of stoc* & D'%e + g


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What are the inputs required for this model?

! #,pected dividend

! "ost of equity

! Growth rate

! Dividend for the

ne,t year ! "-(

! Growth in dividendforever

$alue of stoc* & D'%e + g

. /asic Inputs 0equired for Gordon odel


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TH# F"F# Discount odels


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Selection of D"F odel


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Firm

everage is

constant

Equity valuation

model

Firm -aluation

model

es =

*D8 ratio is

more than

&0 (

yes =

*ividend *iscount

odel

Equity valuation

model

Single Stage,


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•


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! #he $odel is appropriate when

" the fir$ has to %e in steady state

" capital e-penditure is not significantly greater thandepreciation / capital e-penditure is offset %y depreciation

" the %eta of the stoc0 is close to one or %elow one

" #he fir$ FCFE which are significantly different fro$dividends or dividends are not relevant

" #he leverage is sta%le

#he constant growth FCFE Model


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Value of Equity

#he constant growth FCFE Model

Po = FCFE1 K e – g

Po = Value of stock today

FCFE1 = Expected FCFE over the next year

K e = cost of equity of the fir

g =gro!th rate


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Calculation of FCFE

Earnings $er share xxxxxxx

4 ; Ca$ital s$ending 4 de$reciation? x ;2 4 *e#t ratio? xxxxxxx

4 ; change in non cash working ca$ital? x ; 2 4 *e#t ratio? xxxxxxx

444444444444444444444444

Free Cash Flow to Equity xxxxxx

444444444444444444444444


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ow do you measure change in workingca$ital


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The "onstant Growth F"F# odel

In 3'': Indian il Cor$oration had earnings $er share o% Rs G'.>0 and $aid out dividends o% Rs 2: $er share.


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FCFE #wo stage $odel


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FCFE #wo tage Model

Ecola% 1nc sells che$icals and syste$s for cleaning, saniti2ing, and $aintenance 1t

reported earnings per share of 345' in 4674, and e-pected earnings growth of 7''a year fro$ 4675 to 467&, and 8 a year after that #he capital e-penditure per sharewas 344', and depreciation was 3774' per share in 4674 9oth are e-pected to growat the sa$e rate as earnings fro$ 4675 to 467& :or0ing capital is e-pected to re$ainat ' of revenues, and revenues which were 37,666 $illion in 4674 are e-pected toincrease 8 a year fro$ 4675 to 467&, and ; a year after that #he fir$ currently has

a de%t ratio (D/(D


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#"12-/ S123TI14

Growth rate & 5676 8 G70 & 9 8

:;5: :;5. :;5< :;56 :;59 :;5= :;5>

ear ; 5 : . < 6 9

EP

Cap-

Dep

Change in :C

FCFE

#er$inal price (Pn)

=et cash flows

4674 4675 467; 467' 4678 467& 467>

"alculation of change in wor*ing capital?evenue

:C

Change in :C

Change in :C per share


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4674 4675 467; 467' 4678 467& 467>

Calculation of change in wor0ing capital

?evenue 766666 768666 774586 77@764 7484;> 755>45 75@7&'

:C '666 '566 '87> '@'' 8574 88@7 8@'66

Change in :C 566 57> 55& 5'& 5&@ 48&

Change in :C per share 66' 66' 66' 668 668 66;4


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ECBA9 B+#1=

*rowth rate 7'' *? 8 4674 4675 467; 467' 4678 467& 467>

ear 6 7 4 5 ; ' 8

EP 45' 4&7 575 584 ;7> ;>5 '74

Cap- 44' 486 566 5;& ;66 ;84

Dep 774' 756 7'6 7&5 466 457

Change in :C 66' 66' 66' 668 668 66'

FCFE 785 7>@ 47@ 4'5 4@5 '6>

#er$inal price (Pn) >;&;

=et cash flows 785 7>@ 47@ 4'5 >&8&

Calculation of present value

ear cash flows PV 74 #cash flows

7 785 6>@5 7;8

4 7>@ 6&@& 7'7

5 47@ 6&74 7'8

; 4'5 685' 787

' >&8& 6'8& ;@&7

Value pershare ''>;


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FCFE ingle tage

olution

http://../CVMA%20Material/FCF%20format%20excell.xlshttp://../CVMA%20Material/FCF%20format%20excell.xls


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#wo tage FCFE Model

#h # t FCFE M d l


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#he #wo tage FCFE Model

!:hen to use this $odelG " #he two stage $odel is designed to value a

fir$ that is e-pected to grow $uch faster thana sta%le fir$ in the initial period and at a

sta%le rate after that

igh growth rate

Sta#le growth rate


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! #he $odel " #he value of any stoc0 is the present value

(PV) of the FCFE of each year for thee-traordinary growth period plus the PV of the

ter$inal price

#he #wo tage FCFE Model

igh growth rate

Sta#le growth rate

8- o% FCFE

8- o% terminal $rice


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Ecola%


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#hree stage FCFE Model

! :hat are the three stages of growth G

" .igh growth period

" #ransition period

" ta%le growth period


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"#$%E" &F %'&(#)

igh sta#le growth *eclining growth In%inite sta#le growth

ow $ayout ratioIncreasing $ay out

ow $ay out


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Fir$ Valuation Model


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Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:

Grows at constant rateforever

Terminal Value= FCFFn+1 /(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm

- Value of Debt= Value of Equity

Riskfree Rate:- No default risk- No reinvestment risk- In same currency andin same terms (real ornominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type ofBusiness

OperatingLeverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

VALUING A FIRM

DCF Models

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