Business Valuation

Introduction to Financial
methods
Discounted Cash Flow

Marco Vulpiani

"…What I have here in my heart is like faith, but not faith….

What I have here in this room is knowledge without proof…..
What I have here in my hand is like knowing but deeper
It's why I have faith…"
(Marillion, “Faith”)
Introduction to Financial methods
Introduction
Valuation is one of the most critical phases business decision processes
• In M&A projects the theoretical value of a firm is the parameter by which
different counterparties base their expectations.
− The final price may differ significantly from "stand alone" value
• The valuation process is more complex for Business in special situations.
• The following main valuation methods will be described in both theoretical and
practical terms:
− Financial methods;
− Market methods;
− Asset-based methods.
• Financial methods are mostly used from valuation professionals.

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Introduction to Financial methods
Introduction
International recognized valuation methods

Earnings/Cash flows Comparable transaction Assets

• Discounted cash flow • Quoted - Minorities • Replacement cost
• Multiple - Majorities • Neutral value
(i.e. EBIT, EBITDA, PE) • Non Quoted - Minorities • Costs of liquidation
• Dividend yields - Majorities

Valuation range

Investment Specified factors Sector and macroeconomics factors

• Nature (P.E., assets) • Market position • Market
• Size • Financial structure • Law and regulations
• Controlling/no controlling interest • Operative Efficiency • Economic Growth and Development
• Liquid assets • Management’s objective
• Potential Return

Factors that influence the valutation and the methodologies

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Introduction to Financial methods
The theoretical rationale
Fig. 1.1 – Value vs Cash Flow

• The value of a company on a given date can be represented by the cash flows that it will
produce during its future life, appropriately discounted to reflect time and risk factors.
− The chart (Copeland, Koller and Murrin, 1991) shows the correlation between firm
market value and cash flow for S&P 500 Index companies;
− For investors "Cash is King". Source: “Il Valore dell’Impresa” - T. Copeland-T. Koller - J. Murrin
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Introduction to Financial methods
The theoretical rationale
• The financial method is expressed in the formulation of value as the sum of a
firm's future cash flows, suitably discounted, for a hypothetically unlimited
duration:

CFt = Cash Flow in the period t

r = Discount rate reflecting the
risk and the time factor of the
estimated cash flows

• The discount rate takes into account the time value of money (the idea that
money available now is worth more than the same amount of money available in
the future because it could be earning interest) and the risk or uncertainty of the
anticipated future cash flows (which might be less than expected).

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Introduction to Financial methods
The theoretical rationale
• Due to the objective difficulty in predicting the temporal duration of the
enterprise, the idea of a company having a hypothetically unlimited duration is
generally considered acceptable:
− companies usually do have a long-term life expectancy,
− the effect of long-term cash flows has become negligible in recent years.
• For practical reasons the unlimited time period is divided, into two sub-periods

Explicit forecast period

N = Explicit forecast period

CFt = Cash Flow in the period t

r = Discount rate

Terminal Value

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Introduction to Financial methods
The theoretical rationale
Example of discounting of the future cash flows
Cash flow € 1,000 € 1,000 € 1,000 € 1,000 € 1,000

Year 0 1 2 3 4 5

€ 870

€ 756

€ 658

€ 572

€ 497

€ 3,352 PV @ Discount rate = 15%

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Introduction to Financial methods
The theoretical rationale
• The Terminal Value is estimated by using some simplifying assumptions.
• One of the most commonly adopted is the one expressed by the “Gordon
formula”, which assumes the stable growth of cash flows:

CF(n+1) = CFn * (1+g) Application of Gordon formula

N = Explicit forecast period

CFt = Cash Flow in the period t

r = Discount rate

CF = Normalised Cash Flow

g = Growth rate

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Introduction to Financial methods
The theoretical rationale
Cash Flows of the explicit forecast period Normalized Cash Flows

N = Explicit forecast period

CFt = Cash Flow in the period t

r = Discount rate

CF = Normalised Cash Flow

g = Growth rate

Flows value of the Terminal value

explicit period (estimated)
(calculated)

Discount rate Growth Rate

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Introduction to Financial methods
The theoretical rationale
• Under these conditions, within the scope of the general group of financial
methods, each specific valuation technique differs substantially in terms of the
object of valuation:
− equity (direct methods) or enterprise (indirect methods);
− cash flow, punctual or normalized;
− individual assumptions carried out when applying the method (discount rate,
taxes, etc.).

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Introduction to Financial methods
The theoretical rationale
• The main financial methods are DCF method (Myers, 1974) and the APV
method.
− Both methods are based on the conclusions of the theory developed by
Modigliani & Miller (1958-1963):
MM Proposition I

In a perfect capital market, the total value of a firm is equal to the

market value of the total cash flows generated by its assets and is
not affected by its choice of capital structure.

MM Proposition II

The cost of capital of levered equity increases with the firm's market
value debt-equity ratio.

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Introduction to Financial methods
The theoretical rationale
• If one does not take into consideration the simplified assumptions underlying
Modigliani & Miller's propositions, debt has three main effects on firm value:

Considered
− tax benefits associated with indebtedness (“tax shield”); in DCF and
APV method
− the cost of bankruptcy (or insolvency);
− the effect of “psychological tension” ("Equity is a pillow, debt a sword").

• The other two effects are usually neglected in the valuation phase and
considered only when specific circumstances arise.

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Introduction to Financial methods
Discounted Cash Flow Method
The firm value is the sum of future cash flows it will generate

Under these condition, Discounted

within the scope of the Cash Flow
Method
general group of financial
methods, each specific
valuation technique differs
Financial Adjusted
substantially in terms of: Net Income Present Value
Method Methods Method
• Object of valuation;
• Cash Flow;
• Individual Assumptions. Economic
Value Added
Method

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Introduction to Financial methods
Discounted Cash Flow Method

The discounted cash flow method, better known by the acronym DCF, is
the method based on the discounting of the available cash flows.

Explicit forecast period

N = Explicit forecast period
CFt = Cash Flow in the period t

r = Discount rate
CFn = Normalised Cash Flow
g = Growth rate
Terminal Value

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Introduction to Financial methods
Discounted Cash Flow Method

"Unlevered" The method is based on Cash Flows calculated assuming

Cash Flows the absence of debt ("unlevered"),
i.e. without the effect of leverage generated by debt.

Choice of method This method is typically applied in order to

determine the firm value as a whole

Present Value of Cash Flows

Application

Net Financial Position

Theoretical value of Economic Capital

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Introduction to Financial methods
Discounted Cash Flow Method

Expected Cash Flows

Discount rate
Key Inputs

Growth rate

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Introduction to Financial methods
Discounted Cash Flow Method
• Cash basis of accounting vs Accruals basis of accounting

• Cash flows are calculated gross of financial charges (Unlevered Cash Flow) i.e.
without the effect of leverage generated by debt

EBIT

(-) Figurative taxes

(=) NOPAT

(+) Depreciation & Amortisation net of the use of

provisions

(-) Increase/(decrease) in NWC

(-) Investment/(divestment) in fixed assets

= Unlevered Cash Flow
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Introduction to Financial methods
Discounted Cash Flow Method
• The discount rate represents the return required by those who are to finance the
enterprise in terms of equity capital and debt capital.
− It is calculated by applying the WACC formula (Weighted Average Cost of
Capital):
Ke = Cost of Equity
We = Weight of Equity
WACC = Ke * We + Kd * Wd * (1 - t) Kd = Cost of Debt
Wd = Weight of Debt
t = Tax rate

Application of CAPM formula

Rf = Risk-free rate
Ke = Rf + Betal * MRP Betal = Beta levered
MRP = Market Risk Premium

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Introduction to Financial methods
Discounted Cash Flow Method
• The formula most frequently used to calculate Terminal Value is the growing
perpetuity formula, which calculates the terminal value by assuming that the
value of the normalised cash flow will grow at a constant rate each year of its
residual life (“g” – growth rate).
EBIT

(-) Figurative taxes

(=) NOPAT

(+) Depreciation & Amortisation net of the

use of provisions

(-) Increase/(decrease) in NWC = 0 FCFn+1 = Normalised Cash Flow

representing the residual
(-) Investment/(divestment) in fixed life after the year n, the
assets = D&A last year of the explicit
forecast
= Normalized Free Cash Flow
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Introduction to Financial methods
Discounted Cash Flow Method
Free Cash Flow to Firm Approach (Enterprise Value)

N = Explicit forecast period

FCFFt = Free Cash Flows to Firm
TV = Terminal Value

• The total value of the Company ("Enterprise Value") is obtained discounting the
future cash flows “to the firm”, that are the residual cash flows after have paid
operating costs and taxes, but before interests and financial expenses (unlevered
cash flow), to the WACC.

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Introduction to Financial methods
Discounted Cash Flow Method
Free Cash Flow to Equity Approach (Equity Value)

N = Explicit forecast period

FCFEt = Free Cash Flows to Equity
TV = Terminal Value

• The value of Equity is obtained discounting the future cash flows “to equity”, that
are the residual cash flows after have paid operating costs, taxes and financial
expenses, to the Cost of Equity, which represents the return requested by the
shareholders.

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Introduction to Financial methods
Discounted Cash Flow Method

FCFF FCFE
Equity
Firm Net
Equity
Value Capital
Value
Employed
Net
Financial
Position

Net
- Financial =
Position

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Introduction to Financial methods
Discounted Cash Flow Method
• The Enterprise Value is determined by adding the Terminal Value to the
cumulated value of discounted cash flows estimated for the explicit forecast
period.
• The value of the Net Financial Position is then added (i.e. the debt is deducted
from or the cash is added) in order to determine the Equity Value.

Net
Terminal
Financial
Value Position
Enterprise
Value
FCFF Equity
Plan Value Value

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