Venture Valuation: DCF Method Flashcards
What are the three principals of present value calculation?
- value = cash
- time value of money
- risk value of money
What is the idea of the forecast approach vs the terminal value approach?
Forecast approach:
- forecast CF as far as possible
- disregard subsequent CF
Terminal value approach:
Split into two periods:
- explicit forecast of yearly CF
- terminal value: perpetuity assumption
What are the two options for calculating the terminal value?
Option 1: no growth assumed:
PV_0 = CF / r // CF = constant cash flow, r = discount rate
Option 2: growth assumed (Gordon Growth Formula)
PV_0 = CF_1 / (r - g) // CF_1 = CF_0 * (1+g), r = discount rate, g = growth rate, it must hold: g > r
List the steps to calculate the cash flow to equity holders and the byproducts that occur
- Calculate Operating profit (EBIT = earnings before interest and taxes)
Operating cash inflow - Operating cash outflow:
Sales
- cost of goods sold
- depreciation expense
- amortization expense
- selling, general and administrative (SG & A) expenses
- other operating expenses - Calculate Working Capital
current assets - current liabilities = working capital - Calculate Free cash flow
EBIT
- taxes on EBIT
+ depreciation
+ amortisation
-/+ increase / decrease of working capital
- CAPEX (change in fixed assets + depreciation) - Cash flow to debt holders
Interest payments
+ Debt payments
- New debt issued
Tax deductability of interest: Interest payments are tax deductable!
5. Cash flow to equity holders Free cash flow \+ tax shield - cash flow to debt holders // tax shield = Interest paid to debt holders * income tax
Name 3 ways to estimate the discount rate
- Cost of capital: used in DCF methods
- IRR of alternative investments: equivalence principle
- Hurdle rate of return: venture capital method
What two forms of capital are there and how is their cost typically estimated?
- Cost of equity: estimated using a proxy for the market premium, most often: CAPM (Capital asset pricing model)
- Cost of debt: average market cost of debt, average market interest rate
How does CAPM work?
Estimates opportunity costs of equity based on:
- risk free rate
- stock market risk premium
- company risk premium
Formula:
r_equity = r_f + (r_m - r_f) * ß
// r_equity = market determined opportunity cost of equity
r_f = risk free interest rate
r_m = return of market index (market portfolio)
ß = risk factor measuring relation of market risk to equity risk
How are the parameters of CAPM estimated?
r_f: rate of return of government bonds, historical data
r_m: average annual performance of market index
ß: published estimates, average ß of peer group
How can we calculate a betas based on a peer group?
Params: ß_u: unlevered beta factor ß_l: levered beta factor s = tax rate D = debt E = equity
- Calculate unlevered beta of comparable companies
ß_u = ß_l / (1 + (1-s)*(D/E)) - Calculate average of unlevered betas
ß_cc,u - Calculate the levered beta of the target company
ß_tc,l = ß_cc,u*(1+(1-s)(D_tc / E_tc))
Name the different DCF models
Gross approach:
- Weighted Average Cost of Capital (WACC) model
- Adjusted present value (APV) model
Net approach:
- Equity model
How does the Equity DCF model work?
Basic idea:
equity value = cash flow to equity holders over time discounted with cost of equity
Formula: PV_equity = PV_explicit forecast period + PV_terminal value Needed params: n end of explicit forecast period r_equity cost of equity CFTE cash flow to equity holders g growth rate
How does the WACC DCF model work?
Basic idea:
present company value = free cash flow over time discounted by WACC
present debt value = cash flow to debt holders over time discounted by cost of debt
present equity value = present company value - present debt value
Formula:
PV_enterprise = /* present value calculation using free cash flow and WACC as discount rate /
PV_debt = / present net financial liabilities as stated in the balance sheet */
PV_equity = PV_enterprise - PV_debt
WACC = r_debt * (1-s) * debt ratio + r_equity * equity ratio
// s: marginal tax rate
Steps to apply WACC:
- calculate cost of equity for firm
- calculate cost of debt for form
- calculate WACC
- calculate PV_equity
How can a multi-business company be evaluated?
+ added value of operating units
+ corporate cash in
- corporate cash out
= enterprise value = debt value + equity value
What are the differences between Equity and WACC DCF model?
Cash flow stream
Equity: cash flow to equity holders
WACC: free cash flow
Discount rate
Equity: cost of equity
WACC: weighted average cost of capital
Estimation of PV_equity
Equity: direct
WACC: indirect (PV_equity = PV_enterprise - PV_debt)
How can we evaluate DCF valuation in regards to the general requirements of venture valuation mechanisms?
Forward looking:
+ discount of future cash flow streams
- unutilized assets not considered
Realistic portrayal: \+ Intangibles integrated in forecast of cash flows - Intangibles difficult to quantify \+ Risk can be taken into account - only negative view of risk - not flexible
Practicability:
- Forecast problems
+ relatively low complexity, high transparency
Acceptance:
+ widely used
