Chapter 4 DCF
Chapter 4 DCF
1
7.32 5−1
𝑔={ } − 1 𝑥 100%
5.00
g = (1.10 – 1) x 100%
g = 10%
TERMINAL VALUE – BASIS OF TERMINAL VALUE
2. Estimated Perpetual Value
Since the growth rate is 10%, it will be applied on the
farthest cash flows i.e. on the 5th year equivalent to
Php7.32, thus the farthest cash flows is now Php8.05 or
will substitute the CFn+1. It is now assumed that the cash
flows will continuously growth at the rate of 10% per
annum. Thus, the formula can now be applied (on the
next slide).
TERMINAL VALUE – BASIS OF TERMINAL
VALUE
2. Estimated Perpetual Value 𝐶𝐹
𝑛+1
TV =
𝑟 −𝑔
𝑃ℎ𝑝 8.05
TV =
15%
𝑃ℎ𝑝− 10%
8.05
TV =
5%
TV = Php161
TERMINAL VALUE – BASIS OF TERMINAL VALUE
2. Estimated Perpetual Value
In some cases, that the historical growth pattern is
undetermined, some analysts only consider the cost of
capital or their required return to determine the terminal
value. In the given illustration , you may note that
difference on the terminal value: (on the next slide)
TERMINAL VALUE – BASIS OF
TERMINAL VALUE
2. Estimated Perpetual Value
𝐶𝐹𝑛+1
TV =
𝑟 −𝑔
𝑃ℎ𝑝 8.05
TV =
15% − 0%
𝑃ℎ𝑝 8.05
TV =
15%
TV = Php53.66
You may observe that the terminal value in this case is more
conservative by about Php107.
TERMINAL VALUE – BASIS OF TERMINAL VALUE
3. Constant Growth
Challenges for some valuators is to determine that
amount of required return for a specific type of asset or
investment. In lieu of the required return, they use the
growth rate as the proxy especially if the growth is
constant and significant.
TERMINAL VALUE – BASIS OF TERMINAL VALUE
4. Scientific Estimates
Other valuators especially those with vast experience
already in some types of investments uses other basis for
them to determine the reasonable terminal value. Using
guesstimates is not prevented because in the end, equity
values will still be based on negotiation.
TERMINAL VALUE – BASIS OF TERMINAL VALUE
There is no perfect approach to determine the terminal
value. Actually, some risk averse investors don’t consider the
terminal value in their value. The differences in their
appreciation on the determination or even the inclusion of
the terminal value is dependent on their risk appetite. Then
again, the valuation method will only serve as a reference to
determine the reasonable value for the equity or the asset
being purchased. This is why negotiation plays a key role in
finalizing the determined value.
OTHER INPUTS IN THE NET CASH FLOWS
The present value of the Net Cash Flows represents the
value of the assets. It may be recalled further that the assets
are financed by debt and equity. Hence, these are the claims
which are presented at the right side of the Statement of
Financial Position, under an account form of reporting.
OTHER INPUTS IN THE NET CASH FLOWS
The discounted cash flows analysis factors in all the
projected stream of cash flows that the project, opportunity
or investment and valuing it in present time to determine
whether the investment made on this year would be less
than the value it will generate in the future, that means the
investment yielded an amount sufficient to cover the
investment and allowing the investors to earn more. Same
principle applies that the best opportunity is the one that
will yield the highest present value or solely if the
opportunity will result into a positive amount it should be
accepted.
OTHER INPUTS IN THE NET CASH
FLOWS
Conservatively, the total outstanding liabilities mustbe
considered and deducted versus the asset value
determine the amount appropriated to theto equity
shareholders. This is called the equity value. The
opportunity that will result in the highest equity value is
considered.
OTHER INPUTS IN THE NET CASH FLOWS
DCF Analysis is most applicable to use when the
following are available:
• Validated Operational and Financial Information
• Reasonable appropriated cost of capital or required rate of
return
• New quantifiable information
ILLUSTRATIVE EXAMPLE NO. 1
Bagets Corporation has projected to generate revenues,
cash operating expenses, and the corresponding tax
payments for the next five years:
Revenue Cash Operating Taxes Working Capital
Expenses Adjustments
1 92.88 65.02 45.57 18.58
2 97.52 68.26 48.23 19.50
3 102.40 71.68 51.04 20.48
4 107.52 75.26 54.01 21.50
5 112.90 79.03 57.15 22.58
ILLUSTRATIVE EXAMPLE NO. 1
The investment in fixed capital that was purchased and invested
in the company amounted to Php100 Million. To be financed by:
• 60% from loan borrowing with an annual interest of
10%
payable equally in five years. First payment will be due after 1
year; and
•If 10%
youpreferred shares
are going to with 8% coupon
purchase 50% rate.
of Bagets Corporation,
assuming 15% required return, how much would you be willing
to pay?
Based on the foregoing information, the value of Bagets
Corporation equity is Php22.90 Million. If the amount at stake is
only 50% then the amount to be paid is Php11.45 Million
(Php22.90x 50%)
ILLUSTRATIVE EXAMPLE NO. 1
Bagets Corporation
Discounted Cash Flows Analysis
ILLUSTRATIVE EXAMPLE NO. 1
Notes to Analysis
/1 Terminal Value Calculation
𝐶𝐹𝑛+1 45.86 𝑥 (1+5%) 48.15
TV = = = = Php
481.50
𝑟 −𝑔 15% −5% 10%
/2 Proceeds from Borrowings and Debt Service
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
Financial Modeling is a sophisticated and confidential
activity in a company or for an analyst. Information is can
also be considered as competitive advantage of a company
or a person. Most of the companies hire financial modelers
to assist them in determining the value of GCBOs or other
opportunities. They also ask them to validate ballpark
estimates and may also be used to determine impairments.
Most financial modelers have extensive financial acumen
and vast knowledge and experience.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
Financial modelers normally are economists, financial
managers, and accountants. Management accountants are
good candidate for this role given their ability to understand
operational models and design long term financial
strategies.
In order to develop financial models, the following steps
needs to be observed: (in the next following slides)
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Historical information must be made available before the
financial model is to be constructed. Historical information
may be generated from, but not limited to the following:
audited financial statements, corporate disclosures,
contracts, and peer information.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Audited Financial Statements are the most ideal reference for the
historical performance of the company. The components of the
Audited Financial Statements enable the analyst or the financial
modeler to assess the future of the company based on its past
performance. Statement of Income are used to determine the
historical financial performance, Statement of Financial Position is
used to determine the book value of the assets and the disclosed
stakes of the debt and equity financiers, Statement of Cash Flows
illustrate how the company historically financing its operations
and investments.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Statement of Changes in Stockholder’s Equity provides the
information on how much is the claim and dividend background
of the company. One of the most important components of the
financial statements are the Notes to the Financial Statements. It
provides the summary of important disclosure that should be
considered in the valuation. The financial modeler must be able
to quantify these disclosures and more importantly the risks
involved.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Corporate disclosures are also key in developing the
financial model. Corporate disclosures provide more context
for the future plans and strategies of the company. This will
enable the analysts or the financial modelers to identify the
risks about the GCBO and quantify them accordingly. Since
these are available to the public, it is the same information
that is known to others.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Contracts are formal agreements between parties. In valuing
the GCBOs, it is important for modeler to also know the
existing contracts and the covenants contained in it. Large
accounting firms offer transaction advisory services to assist
their clients who enter into new ventures. Due diligence is
necessary to verify any contingent liability and other legal
risks surrounding that opportunity and quantify it
accordingly to have a more conservative value.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Peer information and other public information are also
essential inputs to the financial model. Peer information
provides more context and even supports the risks identified
or will be assumed in the valuation process. Peers may be
other analysts, industry experts and other consultants.
Internal members of the organization may also be
considered as peers.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
1. Gather historical information and references
Collectively, the financial model must be able to filter the
information that would be necessary for the valuation.
Relevance and reliability of information are important. Not
all information should be given consideration.
Materiality is another consideration. Even if there are
additional information gathered, there should be a sense of
materiality assessment involved. Note that projections
remain to be estimates. Therefore, only relevant items
should be considered in the valuation.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
Once all relevant information was gathered and validated,
drivers and assumptions can be established by conducting
financial analysis. Drivers are suggested to be those validated
and is represented by authorities like government or experts.
Growth drivers are normally based on population, since most
of the businesses are consumer goods. If services, industry
growth may be used as a driver. In the Philippines, information
is available from the Philippine Statistics Authority.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
For other economic factors, drivers, and estimates, Bangko
Sentral ng Pilipinas and National Economic and
Development Authority are also other agencies that can be
relied with. Certain statistical information can also be found
from the websites or research centers of the Local
Government Units and National Government Agencies.
Research organizations may also be used, however, strong
validation and evaluation needs to be done to isolate any
form of biases that may affect value.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
2. Establish drivers for growth and assumptions
The usual growth indicators used are: inflation, population
growth, GNP or GDP growth. In economics, the inflation is the
result of the movement of prices from a year to another. This is
calculated by comparing the movement of the price of the
basket of commodities from a year to another or a period to
another. Inflation is computed using this formula:
𝐶𝑃𝐼𝑛
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = − 1 𝑥 100%
𝐶𝑃𝐼𝑜
CPIn = consumer price index – current year
CPIo = consumer price index – base year
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
The consumer price index represents the price of the basket
of commodities for a particular period. In financial
modelling, you need the inflation to be used as driver for
certain operating and capital expenditures. There are two
ways to calculate the value: (1) nominal and (2) real.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
Nominal financial models are already in current prices,
meaning, the prices stated in the model already assumes
that the prices grew or decline, in the case of inflation or
deflation respectively. Some uses the headline inflation to
determine the current price. Real financial model, on the
other hand, does not include the effect of changes in prices,
but rather preserve the price of operating expenses and
capital expenditures, as if no changes in prices occur. If the
financial model is in real prices, the cost of capital should
also excludes the effect of inflation.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
2. Establish drivers for growth and assumptions
With the given equation, to illustrate, that in year 2019 the CPI is
151 meaning the cost of the basket is Php151. In year 2020, the
CPI published is Php155. Obviously, the price of the basket grew,
hence, inflation is expected to be 2.64% [(155/151)-1 x 100%].
On the other hand, if the CPI published for 2020 is Php 149, then
it will be a deflation or decrease in prices at 1.32% [(149/151)-1
x 100%].
To illustrate its application, supposed you are projecting for how
much is the communication costs for 2021 when the cost
in
2020 is Php5 Million. Given the calculated inflation of 2.64%, the
communication costs to be incorporated in the financial model is
Php5.132 Million.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
2. Establish drivers for growth and assumptions
Other indicator is population growth rate. Population growth
rate is factored in to serve as a growth driver for the demand of
the product, particularly for the merchandising or manufacturing
business. The services sector may use the growth rate in the
businesses or the industry or sector that they are going to serve.
The formula to calculate for the population growth rate is similar
with the inflation, except that the input is the population count
of a particular segment in a particular year. To illustrate, suppose
that in Barangay A in 2019 the population is 25,200. The survey
is conducted in 2020 and the population is 26,460.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
Using the formula of inflation to calculate for
population growth rate:
26,460
𝑔= − 1 𝑥 100%
25,200
𝑔 = 5%
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
To illustrate the application, assuming that the estimated
consumption of pan de sal in Barangay A is 5 pcs average per
head. If you are going to project the number of pande sal to
be sold in 2021, it will be 138,915 units computed as
follows:
Current pan de sal sold (26,460 x 5) 132,300
Increase in pan de sal (26,460 x 5% x 5)
6,615
Total estimated pan de sal 138,915
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
Financial ratios may be used as tools to determine the
growth drivers and assumptions. Trend analysis will also
help you establish the trajectory of growth pattern. The
financial modeler must assess whether the company can
sustain the pattern otherwise it is conservative to assume a
less aggressive growth. Normally the weighted growth
pattern will be consideredin the long-term financial
perspective. It must be assessed whether the average year
on year growth will be sustained or may be surpassed.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
To illustrate, PUP Company’s historical production grows
10% per year. It is expected that in the next five years the
probability are as follows:
Scenario Rate Probability
A 5% 10%
B 10% 40%
C 15% 50%
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
With the given information, the weighted average
growth rate to be used is 12% computed as follows:
Scenario Rate Probability Weighted
(1) (2) (3)
A 5% 10% 0.5%
B 10% 40% 4.0%
C 15% 50% 7.5%
Total 12.0%
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
2. Establish drivers for growth and assumptions
In this situation, the financial modeler can safely use the
12.0% for projecting sales moving forward. Hence, if the
sales for this year was reported to 8,500 units then under
the average sales computed will result to 9,520 units sold.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
3. Determine the reasonable cost of capital
In determining the reasonable cost of capital, the financial
modeler must be able to use the appropriate parameters for
the company. Generally, cost of debt and cost of equity are
weighted to determine the cost of capital reasonable for the
valuation.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
4. Apply the formulae to compute for the value
Normally in Financial Modelling, DCF is used to calculate for
the value. Since most information are already available in
Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Return,
Profitability Index etc.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
4. Apply the formulae to compute for the value
For example, Delight Bakery Inc. projected volume of pan de
sal to be sold in Year 1 is 138,915 units, assuming 5% growth
every year, and the estimated required return of 10%. The
pan de sal is sold at Php15 per unit with a cash net income
margin of 20%. Delight’s equipment is capable of producing
the volume required for 10 years. It was noted that the
company has outstanding debt of Php500,000.
FINANCIAL MODELS IN DISCOUNTED CASH FLOWS
ANALYSIS
4. Apply the formulae to compute for the value
Using the inputs, the financial model may be presented
through:
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
4. Apply the formulae to compute for the value
Observe that the enterprise value is calculated by getting the sum of all
discounted net cash flows. Alternatively, NPV function can be used in electronic
spreadsheets. Below is an illustration where both should arrive at the same
results.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
The advantage of having a financial model is that you can
easily tweak the given information and get the results
immediately. For instance, in the previous illustration the
cost of capital used is 10%. How about if you find that cost
of capital will be 12% or 15%, what will be the Enterprise
Value?
If this is the case, we need to design the financial model to
accommodate this through the use of Data Table feature in
Microsoft Excel. First, design a table where the values will be
inputted.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
Next, select the table we prepared by highlighting cells C17
to D19 and you go to DATA Tab and go to “What if” Analysis
then select ‘Data Table’.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
Data Table Dialogue box will appear and will ask you to enter
the inputs. Since the table we are doing provides for a
columnar input. Then we’ll input C17 in the COLUMN INPUT
and click OK.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
Then the results will now be shown to you in the table.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
It will be easier for you to determine which value to use.
Since, in our example the outstanding debt is Php500,000
then you have to play in the range of Php1.2 Million to
Php1.02 Million.
The scenarios will be developed based on the set of possible
occurrences like level of operating expense, mode of
operations, capital expenditure development period etc.
Emerging trend is having a Risk Based Valuation, wherein
major systematic risk is incorporate such as climate change,
war, economic sabotage, pandemic etc.
FINANCIAL MODELS IN DISCOUNTED
CASH FLOWS ANALYSIS
5. Make scenarios and sensitivity analysis based on the results.
Sensitivity Analysis is almost similar with Scenario
Modelling. The difference is that sensitivity analysis will have
to select a driver or few drivers, ceteris paribus, and check
the degree of change it will cause to the results. Sensitivity
analysis is a useful exercise in developing ballpark estimates.
COMPONENTS OF FINANCIAL MODEL
As described in the earlier part of this chapter, a financial
model should be understandable, printable and auditable.
The financial model should be designed in a way that the
investor or the client of the analysis or the proponent
themselves can understand the dynamics and follow the
drivers to enable them to have a better appreciation and
sound judgment of the results. Please bear in mind that the
results of the financial models are just guide for the
investors or even sellers of investment to determine the
reasonable value.
COMPONENTS OF FINANCIAL MODEL
As a quick guide in developing a financial model the
following components are recommended, particularly when
using Microsoft Excel:
• Title Page
This provides an overview and the project being valued or
assessed. This includes also necessary information to
secure the proprietary rights of the modeler or the firm
he or she is working with. It may also include data cut-off
to serve as a guide to the readers.
COMPONENTS OF FINANCIAL MODEL
• Data Key Results
This sheet summarizes the results of the study. This will
serve as the dashboard to enable the modelers to analyze
the results and to facilitate the readers’ appreciation on
the results of the project. This also facilitate preparation
of pertinent reports.
This also contains the valuation results, scenarios, and
sensitivity analysis. Graphs can also be found in this
sheet.
COMPONENTS OF FINANCIAL MODEL
• Assumption Sheet
This sheet summarizes the assumptions used in the
model. This is normally an input sheet where all inputs
should be made. The information that can be found in
this sheet must be linked to all the output sheets like Pro-
forma Financial Statements, Supporting Schedules and
Data Key Results.
COMPONENTS OF FINANCIAL MODEL
• Pro-forma Financial Statements
This presents the 3 components of the financial
statements namely: Statement of Income, Statement of
Financial Position and Statement of Cash Flows. In this
sheet, you can also find some key financial ratios
particularly those that has to do the with financial
performance and efficiency ratios.
Some modelers also find it convenient to have their
valuation computation be done in this sheet since the
inputs of cash flows are already available here.
COMPONENTS OF FINANCIAL MODEL
• Supporting Schedules
This is like a subsidiary ledger which provides supporting
computation to the components of the pro forma
financial statements. There is no limit for the supporting
schedules the only challenge is that the electronic
financial models consume large amount of data because
of the supporting schedules.