DCF Valuation Question
In a DCF with fixed forecasts and a fixed discount rate, what determines whether the EV will increase or decrease when you roll the valuation date forward, lets say from 9/30/13 to 12/31/13? Obviously you lose one quarter of cash flows that you were previously including in the analysis (those that were "recognized"), and the rest of the cash flows plus the terminal value are discounted by one fewer quarter.
How does it make sense that a firms EV will increase/decrease just as time passes, without any changes to the underlying CFs or discount rate assumptions?
I'd appreciate any responses as I'm trying to wrap my head around this concept (or maybe I'm thinking about this wrong).
You kind of answered your own question. 1. Those cash flows are now being ignored, depending on the forecast, this will increase/decrease EV. 2. Each cash flow now has a new present value factor being applied. Depending on the forecast, this could impact the EV. Holding all else equal (including LTGR or exit multiple) , the changes should be minimal.
Thanks for the response. I get mechanically what happens, but what's the rationale as to why this occurs? Getting somewhat theoretical here.
Well the fact that you are excluding x amount of cash flows isn't really a theoretical concept, but as for the change in the present value factor, logically since the period of the forecast becomes shorter, the time until receiving each cash flow decreases. Thereby on the basis of the time value of money principle the value of each cash flow will change.
debt
Mind explaining a little bit further?
As a simple case, look at the valuation of a perpetuity. If you were to value a stream of cash flows that do not change from one period to the next, changing the valuation date will have zero impact on the EV, provided the discount rate also does not change. I'm also assuming a terminal value at the end of the projection period rather than a set project life. Whether the EV goes up or down when rolling the valuation date forward depends on the relative size of the cash flow that is now excluded from the valuation: e.g. if it's a large positive cash flow relative to other periods that's now ignored, the value will likely decline.
"How does it make sense that a firms EV will increase/decrease just as time passes, without any changes to the underlying CFs or discount rate assumptions?"
It makes sense because of the time value of money. If I offered to give you $5M in 5 years or $5M in 10 years, which would you pick? Overly simple example, but I think it still demonstrates the point.
Another concept to think about is sunk costs. The valuation is moved forward because any cash outflows or inflows that have already occurred are irrelevant to the project decision, and should not be considered.
Although past cash flows are not explicitly counted, they were used to purchase new equipment, retain talented employees, or develop new products. In this way, past cash flows feed the growth of future cash flows. The use of these past cash flows are implied in the growth rate of future cash flows, the return on your investment (ROIC) and the certainty that those future cash flows will be paid out (cost of equity). Alternatively, these cash flows could hypothetically be paid in full to their shareholders , at which point you would reinvest in other value Accretive projects.
Agree, but by definition net present value is the value of all future cash flows of a project, not to include cash flows that have already occurred.
Never said you were counting past cash flows, only that if past flows were reinvested, they are implied in the growth rate and ROIC.
Changes the EV if the new realized FCF growth rate differs from your previous terminal value discount rate e.g. if your prior DCF ended at X date, and had a TEV with a discount rate of (r-g = 8%), if in our new DCF, you have your FCF at X+1 being more than 8% above X, then your TEV will be higher. If FCF X+1 is 8% above X, your TEV should be unchanged
There were so many better ways to say this.
Valuation Question - Interview coming up in ER (Originally Posted: 03/16/2010)
Hi guys and girls,
I have an interview coming up in equity research and there’s a couple of basic questions I’m unclear of and hope you can help. I've taken a stab at my understanding so far:
How do you arrive at a company’s target share price? Value the company using an appropriate valuation technique such as DCF and divide the value arrived at by total number of outstanding shares?
How do you value a company? DCF is most common. Calculate the future free cash flow of the company and discount that using an appropriate discount rate such as the WACC. This is where I get lost as I think you need to work out a terminal value and then the present value of that terminal value but unsure exactly what that involves.
i worked in equity research for 2 years. there's a number of ways - it depends what sector/industry etc....
yes dcf is one way. other ways can be multiples comparison. as well as sum of the parts.
you're correct in saying you need to work out the terminal value and then the PV of the terminal value. terminal value can be either the multiple approach or using the gordon growth model. you add the pv to the pv of the cash flows to come to enterprise value. then takeaway debt + cash to get equity value then divide that by number of shares to get price per share.
Thanks for the information.
It's how the multiples are used to arrive at the Terminal Value I'm confused with. Would you mind expanding a little? I've looked at Wikipedia etc. but got a bit stuck at this point.
Industry EBITDA multiples. Usually the same one that exist now. Take EBITDA in the last forecasted year and apply the multiple. Voila.
Valuation Questions (Originally Posted: 09/13/2012)
Just looking for high level thoughts on these questions. Understand granular aspects of valuation. Have included my thoughts for guidance.
Q1) How would you value a company that has no cash flow/earnings today, but will in two years from now and continue to going forward?
You can value as a multiple of estimated 2-year forward EBITDA, based on observed forward multiples in peer group. But.. what I'm wondering is, wouldn't you need to back out value for cash flow not received in the first two years (which is inherently included in the forward EBITDA multiples of peers)
You can also do a DCF with no cash flow in first two years, but want to focus on the first method.
Q2) And inversely, how would you value a company that has cash flow NOW, but will cease to in subsequent years?
DCF with no terminal value (may have liquidation value?
Could you can use multiples higher up on the income statement; i.e.: EV/Sales?
Q2 is interesting... I mean, if you know the company won't have cash flow after year x, then I think a real investor would say the value of the company is zero no matter how much cash they can make now.
So if you have a company that will have one year of cashflow equal to say, $1 billion, and then cease to exist with no future liabilities, a "real investor" would only be willing to pay a maximum price of $0.00 to buy out the entire company and own 100% of that $1 billion cashflow??
Regarding Q1:
Firstly, it is completely fine to DCF to calculate value as at today even if there are years with no cashflow. Plenty of companies / projects have negative cashflow up front, due to heavy capex (pharma, mining, to name a couple).
If you want to use a multiples approach, assuming this is a "normal" company (i.e. not a pharma / mining / etc. asset), biggest consideration is selecting peers with a comparable growth profile. If the company is only just beginning to make positive earnings / cashflows, then it is likely to experience very high growth, which warrants a higher multiple. Thus, you don't need to worry about having to "back out value for cash flow not received in the first two years", as those years should be similarly immaterial for comparable peers (vast majority of present value is very far in the future).
Also, it can be useful to use multiples further up the income statement e.g. EV/Sales, but the problem is that it does not take into account quality of earnings (what margins do you achieve, and how stable are your earnings?). Also, you would expect significant value in an early-stage company to come from top line sales growth, so again, comes back to picking relevant peers.
q2. Just discount cash flows until that final year, no terminal year.
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