Valuing a company with much cash/book equity using DCF
Hi Oasis members,
I have a question regarding the DCF model. As I am teached, the DCF model is used by investors who value a business on its future cash flows. The current financial operating structure is not relevant other than for determining these future cash flow with the right input. However, what if you have a company with immense book equity, for example Apple and its huge amount of cash/marketable investments. Is it common in the usage DCF model to add strong book equity values to value of cash flows that arises from the DCF, perhaps in outliers like Apple who I just mentioned? So far I have not seen this used this way but to me it appears as the logical thing to do.
Kind regards,
This is a confusing question. But, in theory, the operating business does not include equity as that is part of the capital structure and also not an asset. Cash on the balance sheet is also not included in the operating business, as it is fundamentally affected by the capital structure and the strategy for the capital structure. A DCF looks at cash flows only.
Yea, so shouldn't it look at include the value of cash as well if it is a very high amount and causes book equity to be immense? In that case, like Apple, it might not make sense to only look at cash flows when valuing a business but to include its excess capital as well?
I think you're missing that an unlevered DCF is going to give you an EV which you then take out net debt to get to equity value. So no, you don't make any adjustments to your inputs but you do make adjustments to your output to get to equity value, which is what you want.
If you do a DCF and it says Google is worth $500B and you adjust for net debt (which is like -$80B) then your equity is worth more than the value of the company. But Apple has a positive net debt balance so if your DCF says EV is $600B then the equity value will be closer to $550B.
Here's the M&A way. If I run a company and my share price is $50 with 62mm shares outstanding, that implies an equity value of $3.1B but since my net debt is -$100mm (I have 100mm in cash and no debt) then my EV is $3B. If someone offers to buy my company at a ~20% premium, they should pay me $3.7B for the whole thing (all of the equity) but theyll actually just pay me $3.6B and I'll keep the cash. If I had positive net debt of $100m, then they'd have to pay $3.8B because my debts still have to be paid in addition to acquiring the equity.
You may see all this and think that given the same EV valuation that the company with negative net debt would cost less in acquisition since you'd have to pay more for a company with positive net debt. The flip to this is that if you have negative net debt then you would reasonably command a much higher premium on your equity because you know that that cash actually decreases the value of your total capital and therefore an increased equity premium should offset the gap.
Damn dude. You should work on your writing skills before you go deeper into learning technicals. Good writing and communications skills are by far more important to you in life, in general, than being able to understand balance sheets.
Anyways, this question, I think, can boil down to: "why don't we include cash in operating assets?" The simple answer is because cash is theoretically not worth paying for, as cash is: 1. valued the same no matter the industry or company; And 2. cash is not an asset in work--until cash becomes a more tangible operating asset in production, it does not have any significant value-add to the business. Anyway, it's just plain stupid and redundant to think about paying for cash with cash.
If you have a lot of cash = less net debt = more equity value.
2 options:
dcf of fcf to equity + excess cash dcf of unlevered fcf - net debt
This. For the first option, you can think of it as the company paying a dividend equal to the excess cash in year 0 (hence just adding the excess cash to your DCF equity valuation)
Other are correct in that this boils down to net debt (which includes cash, and can be a negative value) in the EV calculation. Here is some more advanced food for thought once you're comfortable with this topic:
Let's say I am in a capital intensive business (like mining) and due to environmental agreements or the requirements of larger partners in a mine, I must set aside cash collateral of $50 million as long as operations are ongoing. The cash is returned once the mine is safely abandoned and the site is fully restored. How do you think this cash is accounted for in the balance sheet? How do you treat this in an EV calculation?
Let's say I am a private equity company evaluating a "roll-up" strategy of acquiring several technology companies to form a larger one. I want to build a financial model to show the returns and capitalization of my roll-up vehicle after each acquisition, culminating in an IPO or exit of the entire business after 5 years. How could I treat the cash acquired in this situation?
Finally, let's say I am a private equity company considering a $100 million follow-on equity injection into a retail business in exchange for increased ownership (and I get to control the board). How would I treat this cash in my financial model?
If any of you care to take a stab at these, post a response and I will let you know whether I agree or disagree. The easy financial math you learn in college is a basic building block, but in your professional careers you will deal with questions like the above on a day to day basis, so I hope this helps.
I don't know the answer to any of these. But just to challenge myself and because I'm curious, I'll take a swing.
I would separate the $50MM collateral into a "restricted cash" asset account and decrease the cash balance on the asset side. No need to double adjustments, this has already been subtracted from cash when calculating EV.
Still, debt should be net of excess cash. But I think there's some sort of a cash expenditure associated with the roll-up.
An equity injection would run through CFs for an increase in the amount of the injection on the asset side and the corresponding increase on the equity side to balance it.
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