Discounted cash flow (DCF)

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Hello everybody, I cannot understand 2 questions so far in DCF valuation:

1) Why cash which is standing on a balance sheet is not included in valuation? We calculate only enterpice value calculating FFCF, but ignore the cash which is outstanding in the firm at the moment. If the company at the moment has a great amount of cash, the DCF method ignore such fact and in my opinion get lower company value than it should be. In my opinion, we should add outstanding cash to discounted FFCF of the company to get the enterpice value today, isn't it?

2) Why should we substract changes in net working capital from FFCF? For example, NWC was 100 in year1 and NWC decreased to 70 due to decrease of A/R, enything else being constant. So we get -30 NWC which is substracted from FFCF, which in our case mean that we add 30 to FFCF. However, I do not understand, how decrease in A/R increases my FFCF?

Comments (7)

 
Feb 21, 2015 - 9:38am

I'm not sure I fully understand your question, but here are my responses based on how I'm reading it.

1) Cash sitting on the balance sheet is not ignored in the valuation. Enterprise Value = Market Cap + Debt + Preferred Stock + minority interest - Cash & Cash Equivalents. Logically we subtract out cash when calculating EV, because EV is equal to "how much you would pay to acquire a firm," so it only makes sense that you could use the firm's cash to pay down its debt once the firm is acquired.

If you are asking why cash is not somehow wrapped into calculating FCF in each year, it is because the cash sitting on the balance sheet has nothing to do with future FCF being generated.

2) NWC is tricky. Logically think about it like this: by decreasing A/R you are essentially collecting more money now from customers rather than having more of sit in A/R waiting to be collected. In other words, A/R going down implies cash is going up. Therefore, in the example you have given above the company has an additional $30 of FCF. The same idea can be used to explain why increases in A/P imply increases in Cash. If A/P goes up then you are pushing back more payments, which gives you more cash now.

Hope this helps.

 
Feb 21, 2015 - 4:43pm

Thanks for answer. I have one more question: When I am calculating cost of equity using CAPM I face a problem. I get relatively low BETA, and R square near 0. In such case because of very small beta I get very low cost of equity which logically seems to me too small for the company which is near bancrupt. Then I suppose that in such case CAPM is not the best method to calculate cost of equity? Any alternatives?

 
Feb 22, 2015 - 1:14am

There is an alternate formula. Cost of Equity = (Dividends Per Share / Share Price) + Growth Rate of Dividends. This formula should be used when you don't have the proper info on Beta or when dividends are vital to the company's structure. When you say you "get a low Beta" what does that mean? You should be looking up the company's Beta from CapIQ or bloomberg or something of the sort (e.g. Yahoo! Finance).

Please let me know if that answers the question.

 
Feb 22, 2015 - 3:52am

The thing is that the company which I am analyzing is in nasdaq OMXV (Vilnius) stock exchange. The company is small and very illiquid and is near bancrupt. Since the company is small there is no info about it in big financial websites. So, I calculated beta by taking daily prices of both stock and index of the past 4years. I got beta=0,35 and then checked R square which I got near 0. So according to R square, my stock price is not explained by index at all, even though there is no better index than OMXV benchmark for this stock. Anyway, my low beta reduced cost of equity a lot. Now, I am thinking, that cost of equity for the company which is near bancrupt should be very big, because investors will require a greater risk premium for such company. But if I get low cost of equity it makes me feel that CAPM in such case probably doesn't work. I cannot callculate cost of equity using dividend method because the company dosn't pay dividends. Any thoughts or suggestions?

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