Target Capital Structure, Implied Enterprise Value, and Implied Equity Value. How to reconcile?
Hello everyone,
Currently learning DCF analysis and the intuition/logic behind it, but am having trouble with the concept below.
In deriving Implied Enterprise Value, one method is to discount UFCFs at the WACC which assumes a target/optimal capital structure. I understand that under this scenario, we are saying that because the company will strive towards such a capital structure, we discount UFCFs at this target structure WACC so as to reflect the long term returns investors (in target structure proportions) will demand on the UFCFs.
However, once we get Implied Enterprise Value, we use existing (non target/optimal) capital structure items such as current market value of debt items to move towards Implied Equity Value. How does one reconcile using an Implied Enterprise Value that assumes a different (the target) capital structure, with using existing capital structure items to get Implied Equity Value? I feel like the Implied Enterpise Value is contingent on the target capital structure, and thus am unsure how it could/should be compared to existing capital structure in valuation analysis.
Any input is appreciated, thanks!
Great question. I believe this is one of the pitfalls of a DCF. As you noted, a DCF assumes a constant capital structure throughout the entire projection period. However, we know that's not realistic in the real world. The capital structure that is used for DCF projections is the current capital structure of the company at the time the projections are made, so you're not really using a different capital structure. Feel free to correct me if I'm wrong.
Hope this helps
Hello and thanks for your input! However, I'm not sure if we are on the same page. From my understanding, while DCF projections can be made based on the current capital structure, it is often more common/recommended to use the target capital structure in WACC, which may differ from its current capital structure. We can estimate this target through public comparables, observing capital structure trends, or if information is directly provided in 10Ks.
Using target capital structure results in different WACC, which we discount UFCFs to get Implied Enterprise Value (EV). This Implied EV thus is a function of the projected cashflows, as well as the target capital structure. However, in using DCF to value shares, we than take this Implied EV and subtract other D&E claims (debt, preferred stock, NCIs...etc) as well as add back non-operating assets to get our Implied Equity Value (EqV).
We then compare Implied EqV to Market EqV to determine relative valuation. However my main concern or area of confusion is that Implied EV is contingent on the target capital structure. Yet, we use existing/current capital structure items to move towards Implied EqV. How may we understand the logic behind this? I'm trying to get an intuitive sense of why this Implied EqV is valid and comparable to Market EqV.
The best I can come up with to understanding what we're doing is by saying "As of today, we simply take Implied EV (w/ target capital structure) as the instrinsic value the core operations of a business should be now, regardless of current capital structure. Thus, even though we may have a different (non-target) capital structure as of today, we say that the valuation method cares only about what we should pay today versus have to pay today, for claims on the UFCFs, which are valued assuming target structure & WACC. Thus we can move from Implied EV (w target capital structure) to Implied EqV despite using existing capital structure items."
Sorry for the wall of text and if I still have not explained myself clearly, the confusion is real.
Appreciate any inputs!
Oh okay I think I see your confusion now. To directly answer your question, I believe the reason we use current capital structure items even if they differ from target capital structure is because it is hard to predict what the actual numbers(for PS, Debt, etc.) would be for the target capital structure. I don't think there is a specific reason that bankers intentionally use current capital structure values for determining implied equity value.
It's easy to assume ratios for a target capital structure based on guidance or public comparables, such as 40% debt and 60% equity. However, how can the banker conclude whether that's $40 debt $60 equity or $400 debt and $600 equity? Obviously the numbers in real life are larger, but I hope you see my point. I think bankers just use existing values from current cap structure because they're still a relatively decent proxy of what the target cap structure values may be. Either way, remember that valuation is an art and not a science.
There is no precise or exact answer in valuation. We rely on a range, and even then we use a shit load of assumptions. Sensitivity analysis is key too. By sensitizing WACC, we are able to account for variation within implied EV as well as EqV which should address the issue you outlined.
This is a great question and definitely made me do a lot more research on DCF's. I like to understand the material deeply as well since I've started learning it, and it seems you are doing a great job of trying to gain a solid conceptual understanding.
Hope this helps and good luck!
Hello, I believe I do see your point! Your insight has indeed been helpful in me trying to understand why we do what we do in these models. I am just beginning to learn the practical side of finance so conceptual understandings are important.
Just food for thought: I was thinking that one could argue that since the Implied EV is calculated w target structure WACC, then in moving to Implied EqV, for capital structure items one could use the assumed target structure percentages for Debt & Preferred Stock and multiply it by the Implied EV to obtain their assumed values in moving to EqV. However, I guess this could lead to a whole host of other problems as the bridge to Implied Eqv from Implied EV consists of many other non-capital structure items also!
Anyways, thanks for your time and words of encouragement, all the best!
That seems like a viable idea initially. However, you need to add the cash balance when moving from implied EV to EqV. Therefore, you couldn't just use the capital structure ratios because it would be ignoring the effect of cash as a component of implied EV. Yet the point of a DCF is to project cash, and even then that's FCF not total cash balance. It would be nearly impossible to predict total cash balance under a target cap structure. I like how in depth you are thinking about the material, and I think you will easily break into IB. Keep up the good work!
This is 100% correct: it's a circular reference. Just solve it 100 times and the increments get smaller and smaller.
Example You base your WACC on 3x leverage, 6x equity = 9x EV/EBITDA Using that WACC you end up with 10x EV/EBITDA valuation ---> you recalibrate WACC to 3x leverage and 7x equity ---> WACC goes up because CoE > CoD and EV/EBITDA comes down You end up between 9 and 10x in this case.
Hello Rover-S,
Thank you for your input! However, I'm not quite grasping the explanation using these multiples nor why there is a circular reference here. Could you kindly elaborate?
Your WACC is a proportional average of CoD and CoE --> this is called gearing (D:E ratio).
When you start determining your WACC, you can start with gearing of listed peers as an input for this. However your target company might be better/worse than the peers and therefore have a higher/lower value (EV/EBITDA) than the peers (better means lower capex, higher profit margins, lower delta NWC, higher growth, etc)
If I think the company can get a max of 3.0x of leverage (and that's the target), the result of my first DCF will give me a value of for instance 10x EV/EBITDA. Appearently the equity is 7x EBITDA and the debt 3x EBITDA (= my capital struture). If I calculated this with a WACC that assumped 3x debt and 6x equity, my new WACC will be higher because the 6 will be 7x (and CoE > CoD). So I adjust my WACC, calculate a new EV and it now is 9.5x EV/EBITDA for instance. I again adjust my WACC (6.5x equity instead of 7.0x) ---> the circular. However with every itteration you get closer and the adjustments ot WACC get smaller.
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