Equity Validation Through Discounted Cash Flow Analysis
Every day, thousands of participants in the investment profession—investors, portfolio managers, regulators, researchers—face a common and often perplexing question: What is the value of a particular asset? The answers to this question usually influence success or failure in achieving investment objectives. For one group of those participants—equity analysts—the question and its potential answers are particularly critical, because determining the value of an ownership stake is at the heart of their professional activities and decisions.
Valuation is the estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Skill in valuation is a very important element of success in investing.
In finance, valuation is a process of determining the fair market value of an asset. Equity valuation therefore refers to the process of determining the fair market value of equity securities.
Importance of Equity Valuation
Systemic Equity Valuation
The whole system of stock markets is based upon the idea of equity valuation. The stock markets have a wide variety of stocks on offer, whose perceived market value changed every minute because of the change in information that the market receives on a real-time basis.
Equity valuation therefore is the backbone of the modern financial system. It enables companies with sound business models to command a premium in the market. On the other hand, it ensures that companies whose fundamentals are weak witness a drop in their valuation. The art and science of equity valuation therefore enables the modern economic system to efficiently allocate scare capital resources amongst various market participants.
Individual Equity Valuation
As discussed, on a micro level, equity valuation is beneficial for the entire stock market ecosystem. However, how does it benefit an individual to study and apply the principles of equity valuation?
Well, markets receive information every moment and make an attempt to factor the financial effect of this information in the stock price. Individual estimates of the effect vary and as such different people may come up with different stock prices. Therefore, there can be a difference between the market value of a company and what investors call its true or “intrinsic value”
Investors, stand to gain a lot of money if they are able to correctly identify this difference. The second richest person in the world, Warren Buffett has made his fortune correcting and applying the art of equity valuation. In fact, the theory of equity valuation has been heavily influenced by the work of Warren Buffett and his mentor.
Applications of Equity Valuation
“Valuation” or the process of assigning a fixed numerical value to the present and potential of a business is considered by many experts to be the most important part of corporate finance and financial markets. The most coveted and highly paid jobs in the financial markets are in this domain.
The reason for this is that the accuracy of the value derived can never be known. It is not a verifiable fact and there is no right or wrong answer. Rather, the valuation is an opinion that is based on the expertise of the person conducting the exercise.
Now, if we take the subjectivity and add to it the fact that decisions involving billions of dollars have to be taken based on the valuation, we see why it is arguably the most important task in finance. Let’s see the kind of decisions that need to be made based on the value derived from equity valuation.
Stock Picking
The most common application of equity valuation is related to stock picking. In a world with perfect markets, stock picking would be a futile exercise. All the stocks would always be valued correctly and it would be impossible to make any supernormal profits from investing in these stocks. However, fortunately or unfortunately, we do not live in this world with perfect markets.
The theory of stock selection is based on the flaws of the market. The belief is that in the short run, due to investor euphoria or pessimism, stocks tend to be valued on the market at more or less price than what they are actually worth. Thus, if one has an objective basis to find out the true intrinsic value of these stocks, one can gain while buying in a depressed market and selling later when markets return to normal.
Therefore, it is implied that any investor must always have their own estimate of value of the stock, which they derive from their very own equity valuation model. Then they must constantly be on the lookout for undervalued stocks or as Warren Buffet puts it, “dollar bills which are selling for ten cents in the market.”
Estimating the Market Sentiment
This is a slightly unconventional application of the field of equity valuation. Now, there are times when the market can be seen to be clearly euphoric and there are other times when the market seems to be clearly depressed. However, sometimes the signals may not be so clear and investors may be clueless as to what the market’s expectations of the future are.
In this case too, equity valuation can come to the rescue. The idea is to arrive at a fair valuation and then compare them with the values prevalent in the market. If the market is overvaluing most of the stocks, then investors are expecting a positive future and the sentiment is positive. The converse of this is also true. Hence, equity valuation can be used as a tool to read the market.
Listing of Private Businesses
Private businesses and capital markets have a symbiotic relationship. Private businesses can obtain cheap funds from the capital markets, whereas investors get a chance to invest in lucrative businesses by being in the capital markets.
However, when a private business initially lists itself on the market and becomes a public company, it faces a problem. How do the owners and investors know what the correct value of the business is? What is the right price for the investors to pay and for the owners to accept? Well, once again the art and science of valuation comes to the rescue. Using equity valuation models, analysts can arrive at a relatively precise price supported by facts and data which is usually acceptable to both the counterparties involved in the trade.
Valuing the business is therefore the number one task that needs to be performed by merchant bankers when they plan on taking a company public.
Mergers and Acquisitions
Lastly, just like listing of private businesses, there is also considerable ambiguity over the price to be paid when mergers and acquisitions happen. How do the investors of both companies know that they are getting a fair deal? Well, once again, equity valuation comes to the rescue. The valuation exercise here is quite complicated. First both individual entities need to be valued and then the combined entity needs to be valued. Then gains from merging the business or “synergy” have to be found out.
Later, based on the bargaining power and the risk-reward bearing agreement of the venture, a fair valuation can be arrived at which is acceptable to both the acquirer and the acquired.
To sum it up, valuation is the lifeblood of financial services. All sorts of organizations, from merchant banks to portfolio management companies need this knowledge. Also, it is an imperfect knowledge hence companies are willing to spend more and more money to hire people they believe have a good understanding of the concept of valuation.
Principles and Techniques of Valuation
Discounted Cash Flow Analysis
In Discounted Cash Flow (DCF) valuation, the value of an asset is the present value of the expected cash flows on the asset. The basic premise in DCF is that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Though the DCF Valuation is one of the three approaches to Valuation, it is essential to understand the fundamentals of this approach, as the DCF method finds application in the use of the other two approaches also. The DCF model is the most widely used standalone valuation model.
To use DCF valuation, we need to estimate the following: (1) the life of the asset (2) the cash flows during the life of the asset (3) the discount rate to apply to these cash flows to get present value.
The expected future net cash flow is defined as after-tax cash flow from operations on an invested capital basis (excluding the impact of debt service) less the sum of net changes in working capital and new investments in capital assets.
The discount rate should reflect the riskiness of the estimated cash flows. The rate will be higher for high risk projects as compared to lower rates for safe or less risky investments. The Weighted Average Cost of Capital (WACC) is used as the discount rate. The cost of capital with which the cash flows are discounted should reflect the risk inherent in the future cash flows.
The WACC is calculated using the following formula:
WACC = [(E/(D+E) x CE] + [(D/(D+E) x CD x (1-T)]
where E is the market value of equity, D is the market value of debt, C E is the cost of equity, CD is the cost of debt and T is the tax rate.
The first step in determining WACC is the assessment of capital structure, i.e., how a company has financed its operations.
It can thus be seen that the company’s net cash flows are projected for a number of years and then discounted to present value using the WACC. The expected cash flows earned beyond the projection period are capitalized into a terminal value and added to the value of the projected cash flows for a total value indication.
Assumptions of the DCF Model
The DCF model relies upon cash flow assumptions such as revenue growth rates, operating margins, working capital needs and new investments in fixed assets for purposes of estimating future cash flows. After establishing the current value, the DCF model can be used to measure the value creation impact of various assumption changes, and the sensitivity tested.
Importance of the DCF Model
Business valuation is normally done to evaluate the future earning potential of a business, and involves the study of many aspects of a business, including anticipated revenues and expenses. As the cash flows extend over time in future, the DCF model can be a helpful tool, as the DCF analysis for a business valuation requires the analyst to consider two important components of:
- projection of revenues and expenses of the foreseeable future, and,
- determination of the discount rate to be used.
Projecting the expected revenues and expenses of a business requires domain expertise in the business being valued. For example, a DCF analysis for a telecom company requires knowledge of the technologies involved, their life cycle, cost advantages and so on. Similarly, a DCF analysis of a proposed mine requires the expertise of geologists to ascertain the quality and quantity of deposits.
Selecting the discount rate requires consideration of two components:
- the cost of capital, and
- the risk premium associated with the stream of projected net revenues.
The cost of capital is the cost of funds collected for financing a project or purchasing an asset. Capital is a productive asset that commands a rate of return. When a business purchase is financed by debt, the cost of capital simply equals the interest cost of the debt. When it is financed by the owner’s equity, the relevant cost of capital would be the “opportunity cost” of the capital, i.e., the net income that the same capital would generate if committed to another attractive alternative.
The choice of discount rate must consider not only the owner’s cost of capital, but also the risk of the business investment.
Advantages of DCF Valuation:
- As DCF valuation is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions.
- DCF valuation is the right way to think about what an investor would get when buying an asset.
- DCF valuation forces an investor to think about the underlying characteristics of the firm, and understand its business.
Limitations of DCF Valuation:
- Since DCF valuation is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches.
- The inputs and information are difficult to estimate, and can also be manipulated by a smart analyst to provide the desired conclusion.
- It is possible in a DCF valuation model to find every stock in a market to be overvalued.
- The DCF valuation has certain limitations when applied to firms in distress; firms in cyclical business; firms with unutilized assets, patents; firms in the process of reorganizing or involved in acquisition, and private firms.
Applications of DCF Valuation:
DCF valuation approach is the easiest to use for assets or firms with the following characteristics:
- cash flows are currently positive
- the cash flows can be estimated with some reliability for future periods, and
- where a proxy for risk that can be used to obtain discount rates is available.
DCF approach is also attractive for investors who have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to “true” value, or those who are capable of providing the needed thrust as in the case of an acquirer of a business.
