CHAPTER 9: DISCOUNTED CASH FLOW (DCF) VALUATION

CHAPTER 9: DISCOUNTED CASH FLOW (DCF) VALUATION
*

WITH FINANCIAL PLANNING MODELS
this version: July 27, 2003
Chapter contents
Overview....................................................................
.....................................................................1
9.1. What does "value of the firm"
mean?.......................................................................
..............3
9.2. Using the DCF valuation-
summary.....................................................................
.................9
9.3. Projecting the FCFs and doing the DCF valuation with a financial
planning model...........15
9.4. Advanced section: What's the theory behind the
model?....................................................20
Summary.....................................................................
..................................................................23
Exercises...................................................................
....................................................................24

Overview
In Chapter 8 we learned how to use accounting concepts to build a
financial planning
model of a company. In this chapter we use financial planning models to
value a company. This
is something that almost every finance specialist has to do occasionally.
The valuation technique
we employ-called discounted cash flow (DCF) valuation-is the valuation
technique
universally favored by the finance profession. DCF valuations are often
based on the financial
planning models discussed in Chapter 8. When these models are used to do a
DCF valuation,
they are also used to do much of the sensitivity analysis which helps
determine if the valuation is
reasonable.
Valuation is not intrinsically difficulty, but because there are several
competing
definitions of what constitutes the "value of a firm," people often get
confused. To shed some
light on this issue, Section 9.1 discusses the different concepts of firm
value. As you will see in
Section 9.1, finance specialists often identify the value of the firm with
the present value of its
future cash flows. We will use the financial planning models of Chapter 8
to determine these
cash flows.
After discussing the concept of firm value in Section 9.1, we summarize
the steps
involved in a DCF valuation in Section 9.2. We then go on to show you how
to value a company
by building a full-blown DCF valuation model (Section 9.3).

Finance concepts used Present value Free cash flow Gordon model
(Chapter 6) Terminal value Mid-year valuation

Excel functions used - NPV
- Data tables


9.1. What does "value of the firm" mean?
The terms "value of a company" or "value of a firm" are often used
interchangeably by
finance professionals. Even finance professionals, however, can use a
confusing variety of
meanings for these terms. Here are a few of the meanings which are often
intended: In finance the definition most often used for "firm value" is
the following: The value
of a firm is the market value of the firm's equity plus the market value of
the firm's
financial debt. This section illustrates two methods of computing the firm
value.
o The simplest method is to value the firm's equity (its shares) using the
firm's
share price in the market, and to add to this the value of the firm's debt.

o A second method, the DCF method, is based on discounted cash flows. In
a
DCF valuation firm value equals the present value of the firm's futures
FCFs
plus the value of its currently available liquid assets. Often when
individuals discuss the firm value, they really mean the value of its
shares. It is better to use the term equity value for the value of a
company's shares
and to use the term firm value (or company value) to denote the market
value of the
firm's equity plus its debt. In our calculations we also show you how to
compute the
value of a firm's shares. Sometimes the term firm value is used to denote
the accounting value of the firm.
Also known as the book value, this value is based on the firm's balance
sheets.
Because accounting statements are based on historical values, people in
finance generally prefer not to use this definition. At the end of this
section we illustrate why
we do not like this valuation method.

Motherboard Shoes: What's it worth?
To illustrate the different concepts of firm value, we'll tell the story
of Motherboard
Shoes. Motherboard is listed on the Chicago Stock Exchange, but the
majority of the stock is
owned by the Motherboard family, which founded the company and still runs
it. The current
date is 1 January 2005, and the Motherboards have received an offer for
their shares from
Century Shoe International. They would like to know if the offer is a fair
one.
Their investment advisor, John Mba has advised them that there are two
plausible ways
to value the company (John just finished business school and liked it so
much that he changed
his last name to reflect his new status). Each of the two methods has
advantages and
disadvantages.

The share price valuation: Valuing a Motherboard by using current share
price
The simplest way to value Motherboard is look at the value of its share.
Motherboard
Shoes has one million shares, which were trading on 31 December 2004 at $50
per share. Thus
the market value of the firm's equity is $50 million. In addition the
company's balance sheet
shows that it has short-term debt of $2.5 million and long-term debt of
$7.5 million; John Mba

uses these balance sheet values (also called book values) of the debt as an
approximation to the 1
debt's market value.


[pic]

The discounted cash flow (DCF) valuation: Valuing Motherboard by
discounting its
future free cash flows
The advantage of the share-price valuation method illustrated above is
that it is very
simple: The firm value equals the market value of the firm's shares plus
the book value of its
debt. Valuing the company at its current price of $50 per share is
perfectly acceptable for
someone considering buying a few shares of the company, but it makes less
sense if
Motherboard Shoes is selling a controlling block of shares. In this case
the purchaser would
probably expect to pay more for the following reasons: If the purchaser
tried to buy a big block of shares of Motherboard shares on the open
market, he would probably have to offer more than the current market price
per share.
As he bought more and more shares, the price would go up; in addition, the

1
This is common practice. Most company debt is not traded on financial
markets, and therefore there is no easily-
available market value for the debt. As a first approximation, most finance
professionals use the book value of a
firm's debt as a proxy for the debt's market value.


announcement that someone was trying to take over Motherboard Shoes would-
in
many cases-force the share price up. There are benefits to controlling a
company that are not priced in the market price per
share. The market price of a share reflects the value of a company's
future dividends
to a passive shareholder who has no control over the company. In general
the value
of a controlling block of shares is larger than the market value, since the
controlling
shareholder can actually decide what the company will do. He can also
derive
considerable private benefits from running the company.

To deal with these problems, John Mba proposes to use the discounted cash
flow (DCF)
valuation method to value the shares. DCF valuations are a standard
finance methodology,
which defines the value of the firm as the present value of the firm's
future free cash flows
(FCF), discounted at the weighted average cost of capital (WACC), plus the
firm's initial cash
and marketable securities. Section 9.4 discusses the theory behind this
method of valuation, but
for the moment we skip all the theory and simply present the formula:
[pic]
2
Economists use the term private benefits to discuss all kinds of financial
and non-financial benefits associated with
firm ownership. The big car with a driver that the company gives its
president is a private benefit of ownership, and
so is the feeling of ownership-a psychological benefit, perhaps, but
nonetheless valuable.

(Notice that the present value of the firm's future FCFs is often called
the firm's
enterprise value.) After some work to estimate the future free cash flows,
John comes up with
the following valuation:
[pic]
There are a few things to explain about this valuation: John has
projected 5 years of future FCFs and has also projected a terminal value at
the end of the 5 years. He explains that the finance methodology requires
him to estimate the allfutureFCFs present value of all the future free cash
flows: PV . However,
discountedatWACC he thinks this is too much guesswork. Instead of
estimating all future FCFs, he's
estimated 5 years of FCFs and then estimated the terminal value, the value
of
Motherboard at the end of year 5:

[pic]

If the weighted average cost of capital is 20%, the enterprise value, the
present value of
3
the FCFs and the terminal value, is $68,657,407.

Adding current balances of cash and marketable securities to the present
value of the
FCFs and subtracting out the value of the firm's debts gives an equity
valuation of
$59,157,407 (cell B15). Since there are one million shares outstanding,
this values each
share at $59.16 (cell B18).

The firm's book value-a definition we'd rather not use
There's another valuation method which John explains to the Motherboard
family-the
accounting definition of firm value uses the balance sheet to arrive at the
value of the firm. For
the case of Motherboard Shoes, the balance sheets at the end of 2004 look
like:
[pic]

The accounting definition of firm value relies on book values, the value of
the firm's debt
and equity as listed in the firm's balance sheet. Recall from Chapter 7
that the accounting
definition, which is based on historical values