## Level 2

## 6.2. Company valuation based on cash flows

## 6.2.1. Basic DCF models

* Methodological prerequisites for DCF evaluation. * The discounted cash flow methodology

**DCF**is based on the fundamental concepts of the temporary value of money and the relationship of risk to yield. The value of any company, every single strategy or investment is equal to the present value of the projected future

*At the same time, in the evaluation of the company as an operating business, an unlimited period of its existence is assumed.*

**free cash flows.** * Free cash flow - * is the amount of cash available to a company's investors that can be withdrawn from the business without affecting its operations.

There are two types of free cash flow:

o free cash flow - * FCF * (free cash flows), or free cash flow of the company -

*cash flows to firm);*

**FCFF (free** o residual cash flow - * RCF * (residual cash flows). Its second designation is free cash flow to equity -

*cash flow to equity).*

**FCFF (free** The free cash flow of firm * (FCF) * is defined as the cash flow available to all capital providers (both borrowed and own), because it is the result of main activity companies, and free cash flow to own capital (residual cash flow) - as a flow available only to the owners (shareholders) of the company.

### How to ...

**Choose!**The largest selection of informative articles.

### Tired of looking for a solution?

Get Your ESSAY Now!There is one important equation that determines the value of free cash flow in the context of valuation: the cash flows generated by the company's operations and investments in assets are equal to the cash flows paid to the company's capital providers (received by investors and the company's creditors):

Free cash flow of the company = Cash flows from investors and creditors of the company.

* Factors of free cash flow (FCF). * The formation factors of the free cash flow

*are reflected in the following formula:*

**(FCF)** where * ЕСЕ - * free cash flow for the period; 5- sales proceeds;

*current costs;*

**C -***depreciation and amortization;*

**OR-***tax rate;*

**T-***capital costs; 5K- the value of the assets being released;*

**SAREX-***Change in working capital.*

**CSS -** Cash flow factors can also be expressed as the difference between net operating profit (CORAT) for the year and net total investments for the year * (B) *

If we correlate the net total investment * (L) * for the period with the net operating profit for the same period

*we get the coefficient of reinvestment of operating profit:*

**(NORAT),**As a result, the company's free cash flow for the year can be represented in the following form:

* Residual cash flow. * The residual cash flow or cash flow remaining by the owners

*differs from the free cash flow by the amount of receipts and the repayment of borrowed funds , debt service costs and the "tax bill" associated with interest payments:*

**(YACE) at** where * YACE- * residual cash flow for the period; HS/7 - free cash flow for the period;

*the net receipt of a debt;/- interest payments on debt; G5- & quot; Tax Shield & quot ;, which is determined by multiplying the interest payments*

**And -***by the effective tax rate*

**(I)**

**(T).** * The basic models are ALL estimates. * Choosing a particular cash flow definition entails different schemes and associated valuation models.

* The PCP-based assessment model. the value of firm (UR). strong> ie *

and the valuation model itself, based on the assumption that the business exists for an indefinitely long period, can be represented in the most general form by the formula

* A model based on the NSR. * If the residual cash flow is selected for the valuation (TcST7). the cost of equity of the company

*is applied as a discount rate and as a result of the valuation, the value of the capital for the owners*

**(kE)***In the most general form, the estimation model can be represented by the formula*

**(UE) is directly obtained.** * The DDM model. * The dividend discounted model

*applies when the dividend stream is defined as free cash flow. In the most general form,*

**DDM***looks like this:*

**DDM** where * d-} - * the net dividends in the forecasting year y.

In principle, the models of discounting dividends and residual cash flows are equivalent if the forecasted dividend policy corresponds to the company's possibilities based on the generation of residual cash flow. The * BBM * model is more suitable for valuing shares by portfolio investors.

### Ready to make your order?

Get your great paper now * Modification of valuation models depending on expected growth rates. * All

*models can have three modifications:*

**OCR***and*

**with constant growth, two-phase***They differ from each other assumptions about the variability and distribution in time of future cash flows. In the first case, an infinite, constant increase in the cash flow is assumed. In the second - the future is divided into two periods: forecast (with changing high growth rates) and residual (with infinitely constant growth rates). In the third case, after a period of high growth rates, a period of damped growth rates is initially envisaged, followed by a period of infinitely constant growth rates.*

**three-phase.** The estimation using two- and three-phase models of company value measurement is divided into parts: the estimation of total discounted cash flows during the period of changing high growth rates and the evaluation of the terminal value (* TV) * in a period of infinite constant growth rates.

The basis for choosing a particular model is the assumptions about future incomes: growth rates, variability, distribution over time and conditionality by the onset of certain events. Depending on these assumptions, valuation models based on both cash flow and residual income are divided into the following main forks:

o model with infinite constant growth (g = const);

o two-phase models, where the future is divided into two periods-a limited period with high changing growth rates and an infinite period with low constant growth rates;

o three-phase models, where the future is divided into three periods - a period of high changing growth rates, a period of damped growth rates and an endless period of low constant growth rates.

* Models with an infinite constant growth rate (FCF-WACC). * The value of a company with an infinite constant increase in cash flow is determined by the formula

where * UE - * the company's equity; ГС ^ 0 - normalized free cash flow in the base period;

*weighted average cost of the company's capital; & pound; & gt; - the fundamental (market) value of debt;*

**WACC-***the growth rate of*

**g-***on an infinite time horizon.*

**firmware** * A model with infinite constant growth (HCP-KE). * When estimating the residual cash flow, the Gordon formula becomes

where * IAS {) * is the normalized residual cash flow of the base year; - residual cash flow of the first forecast year; discount rate, reflecting the required market return of investors; & pound; - a constant growth of the cash flow, while

Serious restrictions are imposed on the application of models with perpetual constant growth rates. The growth rates used in it should be justified relative to the nominal long-term growth rates of the economy. Stable growth rates can not exceed the long-term growth rates of the economy as a whole.

Due to the fact that the estimation for this model assumes rather crude assumptions, it is usually used for preliminary assessment. At the same time, these models are very convenient for analyzing the impact of the company's core value drivers. Let's show this on the example of the model - * Kn. *

* Financial drivers of the company's value. The assumption of a company staying in a stable state also means that it has other characteristics inherent in stable firms: a stable financial lever, a stable rate of reinvestment, a stable return on invested capital, and sustainable growth. *

Under given conditions, the company's free residual cash flow equals

where * b * is the reinvestment ratio that reflects the proportion of net profit reinvested back into the business.

Also, under the specified conditions, the * steady growth formula *

Therefore, the value of the company in conditions of perpetual constant growth rates can be expressed! as

As you can see from this formula, the main factors (drivers) that determine the value of the company are:

o the amount of capital invested in the company at the time of valuation (& pound; 0);

o expected return on invested capital * (ROE) * compared to the cost of capital

**(Kt)** o the expected rate of growth of the cash flow * (g), * which is ensured by the reinvestment rate

**(b).** ** Example **. At the time of valuation, the company's own capital * (E1)) * is $ 100 million. The constant growth rate of the company's cash flow equals 5%, and the reinvestment rate

*is at the level of 0.25. Discount rate*

**(B)***is 10%.*

**(g)**Based on the formula for sustainable growth, the return on equity is

Profit for the first forecast period (million dollars):

respectively free cash flow of the first forecast year (million dollars):

and the company's value is * DCF * ($ mln):

* Two-phase DCF model. * The two-phase model is designed to evaluate a firm that is expected to grow much faster than a stable firm in the initial (forecast) period, and then - growing at a steady pace. The two-phase modification

*is most often used by appraisers and analysts because of its flexibility and practicality.*

**DCF** The value of a company is the present value of * FCF * for a period of high, variable growth rates (also referred to as the forecast period), to which the discounted terminal value is added:/p>

where * ЕСЕ, - * free cash flows per year; 7T & quot; - terminal value at the end of the period;

*Weighted average cost of capital.*

**WACC -**There is also a two-phase model, which sets high constant growth rates in the forecast period, in post-forecast-low, and also a model with the assumption of a uniform decrease in growth rates in the phase of exceptional growth. The choice of this or that modification of the model depends on the conditions given above. A model with constant growth rates in the forecast period can lead to significant errors in the valuation, since a jump from high stable growth to low is less realistic than the assumption of a gradual decrease in growth rates. The most detailed model is with the company's changing growth rates, so it is most often used when there is a need to forecast the cash flows of each forecast year.

* Three-phase OSB model. The three-phase model is designed for assessments that are supposed to undergo three phases of growth: an initial phase of high, variable growth rates, a transition phase when growth rates decline, and a stable period when growth remains unchanged. *

Since the model assumes that growth rates pass through three different phases, it is important that assumptions about other variables are consistent with the assumptions about growth. The need for a three-phase valuation model arises when the company and the market grow at a rapid pace, and by the end of the forecast period, growth rates remain high. One-step transition to low constant growth rates in such conditions can lead to distortion in measuring the company's value. This is due to the fact that the company's economy has not yet entered the phase of * stabilization of the operational and investment regime, * ie. such parameters and ratios as growth rates, yield spread, the ratio of capital outlays and depreciation do not correspond to the stabilization phase.

* Capital costs and depreciation. * As the firm moves from a rapid growth rate to a stable one, the ratio between capital costs and depreciation will change. In the phase of high growth rates, capital expenditures far exceed wear. In the transition phase, the difference will narrow, and in the period of stable growth the difference between capital outlays and depreciation will become smaller, reflecting lower expected growth rates.

* The overall evaluation scheme. * In Fig. 6.2 shows the scheme of business valuation by the method of discounting cash flows. Using this scheme, let us consider successively the main stages of the evaluation.

Any evaluation begins with the definition of goals and the setting of tasks for evaluation. A variety of possible business valuation goals was provided earlier. The objectives of the assessment have a significant impact on the choice of valuation methods, and on the selection of the necessary information for valuation, the choice of cash flow, the determination of the duration of the forecast period, and other valuation procedures.

** Fig. 6.2. Steps by D **

**F**The analysis of the factors of value includes the analysis of financial results, market forces and competitive positions. The financial analysis of the company's past activities as part of the business valuation is necessary to identify the main relationships and proportions between the main financial indicators, the trends in their changes, and identify factors that shape the company's revenues and cash flows. Based on this analysis, key assumptions are formed for predicting future earnings and cash flows. But in order for the results of financial analysis to be correct, it is necessary to begin with the preparation of the initial information.

## Price Plan & Our Features

**Free**Outline**Free**Formatting**Free**Title page**Free**Reference Page

**Free**Revisions**Free**Submission by Chapters**Free**Plagiarism Report**Free**Customer Service

- 1 – page abstract
- VIP Support
- Expedited delivery
- Essay outline

**$25.25****$12.99****$8.99****$25.25**

*
*## Also We Can Offer!

##### Essay Writing

[...]

- Argumentative essay
- Best college essays
- Buy custom essays online
- Buy essay online
- Cheap essay
- Cheap essay writing service
- Cheap writing service
- College essay
- College essay introduction
- College essay writing service
- Compare and contrast essay
- Custom essay
- Custom essay writing service
- Custom essays writing services
- Death penalty essay
- Do my essay
- Essay about love
- Essay about yourself
- Essay help
- Essay writing help
- Essay writing service reviews
- Essays online
- Fast food essay
- George orwell essays
- Human rights essay
- Narrative essay
- Pay to write essay
- Personal essay for college
- Personal narrative essay
- Persuasive writing
- Write my essay
- Write my essay for me cheap
- Writing a scholarship essay

##### Case Study

[...]

##### Citation Style

[...]

##### Additional Services

[...]

##### CV

[...]

##### Assignment Help

[...]

##### Admission Services

[...]

##### Custom Paper

[...]

*
*

*
*## How to ...

**We made your life easier**with putting together a big number of articles and guidelines on how to plan and write different types of assignments (Essay, Research Paper, Dissertation etc)