6.

Generic DCF Valuation

C. Discount Rate Basics

1. The discount rate used should be consistent with both the riskiness and the type of cashflow
being discounted.
a. Equity versus Firm: If the cash flows being discounted are cash flows to equity, the
appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the
appropriate discount rate is the cost of capital.
b. Currency: The currency in which the cash flows are estimated should also be the currency in
which the discount rate is estimated.
c. Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect
expected inflation), the discount rate should be nominal.

2. The cost of equity should be higher for riskier investments and lower for safer investments. While
risk is usually defined in terms of the variance of actual returns around an expected return, risk
and return models in finance assume that the risk that should be rewarded (and thus built into the
discount rate) in valuation should be the risk perceived by the marginal investor in the investment.

3. Most risk and return models in finance also assume that the marginal investor is well diversified,
and that the only risk that he or she perceives in an investment is risk that cannot be diversified
away (i.e., market or non-diversifiable risk or company specific risk).

4. The CAPM (Cost of Equity): While the CAPM (and the CAPM beta) has come in for well-justified
criticism over the last four decades (for making unrealistic assumptions, for having parameters
that are tough to estimate and for not working well), it remains the most-widely used model in
practice.
Cost of Equity = Risk-free rate + Equity Beta × [Equity Risk Premium (i.e., return on market
minus risk-free rate)]

5. In practice,
a. Government securities rates are used as risk-free rates.
b. Historical risk premiums are used for the risk premium.
c. Betas are estimated by regressing stock returns against market returns.

6. A Risk-Free Rate: On a risk-free asset, the actual return is equal to the expected return.
Therefore, there is no variance around the expected return. For an investment to be risk-free,
then, it has to have “no default risk” and “no reinvestment risk”.

7. Time horizon matters: The risk-free rates in valuation will depend upon when the cash flow is
expected to occur and will vary across time. If your cash flows stretch out over the long term, your
risk-free rate has to be a long-term risk-free rate.

5
8. If you are valuing a company in US dollars, you need a US dollar risk free rate.

9. In valuation, we estimate cash flows forever (or at least for very long time periods) and in nominal
terms. The correct risk-free rate to use should therefore be a long term, nominal rate. The
thirty-year treasury bond rate is the longest-term rate that you can find and there is a good
case to be made that it should be the risk-free rate. However, given how difficult it is to get the
other inputs for the discount rate (default spreads & equity risk premium) over thirty-year
periods, you should consider using the ten-year US treasury bond rate as your risk-free rate
for US dollar valuations.

D. Equity Risk Premiums

1. The equity risk premium is the premium that investors charge for investing in the average equity.
It is a function of “How risk averse investors are collectively” and “How much risk they see in
the average equity”.

2. The level of the equity risk premium should vary over time as a function of:
a. Changing macroeconomic risk (inflation & GDP growth).
b. The fear of catastrophic risk.
c. The transparency or lack thereof of the companies issuing equity.

3. The historical premium is the premium that stocks have historically earned over riskless
securities.

4. Estimating a risk premium for an emerging market

a. Assume that the equity risk premium for the US and other mature equity markets was 5.80%
in January 2013. You could then add on an additional premium for investing in an emerging
market.
b. Two ways of estimating the country risk premium:
i. Default spread on Country Bond: In this approach, the country equity risk premium is
set equal to the default spread of the bond issued by the country. Brazil’s default spread,
based on its rating, in September 2011 was 1.75%.
- Equity Risk Premium for Brazil = 5.80% + 1.75% = 7.55%
ii. Adjusted for equity risk: The country equity risk premium is based upon the volatility of
the equity market relative to the government bond rate.
- Standard Deviation in Bovespa = 21%
- Standard Deviation in Brazilian government bond= 14%
- Default spread on Brazilian Bond= 1.75%
- Total equity risk premium for Brazil = 5.80% + 1.75% (21/14) = 8.43%

5. From Country Equity Risk Premiums to Corporate Equity Risk premiums

a. Approach 1: Assume that every company in the country is equally exposed to country risk. In
this case,
i. E(Return) = Risk-free Rate + CRP + Beta (Mature ERP)
ii. Implicitly, this is what you are assuming when you use the local Government’s dollar
borrowing rate as your risk-free rate.
b. Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to
other market risk.
i. E(Return) = Risk-free Rate + Beta (Mature ERP+ CRP)
c. Approach 3: Treat country risk as a separate risk factor and allow firms to have different
exposures to country risk (perhaps based upon the proportion of their revenues come from
non-domestic sales)
i. E(Return)=Risk-free Rate+ β (Mature ERP) + λ (CRP)
* Mature ERP = Mature market Equity Risk Premium
6
 ** CRP = Additional country risk premium

6. Approach 1 & 2: Estimating country risk premium exposure

a. Location based CRP: The standard approach in valuation is to attach a country risk
premium to a company based upon its country of incorporation. Thus, if you are an Indian
company, you are assumed to be exposed to the Indian country risk premium. A developed
market company is assumed to be unexposed to emerging market risk.
b. Operation-based CRP: There is a more reasonable modified version. The country risk
premium for a company can be computed as a weighted average of the country risk
premiums of the countries that it does business in, with the weights based upon revenues or
operating income. If a company is exposed to risk in dozens of countries, you can take a
weighted average of the risk premiums by region.

7. Approach 3: Estimate a lambda for country risk

a. Source of revenues: Other things remaining equal, a company should be more exposed to
risk in a country if it generates more of its revenues from that country.
b. Manufacturing facilities: Other things remaining equal, a firm that has all of its production
facilities in a “risky country” should be more exposed to country risk than one which has
production facilities spread over multiple countries. The problem will be accented for
companies that cannot move their production facilities (mining and petroleum companies, for
instance).
c. Use of risk management products: Companies can use both options/ futures markets and
insurance to hedge some or a significant portion of country risk.
d. The easiest and most accessible data is on revenues. Most companies break their revenues
down by region.
λ = % of revenues domestically firm/ % of revenues domestically average firm

E. Betas

1. The CAPM Beta: The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) (Rj = a + b*Rm) (where a is the intercept and b is the slope of the
regression). The slope of the regression corresponds to the beta of the stock, and measures the
riskiness of the stock.

2. Determinants of Betas:

7
3. Bottom-up Betas:

F. Estimating cost of debt, debt ratios and cost of capital

1. For an item to be classified as debt, it has to meet three criteria:

a. It has to give rise to a contractual commitment, that has to be met in good times or bad.
b. That commitment usually is tax deductible.
c. Failure to make that commitment can cost you control over the business.

2. Using these criteria, all interest-bearing commitments, short term as well as long term, are clearly
debt.

3. The items below can be debt, if they meet other conditions

a. Accounts payable & supplier credit, but only if you are willing to make the implicit interest
expenses (the discounts lost by using the credit) explicit.
b. Underfunded pension and health care obligations, but only if there is a legal requirement that
you cover the underfunding with fixed payments in future years.

4. The cost of debt is the rate at which you can borrow at currently, it will reflect not only your default
risk but also the level of interest rates in the market.

5. The two most widely used approaches to estimating cost of debt are:
a. Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of
this approach is that very few firms have long term straight bonds that are liquid and widely
traded.
b. Looking up the rating for the firm and estimating a default spread based upon the rating.
While this approach is more robust, different bonds from the same firm can have different
ratings. You have to use a median rating for the firm.

6. When in trouble (either because you have no ratings or multiple ratings for a firm), estimate a
synthetic rating for your firm and the cost of debt based upon that rating.

7. The cost of debt for a company is then the sum of the risk-free rate and the default spread:
a. Pre-tax cost of debt = Risk free rate + Default spread
b. The default spread can be estimated from the rating or from a traded bond issued by the
company or even a company CDS (‘Credit Default Spread).

8
8. Weights for the Cost of Capital Computation: In computing the cost of capital for a publicly
traded firm, the general rule for computing weights for debt and equity is that you use market
value weights. That is not because the market is right but because that is what it would cost you
to buy the company in the market today, even if you think that the price is wrong.

9. Dealing with Hybrids: When dealing with hybrids (convertible bonds, for instance), break the
security down into debt and equity and allocate the amounts accordingly. Thus, if a firm has $ 125
million in convertible debt outstanding, break the $125 million into straight debt and conversion
option components. The conversion option is equity.

G. Estimating Cash Flows

1. FCFF versus FCFE

2. If looking at cash flows to equity, look at earnings after interest expenses - i.e., net income. If
looking at cash flows to the firm, look at operating earnings after taxes.

3. Consider how much the firm invested to create future growth

a. If the investment is not expensed, it will be categorized as capital expenditures. To the extent
that depreciation provides a cash flow, it will cover some of these expenditures.
b. Increasing working capital needs are also investments for future growth.

4. If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt
repaid).

5. Operating Lease Expenses are treated as operating expenses in computing operating income. In
reality, operating lease expenses should be treated as financing expenses, with the following
adjustments to earnings and capital:
Debt Value of Operating Leases = Present value of Operating Lease Commitments at the
pre-tax cost of debt

6. When you convert operating leases into debt, you also create an asset to counter it of exactly the
same value. That asset then has to be depreciated.
9
7. Accounting standards require us to consider R&D as an operating expense even though it is
designed to generate future growth. It is more logical to treat it as capital expenditures.

8. To capitalize R&D,
a. Specify an amortizable life for R&D (2 - 10 years).
b. Collect past R&D expenses for as long as the amortizable life.
c. Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the
research asset can be obtained by adding up 1/5th of the R&D expense from five years ago,
2/5th of the R&D expense from four years ago.

9. Consider the effect of taxes

a. Your earnings and cash flows should be after corporate taxes. With cash flow to equity, you
start with net income, which is already after taxes. So, you are set.
b. When you do free cash flow to the firm, you are computing your cash flows “as if you had no
debt”. That is why it is called an unlevered cash flow.
c. Consequently, you have to compute the tax you would have paid on your operating income, as
if it were taxable income.

H. Estimating Growth

1. Historical Growth in EPS:

a. The historical growth rate in earnings for a company may seem like a fact but it is an estimate.
In fact, it is sensitive to “How it is computed (arithmetic or geometric)” and “Estimation period
(starting point i.e., base year is bad year)”.
b. In using historical growth rates, recognize the following:
i. Growth rates become meaningless when earnings go from negative values to positive
values;
ii. Growth rates will go down as companies get larger.
c. Worst of all, there is evidence that historical growth rates in earnings are not very good
predictors of future earnings.

2. Management/Analyst Forecasts:
a. When valuing companies, we often fall back on management forecasts for the future (after all,
they know the company better than we do) or forecasts of other analysts.
b. Management forecasts may reflect their “superior” knowledge, but they have a fatal flaw. They
are biased.

3. Fundamental Growth:
a. In terms of basic fundamentals, for a company to grow its earnings, it has to
i. Add to its asset or capital base and generate returns on that added capital (new investment
growth).
ii. Manage its existing assets more efficiently, generating higher margins and higher returns on
existing assets (efficiency growth).

10
I. Terminal Value

1. A publicly traded firm potentially has an infinite life. The value is therefore the present value of
cash flows forever. Since we cannot estimate cash flows forever, we estimate cash flows for a
“growth period” and then estimate a terminal value, to capture the value at the end of the period.

2. Stable Growth and Terminal Value:

a. When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash
flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
b. This “constant” growth rate is called a stable growth rate and cannot be higher than the
growth rate of the economy (‘GDP’) in which the firm operates.
c. While companies can maintain high growth rates for extended periods, they will all approach
“stable growth” at some point in time.
d. One simple proxy for the nominal growth rate of the economy is the risk-free rate.
Risk-free rate = Expected inflation + Expected Real Interest Rate
Nominal growth rate in economy = Expected Inflation + Expected Real Growth
e. Size of the firm: Success usually makes a firm larger. As firms become larger, it becomes
much more difficult for them to maintain high growth rates.
f. Current growth rate: While past growth is not always a reliable indicator of future growth,
there is a correlation between current growth and future growth. Thus, a firm growing at 30%
currently probably has higher growth and a longer expected growth period than one growing
10% a year now.
g. In stable growth, firms should have the characteristics of other stable growth firms. In
particular,
i. The risk of the firm, as measured by beta and ratings, should reflect that of a stable growth
firm. Beta should move towards one. The cost of debt should reflect the safety of stable
firms (BBB or higher).
ii. The debt ratio of the firm might increase to reflect the larger and more stable earnings of
these firms. The debt ratio of the firm might move to the optimal or an industry average. If
the managers of the firm are deeply averse to debt, this may never happen.
h. The return on capital generated on investments should move to sustainable levels, relative to
both the sector and the company’s own cost of capital.

11