Foundations of Management, Vol. 3, No.

1 (2011), ISSN 2080-7279

DOI: 10.2478/v10238-012-0037-4 81

HOW TO PERFORM DISCOUNTED CASH FLOW VALUATION?

Sławomir JANISZEWSKI
Faculty of Management
Warsaw University of Technology, Warsaw, Poland
e-mail: [email protected]

Abstract: Within the last few decades the quickly accelerating globalization processes contributed to rapid
increase in the value of the global capital markets, and mergers and acquisitions transactions. This implicat-
ed the rising importance of methodologies that enable investors to efficiently value the companies.
The aim of this elaboration is to present practical approach towards the discounted cash flow company valu-
ation method, considered one of the most effective but simultaneously one of the most sophisticated among
all. The article comprises purely theoretical as well as practical knowledge, based on the author’s broad pro-
fessional experiences.
Key words: valuation, discounted cash flow, free cash flows to firm, free cash flows to equity, residual val-
ue, discount rate, beta, market risk premium.

1 Introduction used for different purposes. The Fig. 1 presents the

most often used methodology.
In theory, the fair market value of a company can be The three principal techniques to value a business that
assessed only in a real transaction, at which the shares are commonly used include:
change hands between a willing buyer and a willing
 multiples approaches - comparable companies
seller. In such transaction the buyer is not under any
approach (CCA) and comparable transactions ap-
compulsion to buy, the seller is not under any compul-
proach (CTA),
sion to sell and both parties have reasonable
knowledge of all relevant facts.  discounted cash flow approach (DCF),
In practice there are few generally accepted methodol-  adjusted net book value approach (ANBV) [12].
ogy of company valuation which often are

VALUATION METHODS

Income approach Multiples Book value Other

FCFF CCA ANBV Option pricing 

FCFE CTA Liquidity Value  Mixed methods 

DDM Replacement Value 

Figure 1. Company valuation methods

(source: self study)

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82 Sławomir Janiszewski

Excess cash Equity Value

and marketable
securities

Market value
of preferred
Free Cash equity
flow
Market value
Enterprise
WACC Operating value of minority
Value interests

Residual
Value Market value
of interest
bearing debt
Market value
of financial fixe
assets, including Market value
non-operating of other financial
investments liabilities

Figure 2. Graphical summary of DCF approach

(source: self study)

The purpose of this article is to elaborate how to pre- in DCF valuation the cost of capital or the cost of equi-
pare DCF valuation in most effective way. DCF valua- ty of a valued company, shall be used as discount rate
tion presents future growth of the company and [10].
additionally discounts the risk of the business applying The Fig. 2 presents the graphical summary of DCF
specific discount rate that reflects each industry risk. approach. The following three factors: free cash flows,
discount rate and residual value are used in assessing
2 Discounted Cash Flow Methodology the value of the operating assets (cash-flow generating
assets) of the company. This value combined with the
Discounted Cash Flow methodology assumes that value of non operating assets (non cash-flow generating
the present range of values of the company as of the assets - primarily divided into two group: excess cash,
valuation date is equal to the present value of future marketable securities and other non operating assets)
cash flows to the company shareholders. Due to constitutes the enterprise value of a company.
the limitation of the period of the financial projections The major steps in valuation using DCF approach are
the value of the company is a sum of two factors: summarized in Fig. 3.
 the present value of cash flows (sum of the present
value of dividends that the company may afford 3 Financial Projections - assumptions
to pay out to shareholders and/or additional capital
injections made by the shareholders), Financial projections for the valued entity shall be
 residual value of the company, which is the dis- based on the assumed values of key drivers – inde-
counted value of the company resulting from cash pendent factors that have material impact on the com-
flows generated by the company after the projec- pany financial performance. The thorough analyses
tions period. of the variables affecting financial performance and the
The cash flows are derived from financial projections right selection of the key drivers are the necessary ele-
compiled in accordance with assumptions. Depending ments of the appropriate DCF approach. It also allows
on whether Free Cash Flow to Firm (FCFF) or Free to perform sensitivity analysis in a simple and reliable
Cash Flow to Equity (FCFE) calculation is used way.

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 How to Perform Discounted Cash Flow Valuation? 83

Review of Company’s operations Agreement concerning assumptions

COMPILATION OF THE FINANCIAL PROJECTIONS

FCFF FCFE

Calculation Calculation
Calculation Calculation of the adjusted free
of the adjusted free
of the free cash flow of the free cash flow cash flow
cash flow to the
to the firm during to the equity during to the equity after
firm after the pro-
the projection the projection the projection
jection period
period period period (terminal
(terminal value)
value)

Calculation of the weighted average cost Calculation of the cost

of capital (WACC) for the Company of equity for the Company

Discounting free cash flow and residual value

Performing sensitivity analysis on key drivers

Final value

Figure 3. The major steps in valuations using DCF approach

(source: self study)

It shall be underlined that not the more key drivers  profitability margins (with respect to group of prod-
are identified, the better the valuation would be. Only ucts and distribution channels),
those variables that are independent from each other  number of clients (with respect to group of clients),
and carry significant explanatory power for the finan-  average revenues per client (with respect to group
cial performance of the company shall be assessed of clients),
as key drivers. A rough estimation states that the num-  capital expenditures.
ber of key drivers shall not exceed ten variables (as-
It must be however remembered that key drivers vary
suming standard complexity of the financial model).
within different industries and often include business
An exemplary selection of key drivers is presented specific factors.
below:
The financial projections for the valued company can
 sales volume increases/decrease (with respect to be compiled using three categories of information:
group of products and distribution channels),
 information concerning macroeconomic factors,
 real price increase/decrease (with respect to group
 information concerning the industry in which
of products and distribution channels),
a business operates,
 information specific to the business.

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84 Sławomir Janiszewski

Table 1. List of sources for the basis of DCF approach

(source: self study)

Macroeconomic factors Industry factors Business factors

 External databases and services  External databases and services  Financial statements
- World Market Research - One Source  Management reports
Centre - Factiva  Business analysis
- EIU - Thompson Research
 Information
- Eurostat - SL Bloomberg
from management
- SL Bloomberg - Standard & Poor
 Commercial bank reports e.g.  Industry reports (both external
- Citibank and internal)
- BPH
- Millenium

Table 2. The summary of the benchmark treatment to the calculation of main captions in the financial projections
(source: self study)

FORECASTING FINANCIAL STATEMENTS

Profit & loss account
- % growth
- price % growth
Revenues growth - production output
- production output % growth
- market share % growth
- % of revenues
- mark-up
Operating costs growth - sales margin
- production unit cost % growth
- labour cost salary/employment % growth
Depreciation and amortisation - depreciation rate as % of gross fixed assets

Balance sheet
- turnover in days of selected operating costs
Inventory turnover
- turnover in days of revenues
Receivables turnover - turnover in days of revenues
- % of revenues
Operating cash turnover
- turnover in days of revenues
- turnover in days of selected operating costs
Payables turnover
- turnover in days of total costs
- % of gross fixed assets
CAPEX
- % of depreciation and amortisation

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 How to Perform Discounted Cash Flow Valuation? 85

In general information on the macroeconomic factors  knowledge of significant events,

and industry specific factors might be obtained from  useful life of assets (e.g. coal, oil, etc.),
publicly available sources whereas the information
 comfort of the person responsible for the assump-
on the factors specific to the valued entity shall be pri-
tions,
marily provided by the management of the company.
 length of any competitive advantage.
The list of the sources which might constitute the basis
for DCF approach valuation is presented in Table 1. It is important to remember that usually longer finan-
cial projections period allows reducing the impact
Set of assumptions shall provide both the information of the residual value on the valuation results. It is im-
on the values of key parameters of the model and portant argument for extending the period of financial
on the methodology of calculation of the certain cap- projections – the vogue estimate is that residual value
tions in the financial projections. shall constitute no more than 50,0% of the company
The summary of the benchmark treatment to the calcu- value. In other cases the valuation result becomes very
lation of main captions in the financial projections sensitive for the changes in projected cash flow
is presented in Table 2. in the last year of financial projections, which is
The duration of the financial projections shall be heavi- the base to calculate the residual value [2].
ly dependent on the forecasted performance of the val-
ued entity. The general rule is that the duration 4 Structure of the financial model
of financial projections shall be at least equal to
the period in which the company is supposed to reach The structure of the financial model shall primarily
the stable growth in perpetuity. The financial projec- consist of three separate modules (see Fig. 4). The con-
tions shall cover the period long enough to estimate tent of each of these modules might very case by case
a normalised or mature level of cash flows prior but in general shall follow the following characteristic:
to deriving to terminal value. The residual value shall  Input module
be calculated no earlier than when steady state
 macroeconomic assumptions
of the business’ operations arrives – this implies that all
-market specific factors (market growth, satu-
the value drivers in the financial projections would
ration, etc.),
remain constant [12, 4].
- GDP and inflation,
In spite of the fact that while projections become less - interest rates (T-Bills, WIBOR, LIBOR, de-
reliable further out, it still may be necessary to go posit rate, etc.),
out up to 10 years or more in order to reach normalised
 operational assumptions
levels. Furthermore, if the valued company is expected
-sales (volume increases, real price increases,
to have a competitive advantage for a certain period,
etc.),
the financial projections duration should be of suffi-
- costs (margins, unit costs of materials, etc.)
cient length to capture the entire period of this competi-
- capital expenditures,
tive advantage.
- working capital (turnover of receivables,
Summary of the factors that are useful in determining payables, inventory and operating cash),
the duration of financial projections for the purposes - other assumptions (dividend payout ratio,
of DCF valuation is presented below: etc.),
 the length of high growth or transition growth peri-  KVD spreadsheet with sensitivity analysis
od, and key parameters analysis,
 industry cycle and competitive structure (operating  control cells that indicate the correctness
margins), of both input data and calculation process.
 economic cycle,

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Module Module 
Module  
Input Calculation

KVD

Module
Module  
Module 

Output

Figure 4. The structure of financial model

(source: self study)

 Calculation module - balance sheet,

 calculating formulas and performing conversion - cash flow statement,
of input/output variables:  presentation of additional measures of financial
- calculation of sales revenues (division performance:
of sales in respect to products and distribu- - sales and operating costs analytics,
tion channels), - ratio analysis.
- calculation of cost by nature (materials
While compiling financial projections it is necessary
& energy, depreciation, external services,
to follow a hierarchical model of data. The flow
payroll, etc.),
of information implemented within the financial model
 should not include sensitivity analysis and statis-
shall follow the Fig. 5.
tical tests,
Linking the analytical-level spreadsheets directly
 should not include input cells (input data).
to output-level spreadsheets shall be avoided. The in-
 Output module formation flow shall be always gradual from the most
 presentation of the final results on the aggregat- detailed data to the most aggregated levels (e.g. profit
ed level: and loss account, balance sheet and cash flow state-
- profit and loss account, ment).

Analytics Level  Syntetics Level Output level

Figure 5. The flow of information implemented within the financial model

(source: self study)

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 How to Perform Discounted Cash Flow Valuation? 87

Earnings Before Interest and Taxes – the figure derived from Profit
EBIT
and Loss account (adjusted for extraordinary items)
+
Depreciation of all tangible and intangible assets (separate treatment
Depreciation and amortisation of goodwill amortization might be considered) - the figure derived
from P&L
+
The figure derived from Profit and Loss account adjusted for Balance
Corporate Income Tax paid (-) Sheet captions – deferred tax asset/liability unless additional CIT calcula-
tion spreadsheet is available
=
GROSS CASH-FLOWS
+
Usually split into following categories: changes in operating cash,
Changes in Working Capital receivables, payables and inventory - the figures derived from Balance
Sheet
+
Usually split into following categories: prepayments, financial assets
Changes in other assets and liabilities (excluding cash), reserves and accruals excluding changes in deferred tax
asset/liabilities - the figures derived from Balance Sheet
=
OPERATING CASH-FLOWS
+
This caption might be split into two categories: replacement capital ex-
Capital Expenditures (-) penditures and expansion capital expenditures - the figures derived from
Fixed Assets summary spreadsheet
+
CASH-FLOWS BEFORE FINANCING
+
The difference between the debt issues and debt repayments - the figures
Change in Indebtedness
derived from Balance Sheet
+
The difference between the interest revenue and interest expense the figure
Net Interest
derived from Profit and Loss account
=
FREE CASH-FLOWS TO EQUITY

Figure 6. Methodology of FCFE calculation

(source: self study)

Depending of the complexity of the model the level When valuing the firm (enterprise value) FCFF ap-
of analytics and synthetics might be limited to one proach shall be used and free cash flows to firm (prior
spreadsheet (including e.g. calculation of sales revenue to debt payments) shall be estimated. On contrary,
for product A and B on the bottom of the spreadsheet - when valuing equity of the company, FCFE shall be
analytical level spreadsheet and summary of these cal- used and free cash flows to shareholders shall be esti-
culations on the top of the spreadsheet - synthetic lev- mated [3, 4].
el).
The value of the company is determined by the capaci- 5 FCFE approach
ty of its assets to generate cash. Therefore, after compi-
lation of financial projections, it is necessary Free cash flows to equity are the cash flows leftover
to estimate free cash flows to shareholders/firm after meeting all financial obligations, including debt
for every year of the financial projection period. payments and after covering capital expenditures and
working capital needs. A methodology of FCFE calcu-
lation is presented in Fig. 6.

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Free Cash ‐ Flows to Equity
+
Dividends paid
-
Increases in shareholder’s capital
=
CHANGE IN EXCESS CASH

Figure 7. Formula to estimate change in excess cash

(source: self study)

In order to estimate the value of equity of the company

it is necessary to calculate first annual changes in the
excess cash within the financial projections period. EBIT
These changes might be simply estimated by subtract-
ing the increases of shareholder’s capital and adding +
back the dividends paid out in every year of the finan-
Depreciation and amortisation
cial projections period. It shall be remembered, that
the dividends proposed for one year (redistribution +
of profit for the year N) are usually paid out to share-
holders during the following year (N+1) (see Fig. 7). Adjusted (for interest) Income Tax paid

It is important to estimate and discount cash flows as- =

suming that cash flows occur evenly throughout
the years of financial projections. All the cash flows GROSS CASH-FLOWS
within projection period are assumed to fall on 30th
+
June and are discounted based on half year discount
rate. For example, a cash flow between period 2 and 3 Changes in Working Capital
should be discounted by (1 + Discount rate [%])2,5.
+
6 FCFF approach Changes in other assets and liabilities

Free cash flows to firm are the cash flows that are =
available to all providers of the company’s capital, both
OPERATING CASH - FLOWS
creditors and shareholders, after covering capital ex-
penditures and working capital needs. Therefore FCFF +
are projected on an unlevered basis, before subtracting
interest expenses. In other words, FCFF reflect the cash Capital Expenditures
generated by company’s all assets, independently
of how the assets are financed (capital structure
=
of the company). FREE CASH – FLOWS TO FIRM
A methodology of FCFE calculation used by EYCF
employees is presented in Fig. 8. Figure 8. Methodology of FCFE calculation
used by EYCF employees
The tax paid used in calculation of FCFF shall be ad-
(source: self study)
justed for the effect of tax shield on the financial ex-
penses and financial revenues.

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 How to Perform Discounted Cash Flow Valuation? 89

Income Tax paid

+
Tax shield on financial expenses

+
Tax shield on financial revenues

=
Adjusted (for interest) Income Tax paid

Figure 9. Tax paid used in calculation of FCFF

(source: self study) 

These adjustments shall incorporate the effective tax As terminal value constitutes the material part of ma-
rate (reflecting whether EBIT is negative or positive) jority of the valuations it is necessary to provide addi-
instead of the nominal tax rate. Therefore the following tional control procedures upon correctness of its
formulas might be applied (see Fig. 9) estimations. Therefore it is recommended to use both
It is important to estimate and discount cash flows as- perpetuity and exit multiple approaches as a test
suming that cash flows occur evenly throughout of reliability of the terminal value results. It might
the years of financial projections. All cash flows within be useful to calculate the EBIT, EBITDA and BV mul-
projection period are assumed to fall on 30th June tiples implied by a perpetuity growth terminal value
and are discounted based on half year discount rate, as and vice versa.
explained in previous chapter [9]. A stable growth perpetuity model assumes that
the cash-flows beyond the residual value will grow
at a constant rate in perpetuity. If long term-growth is
7 Residual value
assumed at level of nil it implicitly assumes a company
earns its cost of equity (capital) on all new investments
Residual value of the company is the discounted value
into perpetuity. As such, the level of investment growth
of cash flows generated by the company after the pro-
is irrelevant because such growth does not affect
jections period. Depending on whether FCFE or FCFF
the value. The formulas for a terminal value assuming
is used, normalised cash flow to shareholders or to both
stable growth in perpetuity are as in Fig 10.
shareholders and bondholders (creditors) shall be ap-
plied.
The two approaches to estimate residual value are:
 perpetuity value (based on Gordon Growth Perpe-
tuity Model),
 exit multiple.

Residual value calculation

FCFE (year N) *(1+ Long term growth )
=
CAPM (year N) - Long term growth
Residual
value
FCFE (year N) *(1+ Long term growth )
=
WACC (year N) - Long term growth

Figure 10. The formulas for a terminal value assuming stable growth in perpetuity
(source: self study

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On that chart N stands for the final year of the financial in the last year of final projections. In neither case
projections period, and g stands for the nominal long- the historical results (actually recorded) of the company
term growth rate expected in perpetuity. It is essential might be used and the necessary discount rate then
to ensure that the terminal value is calculated based provided.
on consistent basis (nominator and denominator): The logical explanation is that the difference between
 CAPM – FCFE approach and WACC – FCFF ap- the value of the company estimated using multiples
proach, approaches and the value of the company using DCF
 real long-term growth – valuation in real prices approach, with residual value computation based
and nominal long-term growth – valuation in cur- on exit multiple, shall be comprised by the variations
rent prices. of forecasted company’s cash flows against forecasted
industry average cash flows (implicitly used in multi-
Long-term growth rate is one of the most important
ples valuation approaches)
parameters of the valuation using DCF approach.
It affects both sides (nominator and denominator) of the  Adjusted (normalised) financial results
terminal value equation. Therefore even small changes While estimating terminal value the adjusted (normal-
in the long-term growth rate have significant com- ised) financial results as of the last year of financial
pounded effect on the value of the company. Residual projections shall be used. In other words the financial
value estimation based on exit multiple is treated results constituting the base for terminal value estima-
as an alternative approach. In this approach the value tion shall be adjusted for unusual and non-recurring
of the firm after the period of financial projections items and valuation-specific items. The former might
is estimated be applying an industry multiples (the be performed by either excluding non-recurring items
multiples are usually estimated based on comparable or applying average figures (in case of cyclical busi-
quoted companies analyses) to the relevant financial nesses average EBIT, EBITDA over the course
data of the valued entity. of a cycle might be used). In case of cash-flow derived
The three main aspects shall be reviewed for the con- multiples it is appropriate to use normalised cash flows.
sistency of exit multiple approach. In case of using book value multiples additional ad-
justments are necessary if FCFF or FCFE valuation
 Adjusted (normalised) multiples values as of the
approach is used.A terminal value is typically deter-
last year of financial projections
mined as a multiple of EBIT, EBITDA or BV (mind
When selecting a multiple, a normalised level should the constraints mentioned below). The applicability
be used. An industry multiple, adjusted to take into of the multiples in estimating terminal value in respect
account of cyclical variations and the country growth to different DCF approaches is presented in Table 3.
level at the terminal year, shall be applied.
Resuming it is recommended to use EBIT or EBITDA
Moreover the multiples shall reflect the relative valua- multiples in FCFF and FCFE approaches. BV multiples
tion that would be performed taken into consideration might only be used in case the book value as of the last
of economy and industry growth stage as of the last year of the financial projection period is adjusted (de-
year of the financial projections. Theoretically it might creased) with all the excess cash being distributed
be considered to apply the current multiples calculated among the shareholders [5].
for Western European countries while estimating
the terminal value for the Polish company (assuming
8 Discount rate
the financial projection period of c.a. 10 years) in order
to adjust for the differences in current and future stage
The discount rate is a function of the risk inherent
of Poland’s economy development. However, in valua-
in any business and industry, the degree of uncertainty
tion practise, mainly due to the limitation of date
regarding the projected cash flows, and the assumed
and lack of transparent criteria, it is acceptable to apply
capital structure. In general, discount rates vary across
historical multiples.
different businesses and industries. The greater
 Financial results as of the last year of financial pro- the uncertainty about the projected cash flows,
jections the higher the appropriate discount rate and the lower
While estimating terminal value, it is necessary to ap- the current value of the cash flows.
ply the financial results recorded by the company

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 How to Perform Discounted Cash Flow Valuation? 91

Table 3. The applicability of the multiples in estimating terminal value in respect to different DCF approaches
(source: self study)

Free Cash Flow Free Cash Flow Dividend

Exit multiple
to Equity to Firm Discount Valuation

EBIT
- use normalised cash - use normalised cash - use normalised cash
flows flows flows

- use normalised cash - use normalised cash - use normalised cash

flows (in particular flows (in particular flows (in particular
implicit assumption that implicit assumption that implicit assumption that
EBITDA
depreciation and amorti- depreciation and amorti- depreciation and amorti-
sation equals capital sation equals capital ex- sation equals capital ex-
expenditures) penditures) penditures)

- book value shall be - book value shall be - no adjustments

adjusted (decreased) adjusted (decreased)
with all the excess cash with all the excess cash
Book Value being distributed among being distributed among
the shareholders during the shareholders during
the period of financial the period of financial
projections projections

The consistent approach to valuation requires applica-  - levered beta, a measure of systematic risk calculat-
tion of cost of equity while discounting cash flows ed for the projected Debt/Equity ratio for the company.
attributable to shareholders (FCFE) and weighted aver- CAPM assumes that the risk of a given equity
age cost of capital while discounting cash flows at- to an investor is composed of diversifiable and non
tributable to both shareholders and bondholders diversifiable risk. The former is risk which can be
(FCFF). The exception occurs when the valued entity avoided by an investor by holding the given equity
bears in a portfolio with other equities. The effect of diversi-
the very high financial leverage (c.a. above 90%) dur- fication is that the diversifiable risks of various equities
ing the whole financial projections period. In such case can offset each other. The risk that remains after
calculation of discount rate for FCFF using CAPM the rest has been diversified away is non diversifiable
is appropriate (in such case debt holders carry the risk or systematic risk.
similar to the one carried by shareholders).
Systematic risk cannot be avoided by investors. Inves-
While performing valuation, the discount rate shall be tors demand a return for such risk because it cannot be
equal to cost of equity of the company. It assumes avoided through diversification. Thus, investors de-
to estimate cost of equity using Capital Assets Pricing mand a return for the systematic risk associated
Model (“CAPM”). The discount rate is estimated using with a stock (as measured by its variability compared
the following formula: to the market) over the return demanded on a risk-free
CE = RF +   RP (1) investment. Beta measures the correlation between the
volatility of a specific stock and the volatility
where:
of the overall market. As a measure of a company’s
CE - cost of equity, or portfolio's systematic risk, is used as a multiplier
RF - risk-free rate, to arrive at the premium over the risk-free rate
of an investment.
RP - market risk premium being average rate of return
above risk-free rate required by shareholders over long
time horizon,

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92 Sławomir Janiszewski

B  ’
BETA BASED ON COMPARABLE QUOTED COMPANIES’ BETAS

Choose Calculate Calculate Lever

comparable individual average average beta
companies unlevered betas unlevered beta with D/E and T
of the valued entity
for each year

Figure 11. The steps that shall be performed in order to estimate beta for the valued entity
(based on comparable quoted companies)
(source: self study)

In theory, the risk free rate is the return on a security There are two ways of estimating Beta for the purposes
or portfolio of securities that has no default risk of CAPM calculations:
and is completely uncorrelated with returns of any  Beta based on comparable quoted companies’ betas
other assets in economy. The assets characterised (benchmark treatment)
by risk free rate of return shall also bear no reinvest-
ment risk. Beta is calculated based on the betas of comparable
quoted companies. The criteria for company’s
Commonly used treatment is to use the forecasted comparability shall comprise all the factors de-
52-weeks Treasury bills as a measure of risk free rate. scribed in paragraph plus the requirement for the
The forecasted figures shall be used as to avoid minimum stock listing period. As described
the mismatch between the duration of risk free asset in Fig. 11 while calculating beta the average period
and duration of the valued asset/company’s cash flows. of 5 years shall be applied, although in extraordi-
The other ways of estimating risk free rate that are nary circumstances the period might be shorten
however rarely used include 5- or 10-years Treasury to not less than 2 years (24 months).
bonds. The advantage of this approach is that the long The steps that shall be performed in order to esti-
term rate comes closer to matching the duration mate beta for the valued entity (based on compara-
of the company being valued. The disadvantage might ble quoted companies) are presented in Fig. 11.
be the implicit inclusion of the liquidity premium with-
in long term risk free rate [7]. Before calculating the average unlevered beta,
the individual’s betas shall be unlevered using
Beta is a measure of systematic risk calculated for the capital structures and effective tax rates of individ-
projected Debt/Equity ratio for the company. In other ual companies. The average unlevered beta shall be
words, Beta is a statistical measure of the variability than relevered using the company capital structure
of a company's stock price in relation to the stock mar- and effective tax rate on annual basis throughout
ket overall. Beta is calculated by using the regression the period of financial projections.
of the percentage change in a stock or portfolio against
the percentage change in the market. These might be  Beta based on industry average beta (alternative
applied using the following formula: allowed treatment)

Beta = Cov( RJ, RM ) / (M )^2 (2) An industry average beta is typically more stable
and reliable than the individual company’s betas.
where:
The steps that shall be performed in order to esti-
Cov( RJ, RM ) - covariance between stock returns (RJ ) mate beta for the valued entity (based on industry
and market returns (RM), average) are presented in Fig. 12.
M - variance of the market portfolio.

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 How to Perform Discounted Cash Flow Valuation? 93

B  ’
BETA BASED ON INDUSTRY AVERAGE BETA

Find Research Calculate Lever average beta

best matching for average average unlevered with D/E and T
SIC levered beta beta using average of the valued entity
for the valued for the same SIC D/E and T for each year
entity industry for the same SIC
industry

Figure 12. The steps that shall be performed in order to estimate beta for the valued entity
(based on industry average)
(source: self study)

Industry average unlevered beta shall be calculated For each of the comparable companies used for estima-
based on average industry leveraged beta and aver- tion of beta, market capitalisation as of the closing date
age capital structure and effective tax rates for the of company financial statements shall be used.
companies within industry. The average unlevered For comparable companies, last years effective tax rate
beta shall be than relevered using the company shall be used, unless it differs significantly from
capital structure and effective tax rate on annual the average effective tax rate for the company.
basis throughout the period of financial projections In that case 5-years average tax rate shall be applied.
[4, 1].
For valued entity current rate effective tax rate
The unlevered beta (asset beta) of a company is de- for every year of financial projections shall be used.
termined by the type of the businesses in which It is necessary to ensure that consistent approach to all
it operates and its operating leverage. In other elements of beta equation is followed while unlevering
words it is determined by the assets owned by betas of comparable companies e.g. if 5-years average
the firm. Levered beta (equity beta) is determined Debt/Equity ratio is applied for company A (assuming
both by the riskiness of the business the company material deviation from the last year Debt/Equity ratio
operates in and by the amount of financial leverage is identified) then the same treatment shall be referred
risk it has taken on. Levered beta (equity) beta is to company B.
affected by the capital structure of the company.
Additionally the 5- or 2-years averages of Debt/Equity
In general an increase in financial leverage increas-
ratio might be also considered if material deviations
es the equity beta of the company as the sharehold-
in this ratio appear during the period of financial pro-
ers face more risk on their investment [4].
jections for the valued company.In general beta that
The operation of unlevering/relevering company beta is used in valuation shall be based on 60-months obser-
(removing or adding the effect of capital structure vation monthly return unlevered beta both in respect
on a company beta) is presented in Fig. 13 comparable companies and industrial average.
For comparable companies it is acceptable to use book There are some empirical evidence that as an indus-
value of debt, unless there is evidence that market value try/company matures, its performance seems more like
of debt differs significantly from book value of debt. the performance of the overall economy. Although
In such case the average Debt/Equity ratio over the adjustment of unlevered beta towards one over
the historical period of last five years shall be applied. a longer period of time might be justified.

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94 Sławomir Janiszewski

Unlevering/levering betas

....
Asset Beta Equity Beta
(Unleverd Beta) (Levered Beta)

....

Figure 13. The operation of unlevering/relevering company beta

(source: self study)

The market risk premium is a measure of the return that E - market value of equity (excluding preference
equity investors demand over a risk-free rate in order shares),
to compensate them for the volatility/risk of an invest- D - market value of debt,
ment which matches the volatility of the entire equity
P - market value of preference shares,
market. In other words the market risk premium is the
difference between the expected return on the market T - effective tax rate.
portfolio and the risk free rate. There are only three types of capital included in formu-
In valuation practise theory, the market risk premium la. The actual weighting scheme can be more complex,
can be based on: because a separate market value weight is required
for each source of capital that involves cash payments,
 historical data, assuming comparability of future
now or in the future. Other possible items might in-
and the past or
clude leases, subsidized debt, convertible or callable
 forward looking analysis that attempt to forecast debt, minority interests, warrants and executive stock
the market risk premium this figure in the future. options, income bonds, bonds with payments tied
While performing valuation, the discount rate shall to commodity indexes, etc. This approach provides
be equal to cost of capital of the company [3]. Valua- technically correct estimation of WACC [8].
tion practice assumes estimating cost of capital using
Weighted Average Cost of Capital (WACC).
9 Final range of equity/company value
WACC is the discount rate used to convert expected
future cash flows for all investors. i.e. the rate
The final range of equity/company values is always
that compensates the opportunity cost of both creditors
derived as a sum of three main components:
and shareholders. The general formula for estimating
after-tax WACC is simply the weighted average of the  Discounted cash-flows within the projections period
marginal after-tax cost of each source of capital: This is the sum of the normalised cash flows multi-
WACC = CE plied by the cumulative discount factor for each
* ( E / E+ D + P) + CD * ( D / E+ D + P) year of the financial projection period.
* ( 1 – T) + CP * ( P / E + D + P) (3)  Discounted residual value
where: This is the sum of the normalised cash flows multi-
plied by the cumulative discount factor for each
CE - cost of equity,
year of the financial projection period.
CD - cost of debt,
CP - cost of preferred stock,

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 How to Perform Discounted Cash Flow Valuation? 95

Deriving the final range of values

FCFE FCFE

Equity +  Market value of net debt Enterprise

value
value
Market value of net debt
 

Figure 14. The conversion of valuation results using either FCFE or FCFF approach
(source: self study)

 Excess (non-operating) assets/liabilities the period of financial projections or appearance

This component includes non-operating assets or li- of negative earnings for the significant part of the fi-
abilities that were not reflected in the forecasted nancial projections, it might be appropriate to value
cash-flows but do have impact on the company val- equity of the company using FCFF approach [6, 11].
ue. The exemplary adjustments for excess (non- The diagram presenting the conversion of valuation
operating) assets/liabilities might include the fol- results using either FCFE or FCFF approach is pre-
lowing items: sented in Fig. 14
 excess cash as of the valuation date,
 underfunded/overfunded pension liabilities, 10 Summary
 market value of minority interests,
The Discounted Cash Flow valuation reflects the ability
 market value of non-consolidated subsidiaries,
of the company to generate cash in future. This meth-
 off-balance sheet debt (if income associated with odology, in the best way, presents the real value
such debt is included in cash flows). of the company however it is very sensitive to the as-
The above list is not exhaustive and other potential sumption that constitute the base of the financial pro-
adjustments relevant to specific situations should jection.
be discussed with team members.
Additionally DCF valuation is much more complicated
While deriving the final range of values it is important than multiply or ANBV valuation what may be also
to distinguish between the value of equity and the value concluded from this article that presents complexity
of an enterprise. of DCF valuation process.
In spite of the fact that both equity and enterprise value DCF valuation also is used to present optimistic, pes-
might be assessed using either FCFE or FCFF simistic and realistic scenarios based on different set
it is recommended to use FCFE for valuing equity of assumption. Based on that it is reasonable to set
and FCFF for valuing the whole company. Under cer- a range of the company valuation.
tain circumstances e.g. very high financial leverage,
significant changes in financial leverage within

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96 Sławomir Janiszewski

11 References [6] English J.R. - Applied Equity Analysis, Stock

Valuation Techniques for Wall Street Profession-
[1] Bösecke K. - Value Creation in Mergers, Acquisi- als. McGraw-Hill, New York 2001.
tions and Alliances. Wiesbaden 2009. [7] Fernandez P. - Valuation Methods and Shareholder
[2] Copeland T., Koller T., Murrin J. - Valuation. Value Creation. Academic Press, San Diego 2002.
Measuring and Managing the Value of Companies. [8] Frykman D., Tolleryd J. - Corporate valuation.
John Wiley & Sons, New York 2000. Prentice Hall, London 2003.
[3] Damodaran A. - Damodaran on Valuation: Security [9] Keuleneer L., Verhoog W. - Recent Trends in Val-
Analysis for Investment and Corporate Finance. uation. John Wiley & Sons, The Atrium, Southern
Wiley Finance, 2006. Gate, Chichester 2003.
[4] Damodaran A. - Investment valuation. Tools and [10] Pereiro L.E. - Valuation of Companies in Emerging
Techniques for Determining the Value of Any As- Markets. John Wiley&Sons, New York 2002.
set. Sec. ed, John Wiley & Sons, Inc., New York
[11] Stowe J.D. - Equity asset valuation. John Wiley &
2002.
Sons, Hoboken 2007.
[5] Eccles R.G., Herz R.H., Keegan E.M., Phillips
[12] Szablewski A. - Wycena i zarządzanie wartością
D.M.H. - The Value Reporting Revolution. Moving
firmy, Wydawnictwo Poltext, Warszawa 2007.
beyond the earnings gam. John Wiley & Sons,
New York 2001.

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