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Overview The DCF is one of the main valuation methods available to the analyst. It is the only stand-alone way to estimate the intrinsic value of a business

 The DCF analysis aims to estimate the intrinsic value of a business by calculating the net present value of the generated cash flow

 The more certain the cash flows forecast is, the more accurate the value of the business will be  While the DCF is used to value most companies, it is particularly suited for valuing businesses such as mines, oil well, infrastructure assets etc. which have a finite operations life and/or very predictable cash flow generation

 The analyst will have to be very carefully in how he/she calculate the key driver of the DCF valuation: ― Free cash flow ― The normalized cash flow ― The weighted average cost of capital ― Terminal Value

 To obtain a relevant valuation range, it is important to build sensitivities around key drivers (WACC, perpetuity growth rate) and to cross check Terminal Value calculation (Gordon Shapiro vs. multiple method)

Intrinsic value – Discounted Cash Flow (“DCF”) A method estimating the intrinsic value of a business Introduction

How to run a DCF Free cash flows

 The DCF analysis estimates the net present value of the

future cash flows of a company to the providers of capital of this company

 It is an approach which aims at capturing the intrinsic value of a business

Key comments  Cash flows used are the “Free Cash Flows to the Firm” (FCF) or Unlevered Free ash Flows: the cash flow generated by the company independently of its capital structure

 The DCF valuation is as good as the forecast cash flows ― If the analyst has only 3-year projections, the output will

only be some sort of a cross check

― If the analyst is valuing a mine, with a finite life and

very predictable cash flows, the DCF valuation will be fairly accurate

 A DCF valuation will tend to be higher than the other

methods as it is supposed to capture 100% of the intrinsic value of a business

FCF

Norm

Normalized free cash flow Terminal value calculated using multiple method or Gordon-Shapiro method

1. Build the operating model and projections for the business

2. Calculate Normalized Free Cash Flow based on  Normalized revenue growth  Normalized margins  Normalized D&A  Normalized Working Capital  Normalized Capital expenditure

3. Calculate Terminal Value based on Normalized Free Cash Flow

4. Discount FCF and TV using an appropriate “WACC” (weighted average cost of capital)

From the operating model to the free cash flow (“FCF”) A FCF is the cash flow generated by a business independently of its capital structure Comments  The first step in a DCF analysis is to

Simplified financial statements – levered cash flows Levered financials 2013E

2014E

2015E

2013E

2014E

2015E

Revenue Growth%

150

165 10.0%

183 11.0%

150

165 10.0%

183 11.0%

EBITDA Margin %

30 20.0%

35 21.0%

40 22.0%

30 20.0%

35 21.0%

40 22.0%

build an operating model of the business the analyst wants to estimate the value for

(in $m except specified)

― The operating model is either built

by the bank or provided by the client

 Once the operating model is set up, the analyst has to calculate the unlevered free cash flow

― The DCF aims at estimating the value

of an asset regardless of its own capital structure

― All items linked to capital structure

have to be stripped off: interests, dividend, debt repayment and issue, equity issue, share buy-backs etc…

 Taxes are calculated on EBIT  Capital structure will be later reflected in the WACC

 Depending on the business, the

projections horizon can vary, but it is common to request/ build a 10-year horizon operating model

Unlevered financials

D&A As % of revenue EBIT Margin % Net interest expenses

(5) 3.5% 25 16.5% (3)

(6) 3.5% 29 17.5% (3)

(6) 3.5% 34 18.5%

(5) 3.5%

(6) 3.5%

25 16.5%

29 17.5%

34 18.5%

(3)

Profit before tax Margin %

22 14.5%

26 15.7%

31 16.9%

25 16.5%

29 17.5%

34 18.5%

Taxes Effective tax rate %

(4) 20.0%

(5) 20.0%

(6) 20.0%

(5) 20.0%

(6) 20.0%

(7) 20.0%

Net Income Margin %

17 11.6%

21 12.6%

25 13.5%

EBITDA

Dividend Taxes Variation in WC

(8) (4) 3

(8) (5) 3

(8) (6) 4

(5) 3

(6) 3

(7) 4

(5) (13)

(6) (13)

(5)

(6)

Simplified Cash flow statement

Capital expenditures Net debt service (principal and interes Cash flow

How to get to normalized cash flow For businesses which do not have a finite life, the analyst needs to determinate what the normalized cash flow is Example of a normalized cash flow Forecasts (in $m except specified) Revenue Growth% EBITDA Margin % D&A As % of capex

Extrapolation

2013E

2014E

2015E

2016E

2017E

2018E

2019E

2020E

2021E

2022E

Norm.

150

165 10.0%

183 11.0%

201 10.0%

220 9.0%

237 8.0%

254 7.0%

269 6.0%

282 5.0%

294 4.0%

303 3.0%

30 20.0%

35 21.0%

40 22.0%

45 22.1%

49 22.3%

53 22.4%

57 22.5%

61 22.6%

64 22.8%

67 22.9%

70 23.0%

(5) (6) (6) (8) (9) (9) (10) (10) (10) (11) 111.1% 111.1% 111.1% 109.7% 108.3% 106.9% 105.6% 104.2% 102.8% 101.4%

EBIT Margin %

25 16.5%

Taxes Effective tax rate %

(5) (6) (7) (7) (8) (9) 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%

EBITDA Taxes Variation in WC Capital expenditures As % of revenue FCF Growth %

30 (5) 3 (5) 3.1% 23

29 17.5%

35 (6) 3 (5) 3.4%

34 18.5%

40 (7) 4 (6) 3.8%

36 18.0%

45 (7) 3 (8) 3.8%

40 18.2%

49 (8) 3 (8) 3.7%

44 18.4%

47 18.6%

53 (9) 2 (9) 3.7%

51 18.9%

54 19.1%

57 19.3%

(9) (10) (11) (11) 20.0% 20.0% 20.0% 20.0%

57 (9) 2 (9) 3.7%

61 (10) 1 (10) 3.6%

64 (11) 1 (10) 3.6%

67 (11) 0 (10) 3.5%

(11) 100.0% 59 19.5% (12) 20.0%

70 (12) (11) 3.5%

15.7%

16.4%

4.7%

7.5%

6.9%

6.2%

5.4%

4.6%

3.7%

2.8%

Foreseeable future

Long term growth rate (aligned to inflation) Long term sustainable margin D&A as % of capex @ 100% meaning that the company invest in capex as much as it consumes in its operations Impact of variation of working capital trends to 0 (cash neutral) â&#x20AC;&#x201C; growth more linked to inflation than increase in volumes The company invests enough to continue operations

Trends to normalized year

Calculate the weighted cost of capital (“WACC”) The analyst has to give a particular attention to the calculation of the WACC as it is the corner stone of the DCF valuation Comments

Cost of equity Market risk premium: global risk premium (Bloomberg gives this data) Beta: indication of volatility of the company stock vs. market (data can be found on Bloomberg or on the Barra database)

Market risk premium: 6.50%

Cost of equity

Cost of debt Credit spread = cost of debt – risk free rate If the company is listed and mature, credit spread is an average of its current spread on its debt Credit spread can also be benchmarked to recent peers debt issuances

WACC calculation (example)

Levered company Beta: 1.209

Equity risk premium: 7.86%

Risk free rate: 2.00%

Equity risk premium: 9.86% Target D/E = 40%

Target leverage/ long term financing structure

WACC: 7.10%

what the leverage should be in 10 years, at a sustainable level in the industry)

Small cap premium Small cap companies have to incurred a particular premium as judged riskier (the data can be found in the Ibbotson reports, which run linear regression of returns for different classes of companies) The premium is added to the final calculation of the WACC

Cost of equity

Reflects long term leverage in the industry (e.g. Credit spread: +4.50%

Target D/E = 40%

Risk free rate: 2.00%

Pre-tax cost of debt: 6.50%

Post-tax cost of debt: 5.20%

Marginal tax rate: 20% 6

How to calculate the Terminal Value The analyst has different methods when it comes to estimate the Terminal Value (“TV” or “TEV”) for a business which does not have a finite life The TEV is the value of the business at the end of the horizon, it will have to be discounted to the present Gordon Shapiro approach  Formula:

Multiple approach  Formula:

TEV =

Norm Cash flow * (1+g) (WACC – g)

Most commonly used

TEV =

Normalized aggregate * multiple

TEV =

Normalized EBITDA * EV/EBITDA

 Where g is the perpetual growth rate of the business – supposed to be aligned to inflation @ c.2.50% - 3.50%

 The Terminal Value is a value of the business when the company reached a steady state of cash flow

 EV/EBITDA multiple must be carefully chosen based on

current trading comparable and taken into account a multiple compression

Example based on previous financials:

 g = 2.50%

 Normalized EBITDA: $70m

 WACC = 7.10% (assuming no small cap premium)

 Current EV/ EBITDA multiple: 18.0x

 Normalized cash flow = $47m

 Multiple including compression: 15.0x

TEV =

47 * (1+2.5%)

TEV =

70 * 14.0

TEV =

$1,044m

(7.10% – 2.50%) $1,052m

Calculate the Enterprise Value and build sensitivities In order to calculate the Enterprise Value of a business, the analyst has to discount the FCF and terminal value using the calculated WACC Calculation of Enterprise Value Forecasts

Extrapolation

2013E

2014E

2015E

2016E

2017E

2018E

2019E

2020E

2021E

2022E

Norm.

EBITDA Taxes Variation in WC Capital expenditures

30 (5) 3 (5)

35 (6) 3 (5)

40 (7) 4 (6)

45 (7) 3 (8)

49 (8) 3 (8)

53 (9) 2 (9)

57 (9) 2 (9)

61 (10) 1 (10)

64 (11) 1 (10)

67 (11) 0 (10)

70 (12) (11)

FCF

Discount period WACC Discount factor

0.5 7.10% 97%

1.5 7.10% 90%

2.5 7.10% 84%

3.5 7.10% 79%

4.5 7.10% 73%

5.5 7.10% 69%

6.5 7.10% 64%

7.5 7.10% 60%

8.5 7.10% 56%

9.5 7.10% 52%

Discounted FCF

(in $m except specified)

Sum of discounted cash flows and TEV

9.5 7.10% 52% Discounted TEV

548

Sensitivities

 The sum of the discounted CF and of the TEV is the Enterprise

Enterprise value in $m

 Discount period: we use mid-year period convention

WACC range

Value of the business

Perpetuity growth range 799

― Cash flow is generating all over the year, to reflect this we

discount the cash flow from the middle of each year

Discount factor =

1,052

799

Comments

 Discount factor is calculated as follow

TEV

2.00%

2.25%

2.50%

2.75%

3.00%

6.10%

932

977

1,029

1,088

1,157

6.60%

827

862

900

943

993

7.10%

743

770

799

832

869

7.60%

674

695

718

744

772

8.10%

616

633

652

672

694

(1 + WACC) ^ (1 / discount period)

From the Enterprise Value to Equity Value It is important to have an idea of both the Enterprise Value and Equity Value General

 Once the analyst has estimated the enterprise value

through a DCF analysis, the final step is to deduct the Equity Value of the business

To get to a value per share Enterprise Value - Net debt

― When a buyer make an acquisition, if the debt does

not have to be refinance, it will buy the equity

- Minority interest

 The value of the equity obtained, will be the intrinsic value of the equity

+ Investment in associates

― It will be the theoretical value of the shares if these

ones were fully prices

= Equity Value / NOSH

Value per share

 Calculation of the Equity Value from the Enterprise Value may include more adjustments (debt-liked items such as leases, pensions etc.)