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82Analysis of discounted cash flow method and its application in modern conditions Toleugazy А. (Republic of Kazakhstan)
Анализ дисконтированных денежных потоков и метод его применения в
современных условиях Толеугазы А. (Республика Казахстан)
Толеугазы Айгерим / Aigerim Toleugazy - магистрант, кафедра финансов,
Казахстанско-Британский технический университет, г. Алматы, Республика Казахстан
Аннотация: в статье рассматриваются теоретические и практические аспекты широко используемого доходного подхода, проблемы дисконтирования денежного потока и дивидендные дисконтные методы. Оцениваются потенциалы, а также существующие недостатки. Особый акцент делается на оценку опыта компаний, использующих метод ДДП. В статье подчеркивается, что метод использования дисконтированных денежных потоков является мощным инструментом для анализа даже в сложных ситуациях.
Abstract: this article examines theoretical and practical aspects of the widely used income approach and emphasizes the discounted cash flow and dividend discount methods. It assesses its potentials as well as several weaknesses. A special emphasize is being put on the valuation of companies using the DCF method. The article finds that the discounted cash flow method is a powerful tool to analyze even complex situations.
Ключевые слова: дисконтирование денежных потоков, дивиденд, скидка, модель, рыночная стоимость, доходный подход, капитализация потоков, добавленная экономическая прибыль, дисконтная ставка. Keywords: discountеd cash flows, divident discount model, market value, income approach, capitalization flows addеd еconomic profit, ЕBIT, NCNWC, discount rate.
Successful business is based on a clear understanding of business processes, the analysis of the strengths and weaknesses of the company and continuous monitoring of occupied position among competitors. One of the most important indicators of the success of the company is its value as it determines the income of the owners of the company.
Thus, the evaluation of the enterprise - the definition of the market value of the enterprise entity. Valuation of the company includes in-depth financial, organizational and technological analysis of the current activities and prospects of being evaluated.
The theory and practice of business valuation are widely used in the works, both national and foreign scientists. It is for the developments in this area have been awarded the Nobel Prize George. Tobin (1981), F. Modigliani (1985) and Robert Merton (1997). Such foreign authors as Ansoff I., R. Braley, Mr. Desmond T. Koller, T. Copeland, George. Murrin, S. Pratt, John. Fishman, K. Wilson made an invaluable contribution to the development of theories of value and define the role cost-based approach as a natural factor of evolutionary processes in economics [1].
Discounted future earnings analysis suggests the company's income for a particular forecast period, the establishment of development trends and enterprise value outside of this period, the reduction of all future earnings to present value. Future income to be assessed can be determined by one of several ways. The most accepted are earnings or cash flow. Earnings relates the income received for a certain period to the expenses incurred in the same period, regardless of the actual earnings or cash flow [1].
Empirical evidence from foreign experts, indicate the presence of a stable relationship between the discounted cash flows and the market value of the correlation coefficient in this case is about 0.78.
Discounted cash flows (discounted cash flow, DCF) is one of the methods income approach to business valuation, which is based on the concept of time value of money. Business worth as much as able to bring net income for the period of operation with the possibility of resale at the end of this period, and risks of future net revenue shortfall, as well as factors delaying their receipt.The income approach, under current legislation in the field of evaluation activity, is a set of methods to assess the value of the evaluation, based on the definition of expected revenues from the use of assessment (Imam, S., Barker, R. & Clubb, C. (2008).
In the income approach as there are methods, such as capitalization flows added economic profit (method EVA), model Edvords Bella-Olson (model EBO), the advantages of the method in the profit and others.In practice, the most commonly used methods of discounted cash flow and capitalization of net income. For use of these two techniques include binding conditions:
- the evaluator should be able to estimate future revenues-(net cash flow, net income) with a reasonable degree of probability;
- there must be a reasonable degree that the activities of the company will develop predictable pace [3].
Thus, at the present time, the use of methods of the income approach in assessing the business value causes the greatest difficulties.
Each asset has a value, which can be estimated on the basis of its characteristics in terms of cash flow, growth and risk. In this regard, it is necessary to estimate the useful life of the asset cash flows over the life of the asset, not to mention the discount rate (WACC), to apply for these cash flow to get the present value.
Example, to better understand the use of DCF (with an emphasis on FCF approach "free cash flow"), which are widely used by analysts and evaluation [4]. Steps to determine the "fair value" of the company:
- Certain assumptions: that the company is growing faster, or does not develop? Whether the company will be able to earn income for your asset is greater than its cost capital? In answering these questions, they will help us, notifying about how far in the future we need to forecast cash flows [1].
- Forecasting revenue growth (assumption): We have to consider the company's market expands or contracts as its market share. Are there any new products driving sales or price changes inevitable.
- Forecasting free cash flow (assumptions): FCF is the cash that flows through a company that represents the actual amount that may be left to the opportunities that can be used to increase the power of the company (for example, product development, by increasing the premises, and so forth). FCF is equal to revenues minus operating expenses, net of tax, net of investments, minus the change in working capital.
The discount rate (= WACC): After adjusting FCF, The discount rate must be determined in order to calculate the net present Value (NPV) and find out what these cash flows are today. Discounted cash flow method is used in the following cases: • It is expected that future levels of cash flows will be differ materially from current; can reasonably estimate future cash flowsthe company;
- Business just created;
- Business is a large multifunctional commercial building;
- Flows of income and expenditure are seasonal in nature;
In accordance with the method of discounted cash flows when determining the value of a business appraiser must solve two problems: to analyze and predict the future cash flows of income in terms of their structure, size, time and frequency of their income and determine the rates at which they should be discounted. Briefly the main stages of the method and consider the possibility of its application in the financial and economic crisis.
The first step is the definition of money flow, ie cash flow from operating activities, which may qualify creditors and shareholders.
Distinguish equity cash flow or cash flow to equity (equity sash flows, ECF) and cash flow for the entire capital or cash flow to total invested capital (capital cash flows, CCF) [3].
Cash flow of the equity is determined on the basis of net income or earnings per share (ie on indicators return on equity). Cash flow capital of the company is determined by the operating profit (ie profit before interest on liabilities). In most cases, the rate of growth in operating profit will be lower than the growth rate of net profit, as the company's internal policy can contribute more to an increase in the latter.
Under the cash flow of the company equity is understood the difference between all cash inflows to the company and all outflows from it, except for payments to holders of obligations and preferred shares. Cash flow - cash flow available to all "suppliers" of capital - both debt and equity.
Determine the cash flow of the company capital in the following way:
CCF = EBIT + D - CAPEX +/- ANCNWC - T, (1)
Where
EBIT (earnings before interest and taxes) - Earnings before interest and taxes, calculated as interest expense plus a profit before tax
D (depreciation) - depreciation;CAPEX (capital expenditure) - capital campaign in the creation of investment assets. Investment assets are unfinished production and construction in progress, which rye subsequently be adopted for accounting purposes as fixed assets (including land), intangible assets and other non-current assets. In this investment may be positive, if there is a disposal of assets;
NCNWC (non cash net working capital) - decrease (increase) in working capital excluding changes in basic howl monetary component
T - actually paid income tax. As a calculation period, typically take one year, a month or quarter. Under the cash flow of shareholders understand the difference between all cash inflows to the shareholders and all cash outflow from them during the period, and a cash flow KOELSE is used to evaluate only one component of the capital structure. Measurement of the cash flow of shareholders (owners of ordinary shares) in the following way:
ECF = PAT + D - CAPEX-/+ Ad +/-
- ANCNWC - divna,
where PAT (profit after tax) - net profitAd (debt)- attraction (repayment) of loans and borrowings mov (change for the period); divna - dividends paid on preferred shares (as measured by the total cash flow available to holders of common and preferred shares of the figure in the formulanot taken into account).
Those cash flows can be used in the evaluation of the share capital with large borrowings, for example, bought a controlling stake through a loan. From the above formulas traced the relationship between the cash flow of equity and cash flows of the invested capital:
CCF = ECF + Int +/- A d, (3) where
- Interest on loans. In assessing the value of the discounted cash flow method also use free cash flow FCF (free cash flows), which calculated as follows:
FCF = NOPAT + D - CAPEX +/- ANCNWC. (4)
где
NOPAT (net operating profit after tax) - Net operating profit before interest but less anyincluding taxes:
NOPAT=EBIT * (1 -t), (5)
where
t - marginal or effective tax rate profit.
Free cash flow is close to the company's cash flow, however, as can be seen from the formula in determining the income tax, interest on borrowings do not reduce the tax base. If the value of the cash flow in a given period is negative, then it actually means cash outflow from the company's owners in this period. Typically, such a situation is due to the chronic shortage of working capital, the need for payments under significant debt obligations, the need for capital-investments, understated depreciation charges as a result of numerous ad hoc revaluations of fixed assets.
It is important to determine the type of cash flow to prevent inconsistencies between themmethod for determining the discount rate. To avoid errors should also pay attention to the following point: in nominal (adjusted for inflation) or real (net of inflation) terms to count the cash flows to be discounted in the future at a nominal or real rate of interest. The second stage of the method of discounted cash flow analysis is characterized by the parameters of activity (cost factors) that contribute to the proper construction of the forecast data. givenstage is broad enough to address specifically, in connection with which there will be ranked only basic guidelines when constructing forecasts [5].
Initially, an important input information is forecast of macroeconomic indicators (inflation,refinancing rate, unemployment rate, growth gross domestic product and others.) that show the general state of the economy and have a direct impact on the forecast future sales and expenses. At the microeconomic level can be identified the following areas, which are an integral part of this stage :• Forecasting revenue; • Forecasting cost;- Forecasting investment [6]. During forecasts should take into account the priorities of the company, its structure, the ability to diversify.
Forecasting revenues should be based on an analysis of its productive capacity and economic environment (consumers demand products and offers from competitors), identify the reasons for fluctuations operating and financial results, check compliance with the essential factors of profitability, liquidity and debt load of the average value. The basis for the calculation of gross revenue figures are data on the physical volume of products sold (works / services) of previous years, actual and projected price of manufactured products (rendered works / services). When forecasting the revenues of one of the most important features is the structure of the contracts of the company and the results of its analysis, this is particularly relevant today in connection with the reorientation of business with the increase of capitalization on customer retention. This part should be considered:- Already concluded, but not yet paid advances contracts (when and to what extent the expected collection of the receivables);
- conclusion of the contract for which advances have already arrived (when expected to perform contractual obligations and payment of the remainder of the amount of contracts);
- full implementation of the Treaty, which in the coming period due to the agreements expected future cash flows (when and how);
- overdue customer contracts (the probability and timing of payment);
- contracts that are in the development stage (in which stage: negotiations, formed technicaltasks, etc.);
- percentage of sustainability model contracts with one and those same customers.
The next step is to validate a given discount rate that is very complex.
The discount rate - is the rate of return on invested capital required by investors in comparable level of risk investment objects, in other words - it's required rate of return onavailable alternatives investments with comparable risk levels at the measurement date. The discount factor used to convert future earnings to the currentcharge [5, p. 260]:
k = 1 / (1 + r)n, (6)
где
k - coefficient of discounting; r - discount rate; n - number of years.
If cash flow is calculated not by year, the discount rate to calculate the following formula is used:
(1 + rn) = (1 + r), (7)
where
rn - The discount rate for a given period r - annual discount rate
n - number of periods of the year (for half to be used in the equation of the second degree root for quarter -fourth, etc.).
If the estimate of the discount rate is made on the basis of cash flow to equity, in most cases using the capital asset pricing model (capital asset pricing model, CAPM) along with this model also apply: Arbitration pricing theory (arbitrage pricing theory, ART); Cumulative construction method and others.
The weighted average cost of capitalWACC is used to calculate the discount rate for the cash flow of all capital invested. It is constructed on the basis of the weighted proportion of equity and debt, and does not reflectcarrying and market value of equity:
where
Е - the market value of the share capital;D - the market value of debt capital;ke - expected return required by shareholders;
kd - yield the required lenders.
The value of the company's WACC is reduced when it is using more cheap borrowing instead of expensive equity. However, given the specificity of the Kazakhstan economy (prevalence of a variety of output circuits of capital without significant losses), as well as high interest rates banks use their own capital in some cases be preferable to the borrowed funds.
Apart from the methods of calculation of the discount rate in modern valuation practice used by other methods. As a rule, they are applied in the case considered methods is impossible or difficult for several reasons. Dupont model or method-average return on assets and capital reflects the average rate of return on assets or industry invested capital. The method uses indicators ROA (return ofequity) and ROE (return of assets), which contain all of the risks inherent in the industry estimated the company. Therefore, the main condition for the application of the model Dupont is sufficient information on the state of the industry. Dupont model has the following form [7]:
ROE = PAT / АЕ,
ДЕ (equity) - period average amount of equity capital;
ROA = NOPAT/AA, (15)
where
AA (assets) - period average size of total assets.
Building a discounted cash flow model includes the following preparatory steps:
1. Analysis of gross income and the preparation of the forecast gross income.
2. Analysis of costs and preparation of forecast costs.
3. Calculation of cash flow for each year of the calculation period.
4. Calculation of residual value outside of the billing period.
5. Determination of the discount rate.
6. Calculation of the total present value of future cash flows and residual value. 8. Adding final touch and check the results.
Discounted dividends (discounted dividend model) is fundamental for the discounted cash flow model (discounted cash flow). Discounted dividend was first proposed by John Uiliams after the crisis of the 1930s in the United States [8].
DDM formula is as follows:
where
Price - the price of sharesDiv - dividendR - the discount rateg - the growth rate of dividends.
However, at the moment very rarely use dividends to estimate the fair value of the share capital. Why? Because if you use the dividend payments for the fair value of the share capital, almost all of the shares on the stock markets in the world you will appear to be overvalued for very simple reasons:Dividend payments are very low and virtually dividend yield rarely exceeds 3% per year.
Thus, the model DDM nowadays more used to estimate the fundamental value of the preferred shares of the company. Stephen Ryan, Robert Herz and others in his article saying that the DCF model was the most common, as it has a direct link with the theory of Modigliani and Miller, as free cash flow is the cash flow that is available to all holders of the company's capital, as holders debt holders and shareholders' equity. Thus, using the DCF can be estimated as a company, and shareholders' equity [9].
While many analysts have abandoned the dividend discount model, arguing that its focus on dividends is too narrow, the model has its supporters. The main attraction of the dividend discount model is its simplicity and intuitive logic. Assessment of free cash flow to equity and the firm is evaluating and conservative investors can reasonably argue that they can not qualify for these cash flows. The second advantage of using the dividend discount model is that we have to make fewer assumptions for flows of forecasted dividends than projected cash flows.
References
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3. Imam, S. Barker R. & Clubb C. (2008). The use of valuation models by UK investment analysts. European Accounting Review 77(3), 503-535.
4. Velez-Pareja I. & Tham J. (2003). Do the RIM (Residual Income Model), EVA(R) and DCF (Discounted Cash Flow) really match? (Working Paper No. 25).
5. Krishnamurti C. & Vishwanath C. R. (2008). Mergers, acquisitions and corporate restructuring (first ed.). London, UK: Response books.
6. Lopez F. J. (2008). Valuation of small business: An alternative point of view. Journal of Business Valuation and Economic Loss Analysis 3(1), Article 7.
7. Titman S. & Martin J. D. (2008). Valuation, the art & science of corporate investment decisions. Boston, MA: Pearson education.
8. Gitman L. J. & Trahan Е. A. (1995). Bridging the theory-practice gap in corporate finance: A survey of chief financial officers. The Quarterly Review of Economics and Finance, 35(1), 73-87.
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