DCF- BASED VALUATION APPROACH

The discounted cash flow valuation methodology focuses on an asset's fundamentals to derive an estimate of the asset's intrinsic value. DCF involves taking the expected future cash flows of an asset and discounting them with the right discount rate to arrive at the present value of cash flows (Damodaran, 2012). The general DCF model is expressed through the following equation:

𝑉𝑎𝑙𝑢𝑒 = ∑ 𝐶𝐹_𝑡 (1 + 𝑟)^𝑡

𝑡=𝑛

𝑡=1

Eq.1

Where, 𝑛 = Asset life

𝐶𝐹_𝑡 = Period t cash flow 𝑟 = Discount rate

While a range of discounted cash flow approaches exists in today's financial literature, the literature is generally divided between four commonly used DCF-based methods (Koller et al., 2020): the equity valuation method, the enterprise discounted cash flow method, the

discounted economic profit method, and the adjusted present value method. Appropriately implemented, all the methods mentioned in this sub-chapter will yield the same value.

3.1.1 The equity valuation approach

The equity valuation method is used to value only the equity claims on the business. The equity cash flows show the expected amount of additional cash the firm will have on-hand to conduct repurchases of shares or to pay dividends within each given year. Given that these projected cash flows represent payments to equity holders, the correct discount rate should be the equity cost of capital (Berk & DeMarzo, 2020). The discounted cash flow to equity formula is presented below:

𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 = ∑𝐶𝐹 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦_𝑡 (1 + 𝑘_𝑒)^𝑡

𝑡=𝑛

𝑡=1

Eq.2

Where, 𝑛 = Asset life

𝐶𝐹 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦_𝑡 = Period t cash flow to equity 𝑘_𝑒 = cost of equity

Although the firm and equity models use different cash flow definitions and discount rates, both models should produce the same output in terms of equity value as long as the valuation assumptions are used consistently. Cash flow to equity is calculated by adding non-cash expenses to net income to determine the gross cash flow. Working capital investment is then subtracted, along with fixed assets and non-operating assets. To this, debt increases and increases other non-equity claims are added, whilst any decreases in debt or other non-equity claims are subtracted to finally arrive at the cash flow to equity (Koller et al., 2020).

In the discounted cash flow to equity formula, the cost of equity is used as the correct discount rate, as this method does not adjust for non-operating assets or debt contrary to the WACC-based enterprise model. This is frequently pointed out as one of the model's risk aspects, as it does not take into account any potential changes in the debt-to-equity ratio unless the cost of equity is adjusted accordingly to mirror the risk inflicted on equity holders. Moreover, the equity model is also problematic because it prices non-operating assets, as the non-operating and operating cash flows are incorporated in the cash flow to equity and are discounted at the

same discount rate. Consequently, the equity methodology can be challenging to implement correctly in certain investment cases (Koller et al., 2020).

3.1.2 The enterprise discounted cash flow model

In the enterprise DCF approach to valuation, the firm's entire value is estimated by discounting the cash flows to all firm claim holders at the weighted average cost of capital (“WACC”) rate.

By doing this, the value effect of the debt tax benefits and debt risk is incorporated into the firm valuation. Although the firm and equity models use different cash flow definitions and discount rates, both models should produce the same output in terms of equity value as long as the valuation assumptions are used consistently. Koller et al. (2020) describe a four-step process in order to derive the value of a company's equity using the enterprise DCF approach:

Estimation of the value of the firm's operations

The value of the operating assets of a firm is estimated by discounting the free cash flow to the firm at the cost of capital. This value estimate represents the value of all firm investors' claims independent of company financing, including debt holders and equity holders. In the most general case, the model can be written as follows (Damodaran, 2012):

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 = ∑ 𝐹𝐶𝐹𝐹_𝑡 (1 + 𝑊𝐴𝐶𝐶)^𝑡

𝑡=𝑛

𝑡=1

Eq.3

Where, 𝑛 = Asset life

𝐹𝐶𝐹𝐹_𝑡 = Period t free cash flow to the firm WACC = weighted average cost of capital

Identification and valuation of non-operating assets

Further, to arrive at the enterprise value, the value of non-operating assets is added to the firm's discounted free cash flow. These non-operating assets are assets that possess value but are valued separately and are not enclosed in regular operating profits or accounting revenues.

Among the most frequently encountered non-operating assets, we have marketable securities, excess cash, investments in public firms and private firms, and tax loss carryforwards.

As these non-operating assets all have different characteristics, individual asset characteristics will have to be considered when valuing them (Koller et al., 2020).

Identification and valuation of debt and other non-equity claims

Before extracting the enterprise DCF approach's equity value, the value of all non-equity claims needs to be calculated. Although non-equity claims are a broad concept, it can be divided into four categories (Koller et al., 2020). The first category is traditional corporate debt, which can be raised directly as private debt from banks or groups of investors or public debt in the public marketplace. Standard corporate debt instruments include mortgage bonds, debentures, notes, and asset-backed bonds (Berk & DeMarzo, 2020). The second one, debt equivalents, is the same as regular debt but without the same formal requirements. Debt equivalents encompass operating leases, provisions, contingent liabilities, and preferred stock.

Further, the portion of the minority interest in other entities must also be identified and valued.

Lastly, hybrid financial claims such as convertible bonds and stock options should also be considered when valuing non-equity claims.

Extraction of the shareholder's equity value

Finally, once a value is attached to the non-equity claims, the shareholder equity value can now be calculated by deducting the value of non-equity claims from the firm value. Although the enterprise DCF model and equity model use different cash flow definitions and discount rates, both models should produce the same output in terms of shareholder's equity value as long as the valuation assumptions are used consistently. The price per share can be calculated by dividing the total shareholder's equity value by the firm's most recent number of undiluted shares outstanding. Using the undiluted shares outstanding is essential to avoid a double-counting problem, as we remember having already subtracted the stock options and convertible debt from firm value by the deduction of non-equity claims.

The enterprise discounted cash flow is the preferred valuation method among both academia and practitioners as it builds upon a company's cash flow, contrary to the accounting-based earnings in the economic profit model (Koller et al., 2020). Although the firm and equity models use different cash flow definitions and discount rates, both models should produce the same output in terms of equity value as long as the valuation assumptions are used consistently.

3.1.3 The discounted economic profit model

While the enterprise discounted cash flow builds upon a company's cash flows, the discounted economic profit model, or economic value added (“EVA”) model, spotlights the origin and timing of value creation through the use of accounting-based earnings. It uses the DCF methodology explained in the previous subchapters and will, through proper implementation, yield the same shareholder's equity value as Eq.2 and Eq.3. It is based on the economic profit measure, which is expressed through the following equation (Koller et al., 2020):

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 × (𝑅𝑂𝐼𝐶 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) Eq.4 Where, ROIC = Return on invested capital

Now, by making use of the general DCF model, as illustrated in Eq.1 along with algebraic transformations, we end up with the following general formula for discounted economic profits:

𝑉𝑎𝑙𝑢𝑒₀ = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙₀+ ∑𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡_𝑡 (1 + 𝑊𝐴𝐶𝐶)^𝑡

∞

𝑡=1

Eq.5

Economic profit is a measure of a company's value creation in a single period. This valuation measure is beneficial when examining if value creation in specific businesses has changed from one year to the next. However, one issue is that it does not do an outstanding job describing variation in economic profit for different size businesses. Nonetheless, since the discounted economic profit model is derived from the DCF formula, both models' valuation output should be identical when implemented correctly (Koller et al., 2020).

3.1.4 The adjusted present value model

The adjusted present value model ("APV") is a flexible valuation method with a particular focus on considering corporate tax and financing side-effects. The APV is calculated by combining the levered firm's value with the present value of tax benefits and deducting the present value of financial distress costs. The APV is expressed through the following equation:

𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝑉^𝑈+ 𝑃𝑉(𝐼𝑇𝑆) − 𝑃𝑉(𝐶𝐹𝐷) Eq. 6 Where, 𝑉^𝑈 = Unlevered value

𝑃𝑉(𝐼𝑇𝑆) = Present value of interest tax shield

𝑃𝑉(𝐶𝐹𝐷) = Present value of costs of financial distress

To arrive at the adjusted present value using the equation shown in Eq.6, we estimate the firm's value in three steps (Damodaran, 2012).

Value of the unlevered firm

The first part of the APV approach requires estimating the firm value with no leverage, essentially valuing the firm as if it had no debt. To complete this step, the free cash flows will have to be discounted by the firm's cost of capital if it was without debt financing, known as the unlevered cost of capital (or "pre-tax WACC"). The following equation returns the unlevered cost of capital:

𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐸

𝐸 + 𝐷𝑟_𝐸+ 𝐷

𝐸 + 𝐷𝑟_𝐷 Eq.7 Where, 𝐸 = Market value of equity

𝐷 = Market value of debt

𝑟_𝐸 = cost of equity 𝑟_𝐷 = cost of debt

Further, the expected free cash flows of the firm are discounted at the unlevered cost of capital as follows to arrive at the value of the unlevered firm:

𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 = ∑ 𝐹𝐶𝐹𝐹_𝑡 (1 + 𝑟_𝑈)^𝑡

𝑡=𝑛

𝑡=1

Eq.8

The present value of interest tax shield

After calculating the value of the unlevered firm, the next step is to examine today's value of the interest savings from debt financing. The benefit of the interest tax shield is calculated by multiplying the interest payments with the firm's corporate tax rate. The interest tax shield is discounted by the appropriate cost of capital to reflect the riskiness of interest payments.

To provide a general example, a firm that manages a target leverage ratio will have to apply a cost of capital that reflects the risk of the firm's cash flows, that is, the unlevered cost of capital.

Vice versa, if debt-levels are fixed in advance, the interest tax shield should be discounted using the cost of debt (Berk & DeMarzo, 2020).

Effect of borrowing and expected cost of bankruptcy

The third and final step is to examine the effect of bankruptcy costs. There are three key components in evaluating bankruptcy costs: The first is the probability of bankruptcy, the second is the expected cost in the case of bankruptcy, and the third is the appropriate discount rate for bankruptcy costs (Berk & DeMarzo, 2020). In practice, calculating the components mentioned above is considered challenging, and most practitioners ignore the use of expected bankruptcy costs due to various reasons (Koller et al., 2020). Meanwhile, the APV approach is appreciated by many due to its flexibility in considering side-effects from tax and financing.

When these three steps are concluded, the adjusted present value can be determined using Eq.8.

In document License to krill : aA fundamental valuation of Aker BioMarine (sider 25-31)