DCF based values can be analysed between a current operating value and the value created by short-term growth, medium-term investment, and long-term franchise factors. We provide an interactive value analysis model and explain how this can help in understanding and refining DCF valuations, particularly if combined with adjustments in respect of intangible investment.
DCF value analysis gives more insight than the common split between the present value of cash flows in an explicit forecast period and the present value of the ‘terminal value’ at the end of that period. We demonstrate the approach by analysing the enterprise value of UK retailers Tesco and Ocado.
In two recent Footnotes Analyst articles1See ‘DCF terminal values: Returns, growth and reinvestment’ and ‘DCF terminal values: Using the right exit multiple’., we demonstrate different approaches to calculating a DCF terminal value. In one of these we used a terminal value based on a target exit multiple that is derived from medium and long-term value drivers, including the expected incremental rate of return on invested capital.
DCF is much more than simply an explicit forecast plus terminal value
In the model we feature in this article we take this earlier DCF calculation a step further and analyse the resulting value into four components. Our objective is to show that there is more to DCF than simply an explicit forecast and a terminal value and that, by analysing value in this alternative way, additional insights can be obtained. We also explain why criticism of DCF on the basis that most value is captured in a simplistic terminal value calculation is unwarranted and that, when expressed in a different form, value is perhaps more driven by current operations than might be assumed.
Our DCF model and the related value analysis start with current profitability as being the foundation of DCF value. Because our model derives a DCF enterprise value, the relevant profit measure is post-tax operating profit, generally expressed as NOPAT (net operating profit after tax). The same approach can be applied to discounted equity free cash flow, with earnings and PE ratios used instead of their EV equivalents.
Current NOPAT used in the analysis should be a realistic measure of current profitability. There are two things to consider in ensuring NOPAT is a suitable measure:
- NOPAT must be inclusive: Any historical one-off items are automatically excluded because we use a first-year forecast NOPAT. However, it is important that ‘exceptional’ income and expense items are not forgotten. This means including a ‘normalised’ amount for volatile expense components, such as restructuring costs, rather than ignoring them entirely. It also means not adding back expense items such as stock-based compensation.
- NOPAT should preferably not be distorted by intangibles: We have previously emphasised how the immediate expensing of intangible investment in financial statements can distort accounting metrics. NOPAT is artificially depressed if material expenditure on intangible assets is not capitalised and there is material growth in the business. See our article ‘Missing intangible assets distorts return on capital’ for more about this problem and for an illustration of how to adjust. We also show below how this issue affects our DCF value analysis.
Of course, DCF values are based on cash flows and not accounting profits. However, the two are closely linked, with the difference being the change in invested capital. It is this change in invested capital combined with the change in NOPAT that forms the basis for our DCF value analysis.
Analysing value
Our approach to value analysis is based on the target enterprise value multiple model we have previously applied. This uses an underlying DCF approach to derive a fair value for a business, and from that an implied fair multiple, based on input value drivers, including the incremental return on invested capital (iROIC).
The basic calculation of a target first year forecast (1e) EV/NOPAT multiple based on constant value drivers is:
{ \sf { \dfrac{EV} {NOPAT} = \dfrac{ (iROIC \,– \,g)} {iROIC\, (WACC \,– \,g) }}}
For an explanation of how this formula is derived, and how it is mathematically equivalent to the present value of a simple growing perpetuity of free cash flow, see the ‘Underlying Maths’ tab in our article ‘Interactive model: Target enterprise value multiples’.
The same approach can be used in a two-stage setting where the initial growth and returns differ from the long-term steady state values. The model below shows this two-stage version and presents value in the form of an EV/NOPAT multiple. The model also shows the implied values for other EV multiples based on additional inputs, but these are not relevant for our DCF value analysis.
Interactive model: Target EV/NOPAT and other enterprise value multiples
— iphone and ipad users: This model formats best if viewed in Google Chrome —
See ‘Interactive model: Target enterprise value multiples’ for an explanation about this model, the required inputs and the underlying math.
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Value and the target multiples shown in this model crucially depend on the relationship between the incremental rate of return on investment (iROIC) and the cost of capital (WACC). If iROIC is greater than WACC, value is added through additional growth. However, if iROIC equals WACC then additional investment results in a zero net present value and growth is value neutral, in which case the formula above simplifies to:
{ \sf { \dfrac{EV} {NOPAT\scriptstyle1} = \dfrac{1} {WACC}}}
or
{ \sf { EV \ =\, \dfrac{NOPAT\scriptstyle1} {WACC}}}
The implication is that, even if NOPAT grows, where growth adds no value the deserved NOPAT multiple is 1/WACC. We use this ‘future zero value added’ based valuation to derive the different value components of DCF.
If iROIC = WACC no value is added
In most valuations iROIC is assumed to exceed WACC, both in the explicit forecast period and in the terminal value calculation. As a result, DCF value usually exceeds a simple capitalisation of forecast NOPAT at the cost of capital. However, by changing the assumption regarding iROIC for different periods in the model we can produce different DCF values, and from that analyse the overall DCF value.
We illustrate the process in the table below. Each of the 4 valuations are based on different constraints on iROIC. It is the incremental value achieved by relaxing the constraints that represent our DCF value analysis.
DCF values based on alternative iROIC constraints
In our value analysis, the four components of value each represent the value contribution from different periods. The labels we have given to the different periods do not have great significance but simply reflect a generalisation of how we regard each value contribution.
- Current operating value: This reflects current profitability and is simply the first-year forecast NOPAT capitalised at WACC. The valuation excludes any potential value-adding growth in future periods.
- Short-term growth value: This represents the value-added that is forecast to arise over the explicit forecast period. The added value may be derived from growth, margin changes, new investment, or other factors. All these effects are reflected in the free cash flow growth over that forecast period and the NOPAT expected at the end of the period. In the calculation we assume no value-added growth arises after the end of that forecast period.
- Medium-term investment value: Because in our DCF model we use a two-stage terminal value calculation we can split the value-added in the terminal period into two components that reflect different assumptions regarding returns and growth. The medium-term investment value represents the value-added in the period beyond the explicit forecast period, during which value-added growth is forecast to arise. It equals the overall DCF value, except limited by assuming no value-added in the long term, less the value attributed to current operating value and short-term growth value.
- Long-term franchise value: If a company is forecast to achieve an incremental rate of return on investment that continues to exceed the cost of capital, then investment adds value in perpetuity. You would only expect this for those companies with a strong and sustainable franchise.2If significant intangibles are unrecognised in financial statements, long term returns may be structurally above the costs of capital, resulting in an apparent positive long-term franchise value even if economic returns are not above the cost of capital. See our comments below about intangible assets. Long-term franchise value equals the overall DCF valuation, including a terminal value that reflects the full long-term expected value creation, less the value attributed to the three earlier periods described above.
In the DCF model below we have added the value analysis to the model we previously featured in our article on DCF terminal values. The value analysis is presented in three ways: (1) An analysis of the implied prospective EV/NOPAT multiple; (2) An analysis of absolute value (which we also use to present the chart); and (3) A percentage of the overall DCF value.
Interactive model: DCF value analysis
— iphone and ipad users: This model formats best if viewed in Google Chrome —
The 4 different DCF values and the workings for the DCF analysis are presented in the downloadable version of this model.
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To derive all four value components, it is necessary to use a two-stage value driver model for the terminal value. However, it is still possible to analyse value if you use a more standard constant growth terminal value. In that case, it would not be possible to differentiate between the medium and long-term components of the value analysis. These would be combined into one amount representing value attributed to the period beyond the explicit forecast.
Get additional insight by analysing value based on when it is generated rather than when cash is received
DCF value analysis provides useful insights into the drivers of value and the periods where value has been or will be created. This can help when using DCF to derive absolute value by helping to ensure input assumptions are realistic and in providing an additional dimension for relative value comparisons.
For example, you will notice in the above model that the medium-term investment and long-term franchise value components are a relatively small portion of the overall value. Most of the value inherent in this company is derived from current profitability and short-term expectations, such as growth and cash conversion. This is because the model inputs for medium and long-term incremental return on invested capital are only modestly above the cost of capital. As a result, further growth beyond the explicit forecast period does not add a great deal of value. This is a reminder why it is often important to focus on the sustainability of current profitability as a source of value.
Value may primarily depend on current profitability and short-term changes
The problem with the traditional presentation of DCF as an explicit forecast plus a terminal value is that it suggests that most of the value is in the long-term. It might also give the impression that DCF is more dependent on the terminal value calculation and, therefore, less useful than it actually is. While it is true that most value is embedded in cash flows beyond the explicit forecast period, much of the amount of these cash flows depends on current profitability and short term-changes therein. The DCF value analysis attributes value to the periods where that value is created rather than when it is realised through actual cash receipts.
Applying value analysis to Tesco and Ocado
We have applied our value analysis model to Food Retail companies Tesco and Ocado. Tesco is long established, profitable but low growth and trades on modest valuation multiples. Ocado is newer, online, higher growth but, not (currently) profitable. Given the different business dynamics their value analysis, unsurprisingly, gives a very different picture.
DCF value analysis – Tesco
DCF value analysis – Ocado
The analysis is based the market enterprise value and consensus short-term forecast data taken from Factset on 2 March 2022, together with The Footnotes Analyst estimates.
The charts do not show our valuation of the companies – we have instead applied a reverse DCF approach and use input value drivers that produce a DCF value equal to the current market enterprise value. The resulting value analysis is how we think the market is (approximately) viewing each business and the relative contributions of each period to the overall enterprise value. Clearly there is an infinite number of possible value driver combinations that we could have used, each of which would have produced a different pattern. Nevertheless, we think the overall picture presented is likely to be representative of how these companies are regarded.
The negative current profitability value for Ocado may seem odd in that a stock price cannot be negative. However, we think that this approach is valid and shows by how much performance needs to improve in future periods, and therefore by how much value needs to be created, to justify the current market value of the business.
It is important to remember that value is unaffected by how it is analysed, as illustrated by our interactive model above. Presenting the analysis with a relatively small ‘long-term franchise value’ compared with a larger terminal value of cash flows does not change the overall sensitivity of the model to changes in input assumptions. However, we do think that it puts DCF valuations in perspective and helps investors find the right input assumptions.
Adjusting for intangibles
We have previously discussed how the incomplete recognition of intangible assets in financial statements affects profit and return on capital metrics. In our article ‘Missing intangible assets distorts return on capital’ we provide an interactive model to show how the lack of intangible asset recognition affects NOPAT and ROIC. The model shows how adjustments can be made to allow for the capitalisation of expenses that are ‘future-oriented’ which results in profit and return metrics that we think better reflect the underlying economics.
Adjusting for unrecognised intangibles makes DCF value analysis more realistic
Whether something is capitalised or not does not change cash flow, therefore DCF value should be unaffected by the accounting applied to intangibles. However, intangible accounting does affect the DCF model inputs if returns are used to derive cash flow forecasts. Where intangible investment is not capitalised, NOPAT tends to be understated and ROIC overstated. This means that more value will be attributed to future periods in the model than may be justified by the economics of the business.
The lack of intangible asset recognition does not invalidate the analysis, but it does make the results less comparable and less useful. Therefore, where investment in unrecognised intangibles is material, we recommend making intangible asset adjustments to the accounting data before applying DCF and DCF value analysis.
Is DCF value analysis the same as residual income?
The DCF analysis we present in this article and model is not the same as residual income or economic profit. There is some similarity in that both analyse value into different components, and both do that analysis based on measures of return on capital. However, the presentation and derivation of value is very different.
A residual income valuation involves splitting value into the current invested capital plus the present value of forecast residual income.
Value = Invested capital + PV of forecast residual income
Where the periodic residual income is:
Residual income = NOPAT– Invested capital x WACC
or
Residual income = Invested capital x (ROIC – WACC)
If the underlying assumptions are consistent, and the principle of clean surplus accounting3Clean surplus refers to the relationship between profit, cash flow available for investors, and invested capital. For a residual income valuation to work it is necessary that the change in invested capital each period equals the difference between the profit (NOPAT) earned and the cash distributed to providers of capital (either as interest / dividends or as a repayment of that capital). A common problem arises where items of income and expense appear in other comprehensive income. is maintained, a residual income valuation must be exactly the same as a DCF value. It is just the process of arriving at that value which differs.
Residual income analyses value based on aggregate ROIC not incremental returns
The key difference in methodology is how invested capital and returns are defined and used in the analysis. In the case of a residual income valuation, the analysis is based on total invested capital and the aggregate return on that invested capital (ROIC). However, these do not directly feature in DCF valuation. Instead, DCF either explicitly (as in our model) or implicitly reflects an incremental rate of return on incremental investment (iROIC).
It does not really matter whether you use residual income or DCF when the outcome is the same. However, each approach provides the opportunity to analyse that value differently, which may in turn help in the process of making value judgements.
Insights for investors
- DCF value analysis presents value based upon when value accrues rather than when cash flows materialise. DCF value analysis reflects the incremental return on invested capital that is implied by, or an explicit input to, each stage of a DCF valuation.
- Current operating value equals first year forecast NOPAT capitalised at WACC. Short-term growth, medium term investment and long-term franchise value reflect value creation expected in each segment of a DCF model.
- A DCF value analysis is a more useful alternative to the common split of DCF value between an explicit forecast plus a terminal value. It does not directly change value, but it may affect it indirectly by helping you refine model inputs.
- DCF value analysis correctly shows the extent to which current profitability, and short-term changes therein, contribute to overall value. This is not readily apparent in traditional DCF.
- A more realistic value analysis may be achieved by first adjusting financial statements for unrecognised intangibles and then modelling future growth and returns based on those adjusted figures.
- Residual income is based on total rather than incremental returns, and analyses value based on aggregate invested capital. However, residual income and DCF values must be identical if they are correctly modelled, and the underlying assumptions are consistent.
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