One of the errors we often encounter when reviewing DCF models concerns valuation date and cashflow timing adjustments. Although the effect may not always be that material, getting these adjustments wrong undermines the credibility of DCF valuations.
We explain the correct application of valuation date adjustments, the necessary amounts for the enterprise to equity bridge, and how to roll-forward values to derive 12-month price targets. We also provide a downloadable model to illustrate these different elements of DCF.
Most DCF valuations involve forecasts of annual cash flows, starting with the first forecast accounting period that ends within 12 months of the valuation date. However, the valuation date will likely be part of the way through that accounting period, or indeed one year later than that if the ‘target price’ is a 12-month forward value, as is commonly applied by analysts.
To correctly produce a value on the desired date you should consider the following:
- Whether it is appropriate to use mid-year discounting, and how to apply this in practice.
- How to allow for partial year flows and adjust value to the (current) valuation date.
- What values for net debt and other enterprise to equity bridge items should be used; whether at the beginning (or end) of ‘year 1’ or the current valuation date.
- How to ‘roll-forward’ the DCF value to derive a 12-month forward target price.
Do not turn model simplifications into errors and omissions
There is more than one way to deal with these issues and still obtain the correct answer; however, it important to be consistent to avoid problems of omission or double-counting. Remember that all models involve simplifications and compromise; it is impossible to factor in all real-world phenomena. You need to be sophisticated and comprehensive enough to derive realistic values, without modelling unnecessary detail that is unlikely to move the dial of your valuation.
Valuation date adjustments may not be the most significant part of a DCF valuation. Nevertheless, we believe it is important to always get these aspects of your modelling correct to build credibility for your models and avoid awkward questions from your boss or your clients regarding model validation and consistency.
Mid-year or year-end discounting
Considering that cash flows are generated continuously during a period and are available for distribution (or for the repayment of debt) from the point received, we think that mid-year discounting is appropriate. Therefore, to arrive at a present value at year 0 (the beginning of year 1, the first forecast period) the first-year cash flow should be discounted by 0.5 years and so on.
When using a growing perpetuity calculation for a terminal value at the end of the explicit forecast period, dividing the cash flow in the first terminal period by the discount rate minus growth will produce a value one year earlier. If mid-year discounting is applied, it is important to remember that this value is therefore not actually at the end of the explicit forecast period.
For example, in the case of a 5-year explicit forecast, a growing perpetuity terminal value is typically calculated at FCF6 / (WACC – g), where FCF6 is the forecast cash flow in the first terminal period that is expected to grow subsequently at g% p.a.. However, with mid-year discounting the above produces a value at year 4.5 and not at year 5, as is often assumed.
However, if an exit multiple approach is used for the terminal value, where the forecast year 6 EBITDA (for example) is multiplied by an exit multiple based on comparable companies, this would produce a value at the end of year 5.
Current valuation date adjustments
Mid-year discounting of cash flows starting with the current accounting period (year 1) produces a present value at the start of that period, usually referred to as year 0. However, this is likely to be before the current valuation date.
Discount to ‘year 0’ and then roll forward to your valuation date
One approach to resolving this which we sometimes see is to use a partial year cash flow for year 1 and discount this and subsequent cash flows to the valuation date and not the beginning of the year. However, our preferred approach is to discount full year cash flows to year 0 and then roll-forward the year 0 value to the current date.
When using our recommended enterprise value approach to DCF, this roll-forward could be done at the EV level (i.e. before applying the enterprise to equity bridge) or alternatively directly to the DCF derived target stock price. This choice then affects the timing of bridge adjustments. We recommend that it is the year 0 enterprise value that is rolled forward to the valuation date, and that the enterprise to equity bridge be done on this date. This approach makes it easier to correctly include value changes for other financing claims and non-operating investments after the last balance sheet date.
To roll forward a target enterprise value, increase value to reflect a partial year unwind of the discounting and reduce value by the amount of cash flow already received (adjusted to allow for the effect of mid-year discounting).
Target EV(valuation date) = Target EV(Year 0) * (1 + WACC)f – [FCF1*f*(1+WACC)0.5]
Where f = the fraction of year 1 between the start of the year and the valuation date, for example, f = 74/365 if the valuation date is 15 March 2025 and year 1 is year ending 31 December 2025. Note: The final adjustment of (1+WACC)^0.5 applied to the first year cash flow that has already been realised at the valuation date is necessary only if mid-year discounting is applied, (which is the case in our model).
If you use an equity free cash flow approach then the same calculation applies to the target stock price, except the roll-forward rate is the cost of equity and the fractional equity free cash flow is deducted.
Timing of the enterprise to equity bridge
If the roll-forward to the current valuation date is done in respect of enterprise value, the enterprise to equity bridge must also be done on that same date. This means that the key net debt amount should be an estimated net debt at the valuation date, after taking into account the forecast free cash flow generated from the beginning of the first forecast year to the valuation date.
Net debt can be rolled forward like any other value by increasing debt for interest accretion and reducing it to allow for the enterprise free cash flow. However, sometimes part of the enterprise free cash flow may have been used to purchase investments (or be affected by changes in other items included in the enterprise to equity bridge).
Net debt(valuation date) = Net debt(Year 0) * (1 + COD)f – FCF*f
+/- cash flow effect of changes to investments
Where FCF*f is the cash flow earned between the start of the year and the valuation date.
Include the fair value of investments and claims at the valuation date
An alternative approach is to interpolate between the year 1 opening and closing forecast net debt on the assumption that any change is evenly spread over the period. Clearly, none of these approaches will be wholly accurate. Use your judgement to identify what is good enough for the purpose of your valuation.
Items included in the enterprise to equity bridge should be measured at fair value and not book value1This is one of the mistakes that we highlight in our article ‘Enterprise value: Calculation and mis-calculation’.. It is the fair value on the valuation date that matters and not that at the start of the current accounting period. This is one of the main reasons why we believe it is best to roll-forward the target EV from the start of the year to the valuation date before applying the enterprise to equity bridge calculation. Although fair value is required for all enterprise to equity bridge components, pay particular attention to investments and non-controlling interests where value can fluctuate significantly, often depending on changes in equity markets.
Forward 12-month target stock price
After applying the enterprise to equity bridge on the valuation date, a target equity value is obtained. If there are equity instruments outstanding other than common (ordinary) shares, then the fair value attributable to these other equity claims must be taken into account before deriving a target stock price. Sometimes, simply dividing by the diluted share count is sufficient. Although, as we explain in our article ‘The diluted EPS calculation is 50 years out of date’, this will often fail to correctly allow for the impact of equity derivatives. If options and convertibles are material, we think the enterprise to equity bridge should include the fair value of each non-common share equity claim, and that the basic share count (rather than the accounting diluted shares) is used to derive the target stock price.
Price targets are often a DCF value rolled forward for 12 months
Many analyst target prices are not the estimated value at the current date but a target value in 12 months’ time. Obviously, the actual price at that date depends on company and market developments during the next year. The 12-month target is the expected price, assuming no such changes and assuming the market comes to the same view regarding future prospects and risk, as factored into the DCF valuation.
The 12-month forward price target can be obtained through the same roll-forward explained above, but applied to the stock price rather than to enterprise value; this means compounding at the cost of equity (COE) and deducting expected dividends.
Target price(12-month forward) = Target price(Valuation date) * (1 + COE) – Dividends(Next 12-months)
Rolling forward your model
One of the benefits of having a robust approach to valuation date adjustments is that when your model moves forward by one year (such that the old year 1 drops out and year 2 becomes year 1 etc.) your price target should not change. In other words, value on 31 December is the same as value of 1 January. This is because the adjustment of compounding to the valuation date, and deducting the cash flow realised to date, is the same as valuing without that year’s cash flow and discounting by one less year.
In our illustrative model below, we show how the model roll-forward works, and also illustrate the other adjustments we describe above. As with all our models, this is free to download.
Interactive model: Illustration of valuation date adjustments and year-end roll-forward
The Footnotes Analyst
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More help with DCF valuation from The Footnotes Analyst
We have written many articles on different aspects of discounted cash flow, most of them with accompanying interactive models. Here are some that you may find useful:
DCF and lease liabilities
In our article ‘DCF valuation models” Have you updated for IFRS 16?’ we explain two approaches to dealing with lease liabilities and related expenses in an enterprise free cash flow DCF model. This article and accompanying interactive model have been our most read and most downloaded to date.
DCF and terminal values
In ‘DCF terminal values: Returns, growth and intangibles’ and the related article ‘DCF terminal values: Using the right exit multiple’ we explain 5 different approaches to dealing with the problem of estimating value at the end of an explicit forecast period. Using a simple constant perpetuity growth in free cash flow may not always be the best approach.
DCF and pension liabilities
In ‘DCF and pensions: Enterprise or equity cash flow?’ we explain how a defined benefit pension scheme can affect DCF models and how to ensure the consistency of cash flows, discount rate and enterprise to equity bridge adjustments. In all, there are 4 methods that will work – we demonstrate each and explain our preference.
DCF and the debt tax shield
One factor that impacts value, and is treated differently in alternative approaches to DCF, is the tax shield arising from the tax deductibility of debt interest. In ‘DCF valuation: Financial leverage and the debt tax shield’ we explain the differences between (and reconcile) the discounted equity cash flow, discounted enterprise cash flow and adjusted present value (APV) approaches to DCF valuation.
Analytical insights from DCF value analysis
In ‘Analytical insights from DCF value analysis’ we show how a DCF value can be disaggregated to reveal the sources of value creation and explain how this can be used to refine the model inputs.
Equity beta and the cost of capital
In most DCF valuation models, risk and the discount rate are based on the commonly used Capital Asset Pricing model. In ‘Calculating and analysing the drivers of equity beta’ we explain why you should do more than just look up the equity beta given by a data provider, and provide an interactive analytical model that is linked to stock price data available in Excel.
You can access all interactive models featured in our articles through the ‘Analytical Models’ page on the Footnotes Analyst website.
Insights for investors
- Use mid-year discounting, but be careful to get the terminal value correct – the discounting period for a terminal value depends on whether you use a constant growth or exit multiple approach.
- Discount cash flows and the terminal value to the beginning of year 1 and then roll-forward to the current valuation date.
- When using an enterprise free cash flow DCF model (as we recommend) apply the enterprise to equity bridge on the valuation date. This means adjusting opening net debt for the effects of realised cash flow to the valuation date and using investment and other EV component values on that same valuation date.
- If the discounting and valuation date adjustments are correct you should find that, when a model rolls forward by one year at the accounting year-end, there is no change to your target DCF value.