One of the most important principles of enterprise free cash flow DCF valuations is to separate operating and financing flows. A forecast financing flow, such as the planned issue of new equity, affects the allocation of value between claimholders and not (usually) the value of the enterprise itself.
We provide an interactive model to illustrate how anticipated new equity finance should be included in DCF, and the related concept of pre-money and post-money equity values. We also examine some more complex situations where the separation of operating and financing effects can be challenging, and where financing flows do affect value.
An aspect of equity valuation that can cause confusion is how to deal with expected capital raising in DCF models, specifically where it is expected that equity investors will inject new financing into a company, either to manage high financial leverage or to facilitate a new investment opportunity. The question we have been asked on several occasions is whether and how to include a financing inflow arising from new equity in a DCF model.
Connected to this topic is the concept of pre and post-money valuation. A pre-money valuation is the value of equity (in total and per share) before a capital raising exercise is initiated, and the post-money value is after the new equity has been raised. These terms are commonly used in connection with private equity or an IPO, but can also be applied more widely.
As with other aspects of DCF valuation, consistency and discipline is key. What you must be careful of is not to double count and to separate operating flows from financing flows. Operating flows determine enterprise value, whereas financing flows (predominantly) determine how that enterprise value is shared between capital providers.
Do not include financing flows in enterprise free cash flow
In an enterprise value DCF valuation, the cash flows arising from a forecast of capital raising (whether new debt or new equity) should not be included in enterprise free cash flow. However, you should include the new investment in operating assets. This new investment may well produce negative enterprise free cash flow in the short term. Whether this is funded by new equity, new debt or simply using surplus cash, is not relevant for the DCF valuation itself.
Any change in capital, such as the issue of new equity, will impact the allocation of enterprise value between different claim holders and affect the post-money valuation of each claim. There are two valuations and two allocations, which together produce three different values for equity:
- Pre- announcement + pre-money equity value: This is the equity value before the effect of the new investment and before the equity is considered. It is the present value of the prior forecast of enterprise free cash flows less the existing net debt.
- Pre- announcement + post-money equity value: Once the new investment opportunity is known to the market, the enterprise value should adjust to reflect the net present value of the incremental operating cash flows arising from that investment. Aggregate equity value still reflects the current net debt, but it also increases by the net present value of the investment (although see below for where this may not always be true). The per share equity value rises by the same percentage change as the aggregate equity value.
- Post money equity value: After the capital raising has been completed, aggregate equity value rises by the amount of equity raised. However, the per share equity value should not be impacted (assuming the equity is issued at a fair price that does not disadvantage existing investors). Raising new equity, and the resulting reduction in net debt, should not change enterprise value, it merely changes the allocation of this value between the claimholder groups.
In the following model we illustrate these pre and post-money values and show the link with the capital raised. The model is a straightforward enterprise free cash flow DCF valuation which features a 4-year explicit forecast and a terminal value based on a constant growth in free cash flow after year 4. We separately identify the incremental cash flows related to a new investment opportunity and make an assumption about how much equity will be raised to fully or partially fund the investment.
Interactive model: DCF valuation pre-money and post-money values
The Footnotes Analyst
Download the model to trace calculations and for further explanations.
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Considering the input assumptions shown when this page is first loaded (all blue input cells in the above can be altered), notice how the new equity raised of 200 does not feature in either the current or post investment opportunity enterprise value calculation. The ‘pre-money + post investment’ value simply reflects the net present value of the change to operating cash flows. The issue of equity does not change this EV but merely results in a different allocation of EV between claimholders.
The above model also illustrates how values change in the year following when the new equity is raised (assuming cash flow expectations do not change in that period). Notice how both the value of debt and equity rise by their expected returns and also change due to the distributions and, in the case of net debt, the cash flow effect of new debt or debt repayments. The expected values at the end of the year are called ‘forward values’ which form the basis for forward priced multiples.
Forward values are particularly useful for a multiple based relative valuation
Forward priced multiples are particularly useful where there is structural change to a business, such as that arising from new capital raised, new investments made or perhaps a period of restructuring. Looking beyond the period of change provides a better basis for comparison than current priced multiples
For an explanation of how forward priced multiples can provide better relative comparisons of stocks, see our article ‘Why you should ‘forward price’ valuation multiples’. Peer group forward priced multiples can also be a useful approach to DCF terminal values, as we explain in ‘DCF terminal values: Using the right exit multiple’.
Further explanations about the model can be found in the downloadable version.
Challenges in identifying operating and financing flows
The identification of financing flows is relatively easy for simple claims such as straight debt and equity. However, for some items, particularly those liabilities that arise from transactions that create operating expenses, the separation is more difficult. Indeed, for many of these there are two or more possible approaches to their inclusion in DCF, based on either an operating or financing view of the liability, as we have previously highlighted for leasing and pension liabilities.
Lease liabilities
The capitalisation of lease liabilities results in an operating right-of-use asset and a financing liability. The initial asset and liability recognition is a non-cash entry, with the cash flows being the subsequent lease payments. It is possible to view these lease payments as either operating or financing flows, although other aspects of your DCF model must be consistent.
- Operating view: All lease payments should be included as an operating expense. Add back the right-of-use asset depreciation to reported operating profit as a non-cash item and deduct the lease payments1For US GAAP operating leases, no adjustment is required because the lease payments are already an operating expense. For more about US GAAP versus IFRS accounting for leases, see our article ‘Operating leases: You may still need to adjust’.. Under this approach the lease liability is not included in the enterprise value to equity bridge or in the calculation of the weighted average cost of capital.
- Financing view: Lease payments are treated as a financing flow (the repayment of the lease liability and associated interest) and excluded from enterprise free cash flow. The operating flow that should be included in FCF is the ‘effective cash flow’ lease capex – the new right-of-use assets acquired in the period. Under this approach the lease liability is deducted in the enterprise to equity bridge and the (post-tax) cost of leasing should be a component of the weighted average cost of capital.
If done correctly, both the above approaches are valid and should give the same answer. Nevertheless, we prefer the financing view as we believe that it better reflects the underlying economics of leasing and is less likely to result in complications where the leverage effect of lease liabilities changes. For more about including leases in DCF models see our article ‘DCF valuation models: Have you updated for IFRS 16?’.
Pension liabilities
Pension rights arising from defined benefit pension schemes are an operating expense but the pension liability (or asset if the pension fund is in surplus) has the characteristics of financing. Like for leasing, it is possible to take an operating or financing view in DCF, but it is important to be consistent. This only applies to defined benefit pensions; defined contribution pension expense should always be deducted in operating profit and enterprise free cash flow.
- Operating view: Replace whatever defined benefit pension amounts are reported in operating profit with the forecast actual payments to (or sometimes from) the pension fund. Do not include the pension asset or liability in the enterprise to equity bridge or make any adjustment to weighted average cost of capital.
- Financing view: Only include any forecast pension service cost in operating profit and therefore enterprise free cash flow. Exclude forecasts of net financing income or expense if these are included in operating profit in the financial statements, and exclude the actual employer funding contributions as these represent a financing flow. Deduct the net of tax pension deficit (or add any recoverable surplus) in the enterprise to equity bridge, and include pensions in the WACC calculation.
As with leasing, we prefer the financing view. This also better reflects the economics, and it also avoids the difficult task of forecasting pension fund contributions.
However, the financing approach is not without its own challenges. The treatment of pensions in DCF valuation, and particularly the impact on weighted average cost of capital, is complicated by there being two risk factors that affect the calculation. These are financial leverage risk arising from the deficit or surplus, and asset allocation risk in cases where there is a lack of asset-liability matching in the funded portion of the liability. In fact, how asset allocation leverage is dealt with produces a total of four different DCF approaches, as we explain in our article ‘DCF and pensions: Enterprise or equity cash flow?’.
Why financing flows can sometimes affect value
The general rule in equity valuation is that operating flows determine enterprise value. If operating flows and enterprise value change, there is an equal effect on equity value. Financing flows affect how enterprise value is allocated between debt and equity claims. However, none of this is always true in practice.
Sometimes investors need to consider (1) how the optionality of debt and equity claims may affect the allocation of enterprise value between claimholders and (2) how changes in financing may impact the discount rate applicable in calculating enterprise value.
Debt and equity claims are really options
Due to the limited liability of equity investors, both debt and equity are in reality options. Put-call parity means that this optionality can be expressed in two ways:
- Call option view: Equity is in effect a call option with an exercise price equal to the amount of outstanding debt. Equity holders can choose to ‘exercise’ their option and pay off the debt and take the remainder of the enterprise value. However, equity holders also have the option to not exercise their call and leave the (bankrupt) business in the hands of debt holders and other creditors. Under this view, bond holders in effect own the business but have written a call option for the benefit of the equity investors.
- Put option view: Equity holders own the business less outstanding debt but also have a put option to put the business onto the debt holders in the event the business is worth less than the debt claim. Debtholders have a claim equal to the outstanding debt less the value of the equity investors’ put option.
The value of the shareholder put option can usually be ignored – but not always
Both these views are valid and can be used to value debt and equity claims as options. We think the easiest to understand is the put option view where the put adds to equity value but detracts from value of debt claims by an equal amount. This put option is usually significantly out of the money and can safely be ignored in most valuation exercises. However, for companies with high financial leverage, and particularly if accompanied by high business risk, it can play a significant role in the allocation of enterprise value between debt and equity investors, and in how the value of new investment opportunities impact that allocation.
For more about how the optionality of debt and equity claims affects equity valuation, see our article ‘Allocating value: An option based approach’. The article includes an interactive option valuation model, an extract form the output of which is shown below.
Extract from the model: Option adjusted values of debt and equity claims
The Footnotes Analyst
Equity value, leverage and the discount rate
Although financing flows do not impact the enterprise free cash flow component of a DCF valuation, they may sometimes affect the discount rate, particularly if there is a resulting structural change in leverage.
The cost of capital effect of a change in capital structure is largely a function of tax differences between debt and equity financing. In many jurisdictions there is a tax advantage to the use of debt over equity, considering the tax deductibility of debt interest, although this is often partly or fully offset by the personal tax advantage of equity returns.
The effect of leverage changes on WACC can also usually be ignored – but not always
In most valuations it is safe to ignore the potential change in discount rate arising from financing flows and simply use a weighted average cost of capital that is based on the current or target capital structure, with no adjustment in forecast periods. However, if leverage is high or there is expected to be a significant change in leverage and the tax system suggests this could affect the discount rate, further investigation is probably necessary.
For more about taxation and cost of capital see our article ‘DCF valuation: Financial leverage and the debt tax shield’
A word of caution about leverage changes and the discount rate used in DCF valuations. One of the common errors we see in DCF models is using a different discount rate each period because of a change in leverage but not adjusting the cost of equity appropriately. For example, if leverage declines due to forecast surplus free cash flow reducing net debt, you must allow for the reduction in equity risk (equity beta) in determining the cost of equity component of the weighted average cost of capital. Better still, just use a single WACC, unless the tax shield effect is thought to be material.
Insights for investors
- Do not include forecast financing flows in enterprise free cash flow. DCF enterprise value is determined by forecast operating flows and is only rarely materially affected by financing.
- Financing flows affect the allocation of enterprise value between claimholders. Generally (but not always) the full net present value of a new investment opportunity only affects equity investors.
- The difference between a pre-money and post-money equity value is the amount of new equity raised. Pre-money values are affected by the forecast change in enterprise free cash flows arising from how new equity raised is expected to be utilised.
- When leverage is high (and particularly if business risk is also high) the optionality of debt and equity claims may be relevant when allocating value between claim holders.
- Where there is a structural change in leverage you may need to consider the effect of changes to the value of the debt tax shield on enterprise value, in addition to changes in operating cash flows.