DCF valuation

Stock-based compensation: The cash flow question

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How equity-settled stock-based compensation should be reflected in free cash flow analysis remains the subject of ongoing debate. There are two distinct questions: whether an effective cash cost exists when no shares are repurchased to offset dilution, and whether that cost should be measured at grant date or vesting date.

Both questions have direct implications for free cash flow, DCF valuation and comparisons between companies with different repurchase policies. We have previously argued that an effective operating cash outflow should be recognised at grant date. In this article we address the arguments raised against that view.

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Debt-like customer advances and DCF valuation

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Oracle Corporation says it will use customer advance payments to enhance cash flow and mitigate the amount of debt required to finance its AI infrastructure investment. We think investors should consider whether this, and other components of net working capital, are in-substance debt financing and adjust their analysis accordingly.

The standard approach of treating working capital as operating assets and liabilities for DCF valuation may not always be the best. In an interactive model, we demonstrate how receivables and payables (and similar working capital items) can be treated as financing items in an enterprise free cash flow DCF valuation.

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Net debt in enterprise value – Seasonality and fair values

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Using the most recent balance sheet amount of net debt in enterprise value could produce misleading valuations. Several adjustments may be necessary, including for seasonal fluctuations and where fair value differs from book value.

European travel company TUI is a good example of where the balance sheet net debt may be problematic. We explain when and how to adjust net debt, and why financial statements only partially help. We also consider whether a direct equity valuation, such as using a price earnings ratio, can eliminate net debt complications. 

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DCF valuation: Operating versus financing flows

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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.

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Valuation multiples: Return on investment and growth

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Enterprise value multiples, such as EV/NOPAT and EV/EBITDA, can be derived from underlying value drivers, including growth, return on investment, and cost of capital. These calculations benefit from the rigour of an underlying DCF methodology but present the results as familiar valuation multiples.

Our popular target multiple calculator can be used in both absolute valuations and to derive value drivers implied by current market prices. In a new expanded version of the model we add a disaggregation of growth inputs and a more refined measure of return on investment. The interactive model is free to download.

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Stock-based compensation: Transparency, timing and EPS

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Stock-based compensation can be difficult. Two approaches to measurement, valuation uncertainty, frequent adjustments for changes in estimates (including sometimes the stock price), and a dilutive effect in addition to an expense, all contribute this being a topic many investors try their best to avoid.

Investors are not helped by inadequate stock-based compensation disclosures. Some companies go further than required by accounting standards, such as Swiss bank UBS, whose helpful additional analysis gives more transparency. However, this analysis raises interesting questions about the timing of the expense and the impact on diluted EPS.

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Residual income valuation: OCI and clean surplus accounting

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Considering the market’s focus on earnings, other comprehensive income (OCI) can be easily overlooked by investors. We think OCI is always important in equity analysis, but if you use a residual income approach to valuation the requirement for a ‘clean surplus’ in your model makes it vital to consider gains and losses reported outside profit and loss.

We explain clean surplus accounting and why residual income valuations only work if your forecast financial statements meet the clean surplus condition. One aspect of financial reporting where this may be particularly important is expected currency translation differences.

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DCF models: Valuation date and cash flow timing

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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.

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Effective tax rates for NOPAT and DCF

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Taxation is a significant expense for most companies and an important driver of profitability and value. Differences in the effective tax rate matter in equity analysis, but how should you calculate this metric and what rate should you use as a basis for forecasting?

We explain the different calculations of effective tax rates, why it is important to examine the tax rate reconciliation footnote, the impact of exceptional gains and losses, and how intangible amortisation complicates the analysis. Understanding these effects is important to determine the correct tax rate for use in NOPAT and DCF calculations.

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Valuing sustainability risks and net-zero commitments

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Investors are paying increased attention to risks and opportunities arising from sustainability related issues, particularly the effects of climate change and related ‘net-zero’ commitments made by many companies. Some sustainability risks directly affect financial statements, but you need to look further when considering inputs for equity valuation.

Risk affects different aspects of equity valuation. It is well known that risk factors affect the discount rate, but the impact on other valuation inputs may get less attention. We explain how sustainability risks and opportunities should be included in your analysis.

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DCF Valuation: Financial leverage and the debt tax shield

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DCF valuation models can either be based on free cash flow attributable to equity investors or the free cash flow available for all providers of finance. Each requires a different approach to allowing for financial leverage, including adjustments to beta and recognition of the debt interest tax shield.   

We present an interactive DCF model that illustrates discounted equity cash flow and discounted enterprise cash flow using both the WACC and APV methods. Understanding each approach helps in ensuring consistent valuations, whichever method you choose to adopt.

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Equity beta, asset beta and financial leverage

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It can be observed that higher financial leverage increases equity beta. However, the relationship between the unleveraged asset or enterprise beta (the beta of the underlying operating business), and leveraged equity beta that is commonly applied in practice, is incomplete.

We explain the relevance of asset betas in equity valuation and why it is important to analyse the beta of debt finance and the value, and riskiness, of the debt interest tax shield when delevering and relevering equity beta.

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Valuing the debt interest tax shield

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The fact that the cost of debt finance is tax deductible, whereas the cost of equity is not, seems to give a structural advantage to debt finance. The value (if any) of this ‘tax shield’ is either an explicit or more likely implicit component of any equity valuation.

The most commonly quoted calculation of the value of the debt interest tax shield understates value by ignoring growth but, potentially, overstates value by ignoring the effect of personal taxes. We explain how to incorporate these often-ignored factors in your analysis.

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Calculating and analysing the drivers of Equity Beta

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Equity beta is a valid measure of investment risk and an important metric in equity analysis. However, don’t just plug into your models the equity beta given by a data provider – beta should be analysed and adjusted by investors with the same diligence that is applied to performance metrics.

We present an interactive equity beta analysis model to assist investors in better understanding the drivers of equity beta and its application in equity valuation. The model features the calculation of beta (and its volatility and correlation components) for any investment for which price data is available in Microsoft Excel.

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DCF versus residual income: A difference in returns

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Residual income based valuations are a useful alternative to the more common discounted cash flow. While both approaches must produce the same answer for a given set of assumptions and value drivers, we think it can be easier to derive realistic inputs using the residual income approach, considering the focus on return on investment.

However, residual income also poses challenges. The approach requires ‘clean surplus’ accounting, return inputs must allow for accounting distortions due to the lack of recognition of intangibles, and terminal growth assumptions may need to differ from those used in DCF – as we demonstrate using an interactive model.

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Intrinsic value and the equity risk premium

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Discounted cash flow and similar valuation methods are often cited as the only way to derive an intrinsic value of an equity investment that does not depend on how other assets are priced by the market. In contrast, valuation multiples, such as a price earnings ratio or EV/EBITDA, merely identify value relative to other assets. 

However, this view is not only simplistic – both DCF and valuation multiples can be used in a so-called absolute and relative sense – but it can also be incorrect. We argue that everything is relative in valuation. All equity values, including those presented in financial statements, are measured relative to either current or historical market prices

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Analytical insights from DCF value analysis

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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.

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DCF terminal values: Using the right exit multiple

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If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date. This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies.

We explain and illustrate with an interactive model the use of forward-priced multiples in DCF. We also discuss the choice of multiple (including why EV/EBITDA may not be the best) and whether to apply the exit multiple to reported or adjusted profit.

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DCF terminal values: Returns, growth and intangibles

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If DCF terminal values are based on continuing forecast cash flow, it is important that the reinvestment assumption is consistent with long-term return expectations. We provide an interactive DCF model that demonstrates four alternative cash flow growth-based terminal value calculations, along with related returns analysis.

One of the challenges when using returns in equity valuation is the limited recognition of intangible assets. Adjustments to capitalise intangible investment do not change cash flow but can help in ensuring that the assumptions that drive forecast cash flows are realistic.

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Enterprise to equity bridge – more fair value required

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A largely cost-based measurement approach in financial reporting generally provides sufficient information about operating ‘flows’ to enable investors to apply enterprise value based DCF (or DCF proxy) valuation models. However, fair values are crucial for the ‘bridge’ from enterprise to equity value.

Fair values are available for many, but not all, of the assets, liabilities and equity claims that should be included in the enterprise to equity bridge. We explain the limitations of current financial reporting and where you may need to do further analysis.

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DCF and pensions: Enterprise or equity cash flow?

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Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.

We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.

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Allocating value: An option-based approach

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You might assume that a change in enterprise value completely accrues to equity investors; however, this is often not the case. Other claims, such as debt or equity warrants, also change in value as enterprise value changes. Understanding this effect can be important when analysing many companies, especially those in financial distress.

Option-like characteristics of debt and equity claims drive the allocation of changes in enterprise value between debt and equity investors. We apply an interactive model to analyse recent changes in the enterprise value of Air France–KLM.

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Why you should ‘forward price’ valuation multiples

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The number of alternative valuation multiples can seem endless. Many different metrics, such as EBITDA and EPS, can be combined with different measures of value, such as the stock price and enterprise value. But there is a further variation that often seems to be overlooked – the pricing basis.

Valuation multiples can be based on a historical price (or EV), a current price, or the less commonly used forward price. We advocate greater use of forward priced multiples. They are more comparable and relevant for relative valuation comparisons and provide a better basis for terminal values in DCF analysis.

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