Discounted Cash Flow (DCF) Valuation

DCF calculations have been used in some form or the other, since money was first lent at interest during the ancient times. It gained popularity as a method for valuation of stocks after the market crash of 1929. Irving Fisher, in 1930, in his book “The Theory of Interest” and John Burr Williams, in 1938, in “The Theory of Investment Value” first formally expressed the DCF method in the modern economic terms.

Basically, the DCF method is a method whereby an enterprise as a whole or its shares are valued, using the concept of the time value of money and estimating future cash flows of the enterprise. The cash flows that an enterprise will generate over a fairly long period, are discounted to their present value, to arrive at the value of the enterprise or shares, as the case may be.

Equity valuation vs. Enterprise valuation

The DCF method of valuation is used not only for valuation of equity, but also for the enterprise valuation. When valuing an enterprise, we consider the cash flows before debt commitments unlike in equity valuation where we consider the cash flows available to equity shareholders of the company after fulfilling all other commitments.

Enterprise valuation, also called business valuation of the company is used for arriving at the purchase consideration during amalgamations, absorptions, mergers, demergers, etc. This method also helps credit rating companies like CRISIL, ICRA, etc. to arrive at the ratings to be assigned to a company.

Three Important factors to be considered for DCF
Discount Rates

Discount rates applied to cash flow should be commensurate with the risk involved in the business. Discount is based on the cost of capital to the enterprise which considers the risk involved. Cost of capital is the weighted average of cost of equity and after tax cost of debt.

Cost of Equity is mainly dependent on market risk and the expected return for that investment. There are various types of risks involved in a business – project risk, competitive risk, political risk, economic risk, etc. Cumulatively, all these are called as market risk.

The most common and widely used model for measuring the risk is Capital Asset Pricing Model (CAPM). In CAPM, all the market risk is captured in ‘Beta’. We derive the risk measure ‘Beta’ as follows:

Assets having risk higher than average (market portfolio) will have a Beta greater than 1, while less riskier assets than average will be less than 1. A riskless asset will have a Beta of 0. There are three main factors that affect ‘Beta’.
 i) Type of Business
ii) Degree of operating leverage
iii) Degree of financial leverage

Determination of Beta becomes quite difficult in private and closely held businesses. In such cases, we generally consider comparable Betas of publicly traded companies. Risk free rate is also an important part of determination of cost using CAPM. Generally, risk free rate is the rate of return on government securities of appropriate maturity. But not all government securities are risk–free.

Last part of CAPM model is ‘equity risk premium’. This is the extra return that investors demand over and above the risk–free rate. It is the return for taking higher risk by not investing in riskfree asset. It normally ranges from 4% to 12%.

Next we come to the cost of the debt. Determining the cost of debt is comparatively simple. It is the interest rate on the money borrowed by the enterprise to finance its operations. Interest being a tax deductible expense, the cost of debt to the enterprise should be considered, after taking into account the tax benefit on the interest paid. This is arrived at, using the following formula: After tax Cost of Debt = interest rate *(1-tax rate)

Finally, we determine the Weighted Average Cost of Capital (WACC) by taking the weighted average of the cost of equity and debt according the proportion in which they have been utilised in the enterprise. This WACC is the discount rate for discounting future cash flows. Estimating Future Cash Flows Now, the important thing is to estimate the future cash flows. These are the key to DCF valuation. The term cash flows means free usable earnings. Free Cash Flow is derived as follows:

Free Cash Flow = Net Income – (Capex – Depreciation) – Change in non-cash working capital + (Debt raised – Debt repayment).

The above formula is used for equity valuation. While valuing a business or an enterprise, adjustments on account of debt is not required to be made.

This is just the basic formula, but practically, one needs to do many adjustments to the accounting earnings to arrive at the correct free cash flow to the equity. For example: R. and D. Expenses: Future benefits of these expenses are uncertain. Where benefits are expected, these may be capitalised and amortised over their life while estimating the cash flows. Similarly, for advertisement expenses if benefits are expected over a long period one may take the same stand.

One Time Expenses: All onetime expenses, extraordinary expenses which are not expected to recur in future should be ignored.

Expenses/receipts of fluctuating nature: Items such as foreign currency fluctuation whether positive or negative should be appropriately considered.

Tax subsidies: Government often offers tax subsidies and credits to specified businesses in the form of tax holiday. In such cases, particularly if tax holiday has a sunset clause, then tax is calculated at normal rates ignoring the tax holiday. Cash flows should be after considering the tax impact.

While past earnings may be used as a guide, what is important is to estimate future cash flows. Forecasting period is also an important factor as for how many years the cash flows are to be estimated and discounted. Normally, we estimate the cash flows for a period of five years. But it can be more or less, depending upon the industry and market conditions and certainty with which future cash flows can be estimated. It is subjective and depends upon the valuer and assumptions made.

Terminal Value

Since it is impossible to estimate cash flows for a long period, we estimate cash flows for a finite period, for which estimate can be made and calculate Terminal Value which is liquidation value of the enterprise at that point. Here, we assume, a growth rate of the enterprise. It is a rate at which the enterprise is expected to grow on a year-on-year basis after the terminal year. As we are assuming growth rate for a fairly long period, the rate should not be higher than the overall growth of the economy.

                                  Cash flow (n+1)

During enterprise valuation, we replace cost of equity with cost of capital in the above equation.

Final Valuation
Finally, the enterprise is valued by discounting the future estimated cash flows along with terminal value calculated in the final estimated year with the cost of capital or cost of equity as the case may be. Sum of all these present values will be the enterprise value for an enterprise. For equity value we deduct debts from the enterprise value. We can find value per share by dividing equity value with number of shares outstanding.

Advantages of DCF

•    The DCF model considers the projected cash flow of a company while determining share value of the company. Investors as well as the management are interested in the future growth, rather than the present assets.
•    It gives a more realistic value of shares if the cash flow projections can be made realistically.
•    DCF assumes the going concern approach unlike other valuation techniques.

Limitations of DCF
•    In case of newly incorporated company/non operative company, it is difficult to project future cash flow and DCF may give inappropriate valuation.

•    It is also not suitable for companies with large asset base with negative cash flows, as use of this method will not depict the real value of the company.

•    Assumptions have a big impact on the value arrived at by using DCF. Any change in the estimation of core rates will change the entire value and the purpose of valuation might not be fulfilled.

DCF and Statutory Provisions
FEMA guidelines for issue of shares

The Reserve Bank of India (RBI), by Notification no. FEMA 205/2010-RB, dated 7th April, 2010, amended the pricing guidelines applicable for issue of shares by an Indian company to a non-resident and for the transfer of shares of an Indian company from a resident to a non-resident. The new guidelines stipulate that the value of shares is to be determined using the DCF method, in the case of shares of an unlisted limited company. Prior to this change, valuation was required to be done on the basis of guidelines issued by erstwhile Controller of Capital Issues. These guidelines prescribed valuation based on historical earnings and asset values.

However, the DCF method posed a problem in valuation of shares of a new company. So, recently, RBI issued a Circular No. 36 dated 26th September 2012 under which shares can be issued to non-residents at face value if these are by way of subscription directly to Memorandum of Association which clarified the uncertainty on this issue.

Income-tax Act

Section 56(2)(viib) as inserted in the Finance Act, 2012 provides that if a closely held company issues shares at a higher price than Fair Market Value (FMV), then the difference over and the FMV if exceeding Rs. 50,000 will be taxable in the hand of issuing company.

Recently, vide Notification No. 52/2012 dated 29-11- 2012 amending Rule 11UA of Income Tax, the CBDT introduced DCF valuation as one of the two the methods for determining the FMV of unquoted shares for the purposes of section 56(2)(viib).

ITAT (Chennai) in a recent case of Ascendas (India) Pvt. Ltd. (ITAT No. 1736/Mds/2011) held valuation of shares under DCF method as an appropriate method to determine Arm’s Length Price (ALP). In the said case, assessee sold shares to its ‘Associated Enterprise’ and considered the value as per CCI guidelines for the purpose of determining the ALP. The Transfer Pricing Officer (TPO) rejected the valuation technique and directed to consider the value as per the DCF method for the purpose of determining ALP. The Tribunal held that none of the six methods specified in section 92C and Rule 10B of the Income-tax Rules were appropri-ate in this case. It further held that CCI guidelines were issued for a different purpose and cannot be used for calculation of ALP and held that the DCF method of valuing shares and enterprise which is the method accepted internationally should be used. The Tribunal finally held that the DCF method adopted by the TPO was in accordance with section 92C(1) of the Act and it would give the value as per ‘comparable uncontrolled price’.

Conclusion

Considering the volume of cross–border FDI transactions, the use of the DCF method for valuation has increased substantially. DCF valuation will prove as a great opportunity for the young generation of chartered accountants to expand their services by providing valuation services.

Finally, the valuation itself is a subjective and varies from valuer to valuer. As Warren Buffet says “Price is what you pay and value is what you get”. Value is an intrinsic value derived from the asset unlike price, which is negotiated between the buyer and the seller.