Valuation: Discounted Equity Cash Flows

When I started to read about corporate finance, I was surprised to find that there were techniques capable to give a value to a complex human institution like a company. Maybe, another reasons that lead my interested toward this topic is related to a very good book that I was fortunate enough to find in a library some years ago. The title of the book is: Finance for Executives, from Eduardo Martinez Abascal.

Corporate finance tries to answer 2 main questions:

  • How to calculate the value of a project/company
  • How to finance an investment in terms of equity and debt

From the finance perspective a project can be seen as a set of numbers. The experienced investor is the one that is capable to recognize the important ones and use them to drive the investing decision.

An investment is an increase in assets, NFO (need of funds for operations) or FA (Fixed Assets), which always involves an outlay of cash, either in the form of equity or debt. To frame the analysis of an investment we can use the following framework:

  • Analyse past P&L and balance sheets
  • Estimate future P&L and balance sheets, and then calculate a terminal value. The forecast should be consistent with the duration of the cash flows generated from the investment
  • Calculate the equity cash flows (or cash flows to shareholders)
  • Discount the ECF. For a private company some references for the discount rate are: 1) ROE of the sector, or the best company in the sector, 2) Market return of similar companies quoted in the stock exchange, 3) Risk free + Risk Premium. Where the premium is a sum of an objective measure of the variability of the ECF and the investor risk aversion

A framework is given from the following table. In this excel you can find the analysis of company ABC, and its valuation using the discounted equity cash flows.

To complement the DCF valuation, we can use other techniques:

  • P/E: we can use the price earnings ratio (today market price/expected end of the year earnings) of a traded company in the same sector, and discount 20% if the company is not listed. In this example we take the earnings of 2003 to calculate the today price in 2002: P(0)=E(1)*Ratio
  • Dividend value: we can use the dividend yield of a quoted company and the next year dividend of our company, P(0)=Div(2)/Div Yeld(1)
  • Book Value

The purpose of a project or company valuation is to set a range of prices to be well prepared in an eventual sale negotiation. At the same time is a good exercise to measure the risks of the business and to understand how to manage it better.

Do you know the value of your company?

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