Discounted Cash Flow Method of Valuation in UAE

The Discounted Free Cash Flows (“DCF”) technique is one of the most rigorous approaches to valuation of a business. In this technique, the projected free cash flows from business operations are discounted at the weighted average cost of capital and the sum of such discounted free cash flows is the value of the business.

Prior to this method gaining popularity, it was the Earnings Capitalization Method that was considered to be the most acceptable method for valuing a business. In this method, the value of the business is arrived at by capitalizing its future maintainable profits. The future maintainable profits are calculated based on the past or the projected working results of company, usually for a period of 5-7 years, after adjusting for non-recurring, unusual and extraordinary items of income and expenditures.

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    Although the business valuation under the capitalization of future sustainable earnings method remains generally an acceptable value indication, it suffers from the following drawbacks as compared to the DCF method which is a more scientific method for value determination.

    • The earnings capitalization method does not address the question of additional capital required to meet capital expenditure, which is necessary to generate future profits.
    • It also does not consider the additional working capital required to operate at a higher capacity level.
    • Further, unlike the DCF method, it entirely ignores the concept of time value of money.

    Based on the above, the DCF method is the more scientific and accepted method for value determination.  Adequate cash flows required to meet the capital expenditure and working capital needs are made.  The remaining net free cash flows available for distribution to shareholders are discounted to determine the present value of such future free cash flows.

    The DCF analysis involves determining the following:

    Estimated future cash flows

    Free cash flows are the cash flows available for distribution to the providers of the Company i.e. both lenders and shareholders.

    Time frame of the free cash flows

    An additional issue in valuing an enterprise is its indefinite life, especially where the valuation, as in the present case, is on-going concern basis.  This problem could be solved by dividing the value of the enterprise into two periods – explicit forecast period and post explicit forecast period.  In such case the value of the business will be the aggregate of the present value of free cash flows generated during the explicit forecast period and the present value of free cash flows generated during the post explicit forecast period net of the present value of the external debt. The explicit forecast period in this valuation study is 5 years until 2023.

    Appropriate discount rate

    Under the DCF method the time value of money is recognized by applying a discount rate to the future free cash flows to arrive at their present values. This discount rate which is applied to the future free cash flows should reflect the opportunity cost to all the capital providers namely shareholders and creditors, weighted by their relative contribution to the total capital of the Company.  In other words, the discount rate represents the minimum return required by investors as compensation for investing in the business given the potential risk. This is commonly referred to as the Weighted Average Cost of Capital (“WACC”). The opportunity cost to the capital provider equals the rate of return the capital provider expects to earn on their investments of equivalent risk.

    Discount Rate – Definition: The term “discount rate” has been defined by the American Society of Appraisers, in Business Valuation Standard I, as “a rate of return used to convert a monetary sum, payable or receivable in the future, into present value”.

    Thus, the discount rate is used to determine the amount an investor would pay today (present value) for the right to receive an anticipated stream of payments (e.g., cash flows) in the future.

    Generally, in the context of a business valuation, the discount rate is the rate of return that would be required by an investor to purchase the stream of expected benefits (e.g., future cash flows), given the risk of achieving those benefits.

    For the derived cash flows to be used in assessing the value of the Company, the cash flows must be discounted to take account of the effect that cash today is worth more than cash in a few years’ time.  It is therefore necessary to use a discount rate to arrive at the present (or current) value of cash flows expected to be earned in the future. Accordingly, the expected cash flows to be generated in the future are discounted at an appropriate discount rate to arrive at the current value of the cash flows for the future years.

    This value is then added to what is termed the present value of the perpetuity which considers cash to be generated starting from the period after the end of the projection to a date well into the future. The same discount rate has been used to calculate both the value of the perpetuity and the present value of the cash flows during the projection period.

    The formula used for net present value is as follows:

    Net present value of cash flows = Cash flows * (1+ r)-n

    Where:

    r     =    Discount rate

    n    =     Number of years from the base valuation date that the cash flow occurs.

    Since risk is an important factor in determining the appropriate discount rate, we define below what we mean by risk in the context of business valuation.

    Definition of Risk

    Risk is generally defined as the degree of certainty or uncertainty as to the realization of expected future returns. In terms of a discounted cash flows projection, this can be interpreted as the probability and extent to which the future projections will be realized, in other words, the risk of achieving the projections.

    The discount rate selected must be based on the same definition of cash flows utilized in the valuation model. The various future cash flows and the appropriate discount rate to use are presented below:

      Basis for Cash Flows  Type of Discount Rate
      Debt-free cash flows  Weighted Average Cost of Capital (WACC)
      Equity cash flows  Cost of Equity Capital (CAPM)

     

    The concept of Debt Free Cash Flows is defined as net income before interest and after-tax, plus depreciation and other non-cash charges, less working capital and capital investment requirements.

    In arriving at Equity Cash Flows, the only difference is that interest payments are deducted and net increases or decreases in debt outstanding are accounted for. In either case, the cash flows can be calculated on a real or nominal (i.e., including inflation) basis.

    In either case, the basis for computation of the Weighted Average Cost of Capital or Equity Cost of Capital must be the same as the definition of cash flows used in the financial model.

    The estimation of a discount rate is always one of the key components in valuation; such estimation takes on added significance. Accordingly, the Capital Assets Pricing Model (CAPM) is often used to determine the appropriate equity discount rate to discount the projected cash flows.

    The CAPM is used to calculate the cost of equity. The CAPM is based on the concept that an investor will require an incremental expected return above the return available from risk free securities such as government bonds. This incremental return is the investor’s reward for investing in a riskier asset. The assumptions underlying the CAPM are:

    • Investors are risk averse
    • Rational investors seek to hold portfolios which are fully diversified
    • All investors have identical investment holding periods
    • All investors have the same expectations regarding expected rate of return

    The CAPM theory holds that the cost of equity capital is equal to the risk-free rate of return plus the product of the applicable beta coefficient, being the index of its risk expressed as the volatility of its return in relation to the market, multiplied by the risk premium of the market, plus a specific risk premium to account for any unsystematic risks.

    Thus, the CAPM attempts to measure the required rate of return for a Company by measuring the difference between the return on the market as a whole (Rm) and the risk-free rate (Rf), applying the beta (ß) to this difference, and then adding the risk-free rate (Rf) and the specific Company risk premium (SCRP).

    For calculating WACC, one of the important factors arriving at targeted capital structure of the Company is the Debt /Equity ratio. The cost of debt is usually considered based on actual borrowing costs unless the valuer has a clear reason to believe any changes in the same based on tangible evidence.

    The Weighted Average Cost of Capital thus is arrived at using the cost of equity derived from the CAPM and the cost of debt, multiplied by weightages of debt and equity. The Debt / Equity ratio considered could be based on industry averages unless again there is a stark difference between the way the company structures itself as opposed to industry norms.

    Terminal Value

    It is the value of the business’s expected future cash flows beyond the explicit forecast period. Using simplifying assumptions about the Company’s performance during the explicit period i.e. assuming a constant rate of growth, it permits us to estimate the continuing value with one of the several formulas.

    The continuing value’s formula eliminates the need to forecast the Company’s cash flows beyond the explicit period.  A high-quality estimate of the continuing value is essential to any valuation, because continuing value often accounts for a large percentage of the total value of the business.

    On this basis, the calculation of the continuing value may be made by capitalizing the free cash flows of the year following the final year in the explicit forecast period into perpetuity using an appropriate rate of return (normally the WACC factoring for an element of growth in the future years).

    In conclusion, a valuation exercise would have to proceed on a going concern basis and hence should lay emphasis on earning capacity i.e. what the Company can earn in the short term. In this context the estimated or future maintainable profits/cash flows would have to be taken into consideration.

    A company’s past results may not be completely reflective of its potential earning capacity, the valuation cannot obviously proceed only based on what is known as historical profits or profits of past years. It would be more relevant to consider the projected working results. Hence, if the DCF method is applied for evaluating the business of the Company based on its potential earning capacity, it will remain the most appropriate and scientific method.

    In the ultimate analysis, valuation will have to be tampered by the exercise of judicious discretion and judgement considering all the relevant factors. There will always be several factors, e.g. quality and integrity of the management, present and prospective competition, yield on comparable securities and market sentiment etc. which are not evident from the face of the balance sheet, but which will strongly influence the worth of the business.

     

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