Analysis of historical performance
A crucial step in the DCF model is to collect and analyze relevant historical information in order to evaluate the historical performance. A solid understanding of the past performance will enable reasonable forecasts of future performance. The historical information should at a minimum include income statements and balance sheets.
Additional information such as cash flow statements and relevant notes may also add value. The number of years of historical data included should be sufficient to determine historical performance and business trends. In order for the historical information to provide an understanding of historical performance it needs to be analyzed. The analysis is performed through calculating historical financial ratios such as sales growth, profit margins, capital expenditure etc. Through analyzing these ratios over a number of years the historical performance will become evident and reasonable assumptions regarding future performance can be made.
Forecasting future performance
The analysis of the historical performance should provide a clarifying connection to the assumptions that are made regarding future performance. These assumptions should be able to generate future expected income statements and balance sheets from which the free cash flow can be derived. Furthermore, the assumptions should be clearly stated in a separate section. The forecasting of a firm’s financial performance is divided into two periods: the explicit forecast period and the post-horizon period
For each given year in the explicit forecast period the corresponding income statement and the balance sheet is used to derive the expected annual free cash flow. In some implementations of the DCF model it is a requirement that the explicit forecast period is not shorter than the economic life of the firm’s property, plant and equipment (PPE).
The explicit forecast period should consist of at least 10-15 years. Through forecasting entire income statements and balance sheets an analysis using financial ratios is possible. This analysis can be used to determine the fairness of the assumptions regarding the future.
Estimating the cost of capital
The discount factor for the free cash flows must represent the risk faced by all investors. The weighted average cost of capital (WACC) combine the required rates of return for net debt (rnd) and equity (re) based on their market values. The tax effect on cost of net debt is accounted for in the WACC. Through using a constant WACC it is implicitly assumed that the capital structure will remain unchanged. The WACC is defined as follows:
The components of the WACC should be calculated accordingly:
• The cost of net debt should be calculated using the company’s yield to maturity on its long-term debt
• The marginal tax rate should be used as the tax rate in the WACC formula, which is
the tax that the firm would pay if the financing or non-operating items were eliminated
• For mature companies, the target capital structure is often approximated by the company’s current debt-to-value ratio, using market values of debt and equity
The Capital Asset Pricing Model (CAPM) is used to determine the required rate of return on equity:
CAPM should be calculated accordingly:
• Local government default-free bonds should be used to estimate the risk-free rate. Ideally, each cash flow should be discounted using a government bond with a similar maturity
• To estimate the beta, first measure a raw beta using regression which should at least contain five years of monthly returns and then improve the estimate by using industry comparables
• No single model for estimating the market risk premium has gained universal acceptance
Based on evidence from the different used models suggests a market risk premium around 5 percent. One should note that, given the WACC formula, it is possible to use the required return on equity as the discount factor if it is assumed that the future target capital structure will be 100 percent equity and 0 percent net debt. A net debt of zero requires that the model assumes that no interest bearing liabilities or financial assets will exist in the target in the future, in this case the tax rate become irrelevant in the WACC.
Estimating the continuing value
As already mentioned the forecasting of a firm’s financial performance is divided into two periods: the explicit forecast period and the post-horizon period.
During the explicit forecast period the firm is expected to transform into a steady state. When the firm has reached the steady state the terminal value is calculated by a continuing value formula. The continuing value formula is applied to the first year in the post-horizon period which therefore becomes representative for all subsequent years in the steady state. The explicit forecast period must be long enough for the company to reach a steady state. The following characteristics must be fulfilled in order for a company to truly be in steady state:
• The company should grow at a constant rate and reinvests a constant proportion of its operating profits into the business each year
• The company earns a constant rate of return on new invested capital
• The company earns a constant return on its base level of invested capital
If these conditions are fulfilled in steady state the free cash flow will grow at a constant rate consistent with the assumed terminal growth rate and thereby a continuing value formula can be applied.
The DCF model should be constructed in such a way that an extra year in steady state could be added, this enables to verify if the company truly is in steady state, since the free cash flow during the extra year is supposed to grow with the terminal growth rate.
The continuing value formula that is commonly recommended is the Gordon growth model. It should be noted that even though the terminal value is calculated by a simple Gordon growth model it does not imply that it is unimportant and irrelevant for the value of the firm. Normally a significant part of the total firm value is in the terminal value. The terminal value calculations are crucial for the overall accuracy of a valuation model. The terminal growth rate in steady state must be less than or equal to that of the economy (the GDP growth). A higher growth rate would eventually make the company unrealistically large compared to the aggregated economy. The growth rate is often assumed to equal the rate of inflation.