Session 30: Valuation - Cash Flows & Discount Rates

In this session 30 of a 36 session corporate finance class, we talk about two key inputs into valuation. I will start off talking about cash flows first and different ways of estimating cash flows, and then move on to discount rates. And in the process, we're going to discover that many of the issues we face in the context of corporate finance, we will face again in the context of valuation. The last session, I laid the foundations for thinking about valuation, but I emphasize that the reason we care about value in corporate finance is A, our objective is to maximize value, and B, everything we talk about in corporate finance has to show up somewhere in value. After all, if the objective is to maximize value, then investment decisions, financing decisions, and dividend decisions should all be in there. So in this session, what I'd like to do is start building the details of doing valuation. And in particular, I want to talk about estimating cash flows in the context of valuation, and estimating discount rates in the context of valuation. Before I delve into these numbers, I'm going to give you a preview. Much of what we're going to talk about and do is actually what we did when we talked about capital budgeting, where we estimated cash flows and estimated discount rates. So don't be surprised to see the same tools come into play. So let's step back, let's think about estimating cash flows. Remember in the last session, we talked about making a decision upfront, whether you're valuing the equity in the business or valuing the entire business. If you decide to value equity, here are your three choices for cash flows. You can look at the actual dividends paid, but as we noted earlier in our dividend policy discussions, for most US companies at least, what you actually see as dividends is only a small slice of the cash return. So you could use what I call augmented dividends, where you add the buybacks to the dividends. Or you can try to estimate potential dividends, which is what the free cash flow equity is. If you're valuing the entire firm, then you're trying to estimate a pre-debt cash flow. And here's where I'd like to contrast how we think about free cash flow equity and what I'm going to call free cash flow to the firm. Free cash flow equity is the cash flows after debt payments. So to estimate free cash flow equity, I start with net income. Free cash flow to the firm is a pre-debt cash flow. So to estimate it, I'm going to start with earnings before interest and taxes or operating income. Here's what I'm going to do next. I'm going to act like I pay taxes on that operating income. The reason I say act is you don't pay taxes on operating income. You pay taxes on taxable income. I'm going to act like I'm paying taxes on the operating income. In effect, I'm acting like I don't have interest expenses to claim as a deduction. The reason I want to do that is my cash flow should not include any tax savings from interest expenses because those tax savings will already be counted in my cost of capital. So I start with after-tax operating income instead of net income. The next two line items, net cap X, capital expenditure minus depreciation, and change in working capital are exactly the same for both cash flow computations. But with free cash flow to the firm, once I net that reinvestment out, I'm done. I have the free cash flow to the firm. With free cash flow equity, there's one additional item I have to factor in. When I borrow money, cash comes into the firm. When I repay old debt, cash leaves the firm. I call this the net debt cash flow. I've got to factor that as well because as the equity investor, I have to look at the cash flows left over after those payments and after those receipts. So the first choice is looking at what you're going to do is deciding whether you're going to value the equity in the business or value the entire business and come up with a cash flow to do that. So let's take a few examples. I'm going to start with Deutsche and I'm going to do two separate valuations, one in pre-crisis period in early 2008 and one in 2013. To be quite honest, before the banking crisis of 2008, I used to assume that banks were run by sensible people and that the dividends that they paid actually reflected what they could afford to pay. That is why in early 2008, when I valued Deutsche, I used the actual dividends paid, which were 2,146 million euros in 2007, as my base case and I did my entire valuation based just on dividends. Not only am I assuming that what's paid out is what they can afford to, I'm also assuming that those dividends are sustainable. That was 2008. In 2013, Deutsche was in trouble. It was losing money. It had basically cut dividends post-crisis, but its dividend policy was in tremendous flux. It was changing constantly. I can no longer build my faith on dividends, so I have to estimate potential dividends. We talked about doing this in the context of free cash flow equity. To estimate the potential dividend for a bank, I said, you first have to project out net income. That's what I started with for Deutsche. To estimate the net income, I made the assumption that their return in equity, which right now is a negative number because they're losing money, would recover to 8%. Why 8%? Because that's their cost of equity. I'm not asking for miracles here. I'm just assuming that over time, Deutsche will start earning a return in equity roughly equal to its cost of equity. As the return in equity improves, the net income is going to go from negative to positive. That gets my first line item done. Remember, I also said for a bank, what we count as reinvestment is not the traditional net capex and change in working capital, that I was going to look at their investment in regulatory capital. I did that for Deutsche. Their current tier one capital is 15.13%, but it looks like they're under pressure to increase that capital ratio, both from within, the bank wants to get more conservative, and from without. Regulatory authorities are putting pressure on European banks to increase their regulatory capital ratios. I'm going to assume that Deutsche is aiming for an 18% tier one capital ratio in five years. Here's what I'm going to do next. I'm going to increase their tier one capital ratio from 15.13% to 18% in linear steps, and each year compute how much that'll mean in terms of regulatory capital, and take the change in regulatory capital from year to year as my reinvestment in regulatory capital. So my net income comes from my improving return in equity. My investment in regulatory capital comes from my assumption that the asset base will continue to grow, but that the tier one capital ratio will grow with it. I subtract out the reinvestment in regulatory capital from the net income, I've got my free cash flows to equity for Deutsche. In valuing Deutsche in 2013, those free cash flows to equity, which are actually negative up front, are what I used to value the equity in a business. Two different points in time, two different ways of approaching bank valuation. Now with Tata Motors, I did the far more conventional free cash flow to equity valuation. I started with net income, I subtracted out capex, added back depreciation, subtracted the change in working capital, took the net debt cash flow, the change in debt, and came up with a free cash flow to equity each year. I also computed how much of the net income Tata Motors was putting back into the business. And based on my estimates across the five years, while the number is volatile, the average equity reinvestment rate is about 88%. You say, what does that mean? Between 2008 and 2013, here's what it looks like Tata Motors is doing. For every $100 in net income that's coming in, they're putting back $88 back into the business. Is that good? Is that bad? For the moment, I'm not ready to pass judgment on that. But during this period, it tells me that the free cash flow to equity, the potential dividend that Tata Motors had was a small number because they were so actively reinvesting back into the business. Now, if I'm looking at free cash flow to the firm, I'm going to look at Disney because I'm going to do a firm valuation of Disney. Here I start with operating income. And the operating income for Disney we've been using all the way through this class is $10,032 million. That's a trailing 12-month number. Actually, it's actually the fiscal year's operating income for 2012-2013. I'm going to act like I pay taxes on that operating income, right? But here I face a choice. What tax rate should I use? If you remember, in computing the after-tax cost of debt, I used the marginal tax rate of 36.1%. I could use that tax rate now, but I think that'll be too conservative. And here's why. The marginal tax rate is the tax rate you pay on your last dollar of income. And it's the right tax rate to use when you compute the after-tax cost of debt. The tax rate I'm talking about here is the tax rate across all of your income. And for that tax rate, I think we're on more solid ground, at least for the moment, using an effective tax rate. Why? Because Disney doesn't pay 36% of its total income as taxes. It pays only about 31%. I use that effective tax rate to get started, and that gives me an after-tax operating income of $6.92 billion. I subtract out net capex. I take the capital expenditure and depreciation numbers, including any acquisitions that Disney made and correcting for whatever accounting distortions there might be. I subtract out the change in working capital. I come up with my free cash flow to the firm. The free cash flow to the firm that I come up with for Disney is $3.188 billion. And as a percentage of my overall after-tax operating income, it reflects the fact that Disney is reinvesting about $3.8 billion into the business. So Disney had a pretty active 2012, 2013 as well. And in fact, if I look at how much they reinvested, their net capex and change in working capital, as a percentage of their after-tax operating income, it looks like they're reinvesting about 54% of their after-tax operating income back into the business. I want to emphasize that with both Tata Motors and Disney, what I'm getting is a snapshot of the past. When you're doing valuation, what do you want to forecast for the future? What happened in 2012 and 2013 is instructive, but it might not be predictive. We'll come back and talk about that in a little while, but that's my first stop, is getting the cash flows. Dividends, potential dividends, free cash flow to equity, and free cash flow to the firm. Now let's talk about discount rates. There are a couple of things that I want to mention about discount rates and valuation before we get started in the mechanics. I personally believe that in most valuations, we spend far too much time estimating discount rates and too little time estimating the cash flows. Is it a critical ingredient in discounted cash flow valuation? Obviously, it's discounted cash flow valuation, but it's not as critical as we think it is. In fact, the way I describe it is when you have a screwed up valuation, it's usually because you got the cash flows horribly wrong. It's not because you got the cost of capital horribly wrong. So I'm suggesting that you keep this in perspective. But here's the key thing to remember about discount rates. It has to be defined consistently with your cash flows at several levels. If your cash flows are in U.S. dollars, your discount rate has to be U.S. dollar discount rate as well. If your cash flows are to equity, your discount rate has to be a cost of equity. If your cash flows are to the firm, your discount rate has to be the cost of capital. In fact, you tell me how you estimate your cash flows, and I'll tell you what the right discount rate to use in that particular valuation is. So again, let's look at estimating these discount rates. Let's start with the cost of equity for Deutsche Bank. Why do we use cost of equity? Because we're using a dividend discount model in 2008 and a potential dividend discount model in 2013. In 2008, to estimate my cost of equity, I started with the Euro risk-free rate then, which is 4%, the beta that I estimated for Deutsche then, which is 1.16, and the equity risk premium I used to use for mature markets then, which is 4.5%. I come up with a cost of equity of 9.23%. In 2013, I revisit these computations. My Euro risk-free rate is now 1.75%. I use that. For the beta that I come up with, I still use a bottom-up beta, but it's shifted slightly between 2008 and 2013. It's about 1.156. And for my equity risk premium, I use a weighted average risk premium across the markets that Deutsche operates in, which gives me a 6.12% premium. My cost of equity in my 2013 valuation is going to be 8.8%. So in 2008 and 2013, I have the cost of equity for Deutsche, risk-free rate plus beta times equity risk premium. Now let's talk about Tata Motors. To get the cost of equity for Tata Motors, first I make a choice. I'm going to do my valuation in Indian rupees. That's a choice. I could have valued Tata Motors in US dollars, but I chose to value it in rupees. My risk-free rate is an Indian repeat risk-free rate, which if you remember from way back when we talked about risk-free rates was 6.57%. The beta that I came up with for Tata Motors operating assets was 1.10. That's based on the automobile business they're in and the debt-to-equity ratio they have as a company. However, here's something to remember. I'm estimating a free cash or equity for Tata Motors, and I chose to use the total net income to get started. And that total net income also includes the income from cash. This might sound like a subtle distinction, but because I'm including the cash flows from the income from cash as part of my free cash or equity, my beta has to be adjusted to reflect that. What do I mean? I take a weighted average of the 1.10 that I got as my beta for the operating assets and zero, which is the beta of cash, and I take into account the fact that Tata Motors has a fairly significant cash balance to come up with a beta. And this is a levered beta for Tata Motors as a company of 0.944, or I'm sorry, 0.964. That is the beta that I plug in to my cost-of-equity computation. So let's bring the numbers together. Risk-free rate in rupees, a bottom-up beta reflecting both Tata Motors operating assets and cash, and it's a levered beta. The equity risk premium is a weighted average risk premium of the regions of the world Tata Motors operates in. I end up with a cost of equity of 13.5% in Indian rupees. That's what you're gonna see as my discount rate in my free cash or equity valuation of Tata Motors. Last piece of the puzzle, I compute a cost of capital for Disney. If this page looks familiar, it should, because this is the fourth time we've looked at the same page. We started when we talked about hurdle rates for Disney. We talked about the cost of capital for Disney as a weighted average of the cost of equity, which we got by looking at the bottom-up beta and the cost of debt based on the rating. The cost of capital we came up with was 7.81%, and we said that's the hurdle rate for Disney as a company. We revisited this concept at the start of capital structure and said, is there something we can change at Disney to make the cost of capital lower? And we concluded we could. We're gonna use it again, because this cost of capital is the cost of capital I'm gonna start my valuation with. Key word is start, and here's why I emphasize that. When you're looking at a capital budgeting project, leaving the cost of capital unchanged over the life of the project is okay. When you're valuing a business, that might be dangerous, because on your spreadsheet, as you're valuing this business, as growth changes, you'll expect the cost of capital to change. In the case of Disney, the change is not dramatic. In fact, the big change in Disney is the beta goes from just above one to one. I leave the debt ratio at 11.5%, the existing debt ratio for the next five years, but after year five, I start pushing it out towards a 20% debt ratio. Not quite optimal, but given how reluctant Disney has been to borrow money, I'm gonna leave it at 20%. And as a consequence, my cost of capital, which starts at 7.81% for the first five years, starts to drop after year five, down to 7.16%, or I'm sorry, 7.29%. That's something that you should think of as a rule rather than exception. There are very few discounted cash flow valuations, but the cost of capital will remain unchanged over the life of the valuation. Especially with young growth companies, be careful to adjust the cost of capital as your company changes in your spreadsheet. As growth changes, your beta will probably start to move towards one. Your cost of debt will start to resemble the cost of debt of a mature company, and your company might actually start to borrow more as it becomes more mature. Factor those all into your cost of capital and let the cost of capital shift over time. So in summary, when you think about cash flows and discount rates, step back and think about the principles we developed in the context of capital budgeting. Those same principles will apply in the context of valuation. Thank you very much for listening.