Discounted Cash Flow – Fine Tuned

2015-12-15 Uncategorized DCF, Discounted Cash Flow, Featured Articles, Shares Investment

Recently, I have made some fine tuning to my DCF model. I have planned this for months, but I wanted to get the concept right before I make any change.

Stub Period Fraction

1. Previously, I use integer for discount period – 1, 2, 3, 4, etc… What’s wrong with the “Normal” Discount Period – 1, 2, 3, 4, etc. are not the best representations of cash flow because companies generate cash flow over the course of the year… not all at the end! Also, we might be valuing the company mid-way through the year after Q1, Q2, etc. have already passed.
2. Solution #1: The Mid-Year Convention – Rather than using 1, 2, 3, etc., you can use 0.5, 1.5, 2.5, etc. to better represent cash flows arriving throughout the year – “on average,” they are generated “in the middle” of the year instead.
3. Solution #2: Stub Periods – Even if you use 0.5, 1.5, 2.5, etc. that still assumes that you’re valuing the company at the beginning of the year since cash flows arrive exactly 50% of the way through… but what if some time has passed? We can use the DAYS function in Excel to estimate this:=DAYS(Next_Year,Valuation_Date)/DAYS(Next_Year,Hist_Year)Gives us the fraction of the year remaining between now and the end of the year – e.g., 0.25, 0.75, 0.63… and then in future periods, you just take that stub period from the first year and add 1, 2, 3, etc.: So 0.25, 0.75, and 0.63 would become 1.25, 1.75, 1.63, then 2.25, 2.75, 2.63, etc.
4. Combining the Mid-Year Convention with Stub Periods – Split it into Year 1 and the years afterward:Year 1: Just divide the stub period by 2 – so 0.5 becomes 0.25, 0.75 becomes 0.375, etc.Following Years: Take the “normal” discount period for the year and subtract 0.5 each year. Why? Because we get cash flows midway through THAT FUTURE YEAR – not the stub period in the first year!
   Here, for example, it’s 1.147 in FY15 because 0.647 is the remaining period in Year 1… and we don’t get any Year 2 cash flows in Year 1! And then we just add 0.5 from Year 2, to approximate the cash flows arriving midway through Year 2.

Implied Enterprise Value and Implied Equity Value

I have outlined the calculation into line items, so you will be able decode the formula easily. Besides, I have used different terminology: Implied Enterprise Value and Implied Equity Value.

Before I explain further, let’s get one thing clear. What does “Implied” mean?

Imply means to express (something) in an indirect way : to suggest (something) without saying or showing it plainly

So, definition of “Implied Enterprise Value” and “Implied Equity Value” here is not exactly the same with “Enterprise Value” and “Equity Value”.

Implied Enterprise Value – Think of “cash flow” as a way to pay investors in the company. At the top, before you take out interest expense and debt repayments, that cash flow is available to everyone – both equity and debt investors. What metric represents both equity and debt investors? That’s right, Implied Enterprise Value.

Implied Equity Value – After you have got this “cash flow available to everyone,” you then pay debt investors by making the required interest payments and principal repayments to them. Now that they’ve been paid, that remaining cash flow is only available to equity investors, and you can “pay” those equity investors by issuing dividends or repurchasing shares from them. Since this cash flow is only available to equity investors, when you use it in a DCF you calculate the company’s Implied Equity Value.