Modeling Help/Examples

Hi all – I am starting to build a few models out, and I have a few questions regarding the different discounting valuation methods. I am finding conflicting results online, and would love to open the conversation up to the group, and maybe even have someone share some excel examples. Below is what \ *I think * to be correct, please let me know where I’m wrong.

  • DCF using FCFF – The intrinsic value is Cash minus debt + the present value of future cash flows
  • DCF using FCFE – The intrinsic value is just the present value of future cash flows (Net debt is part of the FCFE equation)
  • DCF using Owners Earnings – The intrinsic value is Cash minus Debt + the present value of future cash flows
  • Residual Income Model – The intrinsic value is the present value of future residual income (Should not be used for a company paying dividends or doing share buybacks
  • Dividend discount model – The intrinsic value is the present value of future dividends (Should only be used for high dividend paying companies)

Thank you, looking forward to the discussion.

JZAF

What is the conflicting information, and which ones are you not sure about? You should be able to easily find unambiguous definitions for all of these in many places.

Are you suggesting my above assumptions are correct?

The unambiguous definition you speak of is what I am searching for/trying to collate here. I see different methods used in different places everywhere I look, and would like to learn the correct way. If the answer is everyone has their own methods, I would love to have a conversation about their thinking (why one person would subtract debt using a certain method, and another would not). Ideally, I would love examples of models or constructive comments on what I’ve written in my initial post.

DCF using FCFF – The intrinsic value is Cash minus debt + the present value of future cash flows As a level 2 candidate, I have a strong objection to this expression. Value of equity = FCFF (1+g)/(WACC-g) - MV of debt. You don’t need cash. You’d need cash if you were calculating Enterprise Value. With FCFE, value of equity = FCFE (1+g)/(r-g). With RI, intrinsic value is B0 + (ROE-r)X B0/(r-g). If using a spreadsheet, value is discounted value of future RI, plus current book value. You use RI when the firm has negative FCFF/FCFE, and pays no dividend. You may need adjustments for accounting issues that violate clean surplus relationship (e.g. unrealized gains in OCI under AVS). You may also need persistence factor adjustments for forecasting RI into perpetuity. With DDM, v= d1/(r-g). It doesn’t matter if the dividend is high or low. As long as the company has a history of paying dividends (either stable or constant dividend policy), DDM works. Concluding remarks, there’s a lot of misinformation online (e.g. some will tell you EBITDA can be used to find intrinsic value. EBITDA is a poor proxy as it doesn’t account for WCinv or FCinv. So with EBITDA (or EBIT) you would overstate the intrinsic value. This is why I’d stick with the methodologies laid out in the CFA curriculum.

If you are using FCFE you would still generally add in cash (and other non-operating). When you do this make sure to remove interest income from your projections.

for RI, you can use it if a company is paying dividends/buybacks, many people use a RI for banks which often pay dividends (if you are going to value a company this way make sure to sanity check it against the comps price to book vs ROE on a scatter plot).

Also, and this might be a bit nit-picky, but t seems like from your first line you’re not understanding why a FCFF DCF works. Usually people state it as PV of FCFF = enterprise value. And then enterprise value less debt plus cash is equity value (as opposed to the reverse order). The logic being that the future operations of a company is its business value or enterprise value. Some of that enterprise is owned by debt, so that’s removed, and some assets are non-operating (the cash) but are owned by the shareholders, so that’s added back to get to equity value. Again it might just have been stated in a non-standard way, but figured I would mention it.