DISCOUNTED CASH FLOW VALUATION

Discounting the expected cash flow at a risk adjusted discount rate Discounting a Certainty Equivalent of the cash flow at the risk free rate

DETERMINING THE RISK ADJUSTED DISCOUNT RATE  Risk–and–Return Models (CAPM) –Expected Return = r f +  (r m – r f ),  whereby (r m – r f ) is the equity risk premium  Calculation of  :  Historical regression  by regressing its ROI against return on the market index  Bottom-up , by looking at the betas of other public traded companies  Example on Google :  10 year Treasury Bond is 4.25%  Bottom-up beta for internet companies is 2.25  Risk premium is 4.09%  Expected return on Google stocks = 4.25% *4.09%=13.45%

Proxy Models –Find variables that characterized high return stocks and regressed them –Findings of Fama & French r j =1.77%-0.11*ln(MV j )+0.35*ln(BV j /MV j ) Expected annual return = (1+r j ) 12 – 1 Example : –Market Value = usd 500 –Book Value = usd 300 r j =1.77%-0.11*ln(500)+0.35*ln(300/500)=0.9076% Expected annual return = ( ) 12 – 1=11.45% DETERMINING THE RISK ADJUSTED DISCOUNT RATE

Implied Discount Rates –Market Value = Exp CF t+1 / ( r adj – g exp ) Example : –USD 1,000 = USD 100/(r adj – 0.03)  r adj =13.00% DETERMINING THE RISK ADJUSTED DISCOUNT RATE

FLAWS OF THE METHODS Assumptions of stocks are publicly traded Assumptions that Market Value used are correct Calculated returns are for a single period only, but used as a multi period rate Discounting uses one same discount rate Negative cash flows discounted will result in increasing value

DETERMINING CERTAINTY EQUIVALENT CASH FLOWS Risk-and-Return Models Cash Flow Haircuts –Cuts are done based on analysts judgment –Risks can be considered twice to this intuitive judgment

HYBRID MODELS Type of RisksExamplesRisk Adjustment in Valuation Continuous market risk where buying protection is difficult or impossible Interest rate risk, inflation risk, exposure to economic cyclicality Adjust the discount rate for risk Discontinuous market risk, with low likelihood of occurrence but big impact Political risk, risk of expropriation, terrorism risk If insurance exists, include premium as cost and adjust cash flow. Otherwise adjust discount rate Market risk that is contingent on a specific occurrence Commodity price riskEstimate the option premium to hedge against the risk, include as cost and adjust cash flow Firm-specific riskEstimation risk, competitive risk, technology risk If investors are diversified, no adjustments needed. If investors are not diversified use the models for market risk

POST VALUATION RISK ADJUSTMENT Adjusting the value for risk after the valuation for downside as well as upside risk

DOWN SIDE RISK Illiquidity Discount –Common practice to deduct % from value

UPSIDE RISK Control Premium –Common practice to add 30% for benefit of controlling the company Synergy Premium –Calculated via consolidated cash flow projection

DANGER OF POSTVALUATION ADJUSTMENT Risks can be easily double counted Magnitude of discount/premium is arbitrary By adjusting an estimated value again with discounts/premiums opens the door for additional biases in the numbers

RELATIVE VALUATION APPROACHES The value is derived from either a comparable/similar asset or a standardized price using : –Sector comparison –Market capitalization or size –Ratio based comparisons –Statistical controls

CFaR VALUATION Define all risks that might have an impact on the cy’s cash flow Do several cash flow projections with the assumptions of each respective occurring  use MONTE CARLO simulation Use valuation method for every projected cash flow  Cash Flow at Risk (CFaR) Cash flow before risk management vs cash flow after risk management Difference of value is the gain from risk management Value the gain

CFaR VALUATION PV ( of company’s cash flow with hedge plus hedging cost ) --- PV ( of company’s cash flow without hedge plus bankruptcy cost) === Benefit of risk management

Requirements : Use EBITDA or operational cash flow excluding interest Calculate projected Cashflow/EBITDA considering probabilities of occurrence Use WACC as discount rate Include risk premium in cost of equity Include transaction cost of hedging Include bankruptcy cost