Download Choosing the Right Model for Cash Flow Valuation: Equity vs. Firm, Dividends vs. FCFE and more Slides Marketing Management in PDF only on Docsity! Aswath Damodaran 176 V. Beyond Inputs: Choosing and Using the Right Model Discounted Cashflow Valuation Aswath Damodaran 177 Summarizing the Inputs In summary, at this stage in the process, we should have an estimate of the • the current cash flows on the investment, either to equity investors (dividends or free cash flows to equity) or to the firm (cash flow to the firm) • the current cost of equity and/or capital on the investment • the expected growth rate in earnings, based upon historical growth, analysts forecasts and/or fundamentals The next step in the process is deciding • which cash flow to discount, which should indicate • which discount rate needs to be estimated and • what pattern we will assume growth to follow Aswath Damodaran 180 What discount rate should I use? Cost of Equity versus Cost of Capital • If discounting cash flows to equity -> Cost of Equity • If discounting cash flows to the firm -> Cost of Capital What currency should the discount rate (risk free rate) be in? • Match the currency in which you estimate the risk free rate to the currency of your cash flows Should I use real or nominal cash flows? • If discounting real cash flows -> real cost of capital • If nominal cash flows -> nominal cost of capital • If inflation is low (<10%), stick with nominal cash flows since taxes are based upon nominal income • If inflation is high (>10%) switch to real cash flows Aswath Damodaran 181 Which Growth Pattern Should I use? If your firm is • large and growing at a rate close to or less than growth rate of the economy, or • constrained by regulation from growing at rate faster than the economy • has the characteristics of a stable firm (average risk & reinvestment rates) Use a Stable Growth Model If your firm • is large & growing at a moderate rate (≤ Overall growth rate + 10%) or • has a single product & barriers to entry with a finite life (e.g. patents) Use a 2-Stage Growth Model If your firm • is small and growing at a very high rate (> Overall growth rate + 10%) or • has significant barriers to entry into the business • has firm characteristics that are very different from the norm Use a 3-Stage or n-stage Model Aswath Damodaran 182 The Building Blocks of Valuation Choose a Cash Flow Dividends Expected Dividends to Stockholders Cashflows to Equity Net Income - (1- δ) (Capital Exp. - Deprec’n) - (1- δ) Change in Work. Capital = Free Cash flow to Equity (FCFE) [δ = Debt Ratio] Cashflows to Firm EBIT (1- tax rate) - (Capital Exp. - Deprec’n) - Change in Work. Capital = Free Cash flow to Firm (FCFF) & A Discount Rate Cost of Equity • Basis: The riskier the investment, the greater is the cost of equity. • Models: CAPM: Riskfree Rate + Beta (Risk Premium) APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors Cost of Capital WACC = ke ( E/ (D+E)) + kd ( D/(D+E)) kd = Current Borrowing Rate (1-t) E,D: Mkt Val of Equity and Debt & a growth pattern t g Stable Growth g Two-Stage Growth | High Growth Stable g Three-Stage Growth | High Growth StableTransition
