There are three inputs that are required to value any asset in this model - the expected cash flow, the timing of the cash flow and the discount rate that is appropriate given the riskiness of these cash flows. While we will be looking at discount rate and cash flow estimation in far more detail in the coming chapters, we will lay out the fundamentals in this section.
a. Discount Rates
In valuation, we begin with the fundamental notion that the discount rate used on a cash flow should reflect its riskiness, with higher risk cash flows having higher discount rates. There are two ways of viewing risk. The first is purely in terms of the likelihood that an entity will default on a commitment to make a payment, such as interest or principal due, and this is called default risk. When looking at debt, the cost of debt is the
rate that reflects this default risk. The second way of viewing risk is in terms of the variation of actual returns
around expected returns. The actual returns on a risky investment can be very different from expected returns; the greater the variation, the greater the risk. When looking at equity, we tend to use measures of risk based upon return variance. While the next chapter will look at the different models that attempt to do this in far more detail, there are some basic points on which these models agree. The first is that risk in an investment has to perceived through the eyes of the marginal investor in that investment, and this marginal investor is assumed to be well diversified across multiple investments. Therefore, the risk in an investment that should determine discount rates is the non diversifiable or market risk of that investment. The second is that the expected return on any investment can be obtained starting with the expected return on a risk-less investment, and adding to it a premium to reflect the amount of market risk in that investment. This expected return yields the cost of equity.
The cost of capital can be obtained by taking an average of the cost of equity, estimated as above, and the after-tax cost of borrowing, based upon default risk, and weighting by the proportions used by each. We will argue that the weights used, when valuing an on-going business, should be based upon the market values of debt and equity. While there are some analysts who use book value weights, doing so violates a basic principle of valuation, which is that at a fair value, one should be indifferent between buying and selling an asset.
b. Expected Cash Flows
In the strictest sense, the only cash flow an equity investor gets out of a publicly traded firm is the dividend; models that use the dividends as cash flows are called dividend discount models. A broader definition of cash flows to equity would be the cash flows left over after the cash flow claims of non-equity investors in the firm have been met (interest and principal payments to debt holders and preferred dividends) and after enough of these cash flows has been reinvested into the firm to sustain the projected growth in cash flows. This is the free cash flow to equity (FCFE), and models that use these cash flows are called FCFE discount models. The cash flow to the firm is the cumulated cash flow to all claim holders in the firm. One way to obtain this cash flow is to add the free cash flows to equity to the cash flows to lenders (debt) and preferred stockholders. A far simpler way of obtaining the same number is to estimate the cash flows prior to debt and preferred dividend payments, by subtracting from the after-tax operating income the net investment needs to sustain growth. This cash flow is called the free cash flow to the firm (FCFF) and the models that use these cash flows are called FCFF models.
c. Expected Growth
It is while estimating the expected growth in cash flows in the future that analysts confront uncertainty most directly. There are three generic ways of estimating growth. One is to look at a company’s past and use the historical growth rate posted by that company. The peril is that past growth may provide little indication of future growth. The second is to obtain estimates of growth from more informed sources. For some analysts,
this translates into using the estimates provided by a company’s management whereas for others it takes the form of using consensus estimates of growth made by others who follow the firm. The bias associated with both these sources should raise questions about the resulting valuations. We will promote a third way, where the expected growth rate is tied to two variables that are determined by the firm being valued - how much of the earnings are reinvested back into the firm and how well those earnings are reinvested. In the equity
valuation model, this expected growth rate is a product of the retention ratio, i.e. the proportion of net income not paid out to stockholders, and the return on equity on the projects taken with that money. In the firm valuation model, the expected growth rate is a product of the reinvestment rate, which is the proportion of after-tax operating income that goes into net new investments and the return on capital earned on these investments. The advantages of using these fundamental growth rates are two fold. The first is that the
resulting valuations will be internally consistent and companies that are assumed to have high growth are required to pay for the growth with more reinvestment. The second is that it lays the foundation for considering how firms can make themselves more valuable to their investors.
