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25 Questions On DCF Valuation

The document discusses 25 questions on discounted cash flow (DCF) valuation and provides the author's opinions on the answers. Some key points addressed are: - Operating income should exclude items that don't reflect core operations, such as operating leases and R&D expenses. These need adjustments in the valuation. - Operating income can be volatile due to normal business fluctuations or one-time items. Smoothing or normalizing may be needed depending on the industry and situation. - When computing taxes, the effective tax rate is generally best for near-term years, transitioning to the marginal tax rate for later years. Multinational situations require considering different country tax rates. Losses mean using a 0%

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Zain Ul Abidin
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379 views

25 Questions On DCF Valuation

The document discusses 25 questions on discounted cash flow (DCF) valuation and provides the author's opinions on the answers. Some key points addressed are: - Operating income should exclude items that don't reflect core operations, such as operating leases and R&D expenses. These need adjustments in the valuation. - Operating income can be volatile due to normal business fluctuations or one-time items. Smoothing or normalizing may be needed depending on the industry and situation. - When computing taxes, the effective tax rate is generally best for near-term years, transitioning to the marginal tax rate for later years. Multinational situations require considering different country tax rates. Losses mean using a 0%

Uploaded by

Zain Ul Abidin
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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25 Questions on DCF Valuation (and my opinionated answers)

Everybody who does discounted cash flow valuation has opinions on how to do it right. The following is a list of 25 questions that I believe every valuation analyst has struggled with at some point in time or the other and my answers to them. As the heading should make clear, I do not believe that I have the final word on any of them. So feel free to disagree, and let me know that you do. Maybe we can muddle through to the right answer. Cheers! All valuations begin with an estimate of free cash flow. The free cash flow to the firm is computed to be: After-tax Operating Income - (Capital Expenditures - Depreciation) - Change in working capital = FCFF Netting out cash flows to and from debt, subtract out interest and principal payments and add back cash inflows from new debt, will yields the free cash flow to equity (FCFE).

Q1. Operating income is defined to be revenues less operating expenses and should be before

financial expenses (interest expenses, for example) and capital expenses (which create benefits over multiple periods). Specify at least two items that currently affect operating income that fail this definitional test and explain what you would do to adjust for their effects.

A1.The two items that most directly contradict this definition of operating income are operating leases and R&D expenses, both of which are categorized as operating expenses. Operating leases are financial expenses and R&D expenses are capital expenses. To correct the operating income, we have to do the following:

Take the present value of operating lease commitments, using the pre-tax cost of debt of the firm as the discount rate, and treat the present value as

debt. The operating income has to be adjusted by adding back the operating lease expense and subtracting out the depreciation created by the operating leases.

Specify the number of years before R&D can be expected to generate commercial products, collect R&D expenses from the past for that many years and then amortize them; straight line usually works. The remaining unamortized R&D from prior years can be considered the book value of the R&D asset, and operating income has to be adjusted by adding back the R&D expense from the current year and subtracting out the R&D amortization for the current year.

Q2.Operating income can be volatile both as a result of the normal ebb and flow of business and as a result of accounting transactions (one time income and expenses). Should you smooth or normalize operating income and if so how do you do it?

A2.If you plan to base your future operating income on current operating income, it stands to reason that you want to remove any items that are transitional (one time charges or income) or cancel out over time (exchange rate or pension fund gains or losses). It is a tougher call as to whether you should smooth out operating income by using the average income over time. For some firms, such as commodity companies, it clearly makes sense given the ups and downs in commodity prices over time. For other firms, especially those that are facing long term structural or operating problems, you should not replace current depressed earnings with an average earnings over time. Instead, you should recognize that the earnings improvement, if it occurs, will happen gradually over time and reflect that in your valuation by a gradual improvement in operating margins.

Q3.In computing the tax on the operating income, there are three choices that you can use effective tax rate (about 29% for the average US company in 2003), marginal tax rate (35-40% for most US companies) and actual taxes paid. a. Which one would you choose?

b.

What happens if you are a multinational and are in several countries with very

different tax rates? c. What happens if you are reporting an operating loss?

A3. a. Which one should you choose? Let's start with what you cannot use - the actual taxes paid. Why not? The actual taxes paid will reflect the fact that you save on taxes when you make interest payments. The problem, however, is that you have already counted the tax benefits in your cost of capital (by using the after-tax cost of debt) and increasing your cash flow for the same reason would be double counting. It boils down to a choice between effective and marginal tax rates. The effective tax rate is lower than the marginal tax rate for a number of reasons but one reason is that companies defer paying taxes. Since this is a tax saving, there is nothing wrong with using the effective tax rate in computing the after-tax operating income for last year and even for the next few years. If you use it forever, though, you are assuming that you can defer taxes in perpetuity and that is a dangerous assumption. The best compromise is to use effective tax rates for the early forecast years and move towards a marginal tax rate in the later years. b. What happens if you are a multinational and are in several countries with very different tax rates? While some would push for an average tax rate, weighted by the income in each country, I think it makes far more sense to use the marginal tax rate of the country the company is domiciled in as a floor. After all, income earned in countries with lower tax rates than the domestic tax rate eventually has to be repatriated back to the domicile at which point it will be taxed. It is a tougher call for countries with higher marginal tax rates than the domestic tax rate. Here, it does make sense to use a weighted average. c. What happens if you are reporting an operating loss? A4.In the year of the operating loss, the tax rate used in computing the after-tax operating income and the after-tax rate cost of debt should be zero. As you project the earnings into future years and they turn positive, you first have to cover your net operating losses from

prior years, during which period your tax rate will still be zero. When you use up your net operating losses, your tax rate will converge on the marginal tax rate.

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