The Business Times
Cai Haoxiang
22/7/2013
THE discounted cash flow (DCF) model is a complex model used to determine the value of a business. This is because numerous variables go into it.
Valuing a business
One major variable is the cost of capital. This goes into the denominator, and is the interest rate investors use to evaluate the attractiveness of the business versus its risk.
Another major component is the cash flow itself. This is the numerator of the calculation.
Here is a brief example of how one might value a real company. I use mainboard-listed watch retailer, The Hour Glass, whose cash flow statement I introduced last month.
Usually, analysts project how much a company will earn three, five or even up to 10 years into the future. Beyond that, they will calculate a terminal value for the company using some kind of perpetuity or multiple model, because it becomes increasingly impossible to project cash flows with certainty the further away you get from the present day.
In my very simplified model, I do not make a detailed analysis of the company's investment and earnings cycle. I assume the company, with most of its revenues coming from a mature market like Singapore, has reached a steady state of affairs and will just chug along as it had done so in the past.
In the numerator of the DCF model, I have to estimate free cash flows to see how much cash the company is actually generating. I notice The Hour Glass's free cash flows fluctuate as they spend money on opening new stores and on working capital. So, I take a five-year average and assume - rightly or wrongly - that this number is representative of the future.
Free cash flow is the cash that is left after a company funds capital expenditures with the cash generated by its day-to-day activities. You get this by taking a company's cash flows from operations and deducting its expenditure on property, plant and equipment. Both items are found in the cash flow statement.
The company generated average free cash flows of $13.3 million a year in the last five years. Taking an average of the last eight years, I get $13.3 million a year as well. So, I will use $13.3 million in my numerator.
Now, I have to figure out the company's cost of capital and growth rate, which goes into my model's denominator. Calculating this properly is a complicated process and will be discussed in next week's article. The average investor, however, might not have time to get all the data required to do so. I will make some assumptions, again.
What growth rate do I use? The Hour Glass sells luxury watches. Global sales in Swiss-made timepieces have grown at a breakneck pace in the last few years and slowed recently. Last year, total exports of Swiss watches rose 10.9 per cent to 21.4 billion Swiss francs ($28.8 billion) from the year 2011.
Can I use 11 per cent as the growth rate? That sounds too optimistic. It is hard to imagine something growing at 11 per cent a year forever. For example, if a company sold just one $1,000 watch a year, and this revenue grew by 11 per cent a year, its revenues would be $34 million in 100 years and $1.2 trillion in 200 years.
Most of The Hour Glass's revenue comes from Singapore. Its revenue has grown at a compounded rate of roughly 8 per cent a year since 2006. But again, perhaps this was driven by strong consumption from the Chinese - one of the world's largest groups of consumers of luxury goods. Going forward, as China's economy slows, we might not see such a strong increase in sales a year. For a model that forecasts growth forever, we need to be careful about the growth rate we use.
I could use 5 per cent, the 2008-2012 average of retail sales growth for watches and jewellery announced by the Department of Statistics Singapore. Another possible number could be 3 per cent, the historical growth rate of the US economy in the last 100-odd years.
What about the cost of capital? According to a database on the website of New York University professor and valuation guru Aswath Damodaran, retailers have a cost of capital of 9 to 10 per cent. A July 10 JP Morgan Cazenove investment research report on Swiss high-end watch company Swatch Group notes that its DCF model incorporates assumptions of "medium term growth of 5.5 per cent, terminal growth of 2.6 per cent, WACC (weighted average cost of capital) of 9.6 per cent". I could use some of these assumptions as well.
In the table, we see that a cost of capital of 9.5 per cent and a growth rate of 6 per cent would give a market value of about $380 million for the company. This value is premised just on future cash flows. The Hour Glass has quite a bit of cash in the bank that we must add to get how much it is worth.
It has $79.5 million of cash and $41.2 million of debt. Assuming we use the cash to pay off the debt, the company is net cash to the tune of $38.3 million.
We thus add that to $380 million and get around $418 million - close to the market valuation of $420.66 million, or $1.79 a share, that the company was trading at as of Friday.
To sum up, I could arrive at the company's current market valuation using a $13.3 million steady state free cash flow assumption, a growth rate of 6 per cent and a cost of capital of 9.5 per cent.
Remember, no model is perfect. I am just embarking on a thought exercise. The DCF model is just one among many used to make an investment decision.
Is The Hour Glass's cost of capital higher than 9.5 per cent? The stock is not very liquid. No trades were made on Thursday and Friday. Perhaps it costs even more to get money from the local equity markets. If so, its valuation will be lower. And is it realistic to price in a 6 per cent perpetual growth rate?
If my cash flow assumption is not too pessimistic, my conclusion - based on this simplistic model - is that the company is slightly pricey.
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