In this article, we look at how to apply the DCF method to estimate the equity value of a business, based on forecasted Free Cash Flows to Equity ("FCFE") or dividends (for the latter more appropriately called the Dividend Discount Model, or "DDM") discounted at a cost of equity.
Click here to jump to our article on how to structure a DCF to directly estimate the Enterprise Value of a business, based on forecasted Free Cash Flows to the Firm ("FCFF") discounted at a WACC.
When to use the DCF or DDM to perform an equity-side valuation
As mentioned in our previous article, the DCF is the primary valuation method to use when financial projections are made available by the management of the company or project that you are valuing.
Case 1. Use the DDM to value financial services firms, for the following reasons: 1. Debt is difficult to define and measure for financial services firms, making it difficult to estimate firm value or costs of capital. Consequently, it is far easier to value the equity directly in a financial service firm, by discounting cash flows to equity at the cost of equity (source: A. Damodaran). 2. The inability to identify and separate out capital expenditures and working capital investments in financial services firms makes it difficult, if not impossible, to estimate cash flows with any degree of precision (source: A. Damodaran).
Case 2. Use the equity-side DCF to value a project with a maturity date established in a signed contract (e.g. a Power Purchase Agreement, or "PPA"), as the future cash flows are foreseeable (being already defined within the agreement). In this case, you would not need to estimate a terminal value for the project, but would discount the future cash flows expected up until the maturity date.
Dividends or Cash Flows to Equity
The Dividend Discount Model is based on distributable dividends. You may consider the payout ratio targeted by the company's management across the projection period, applying it to forecasted net profit. However, the preferred assumption is to consider net profit as entirely distributable to equity holders (after transfers to the legal reserve, if required), plus any capital in excess of the minimum regulatory requirements (if applicable).
The cash flows available for distribution to equity holders (cash flows to equity, or "CFE") are calculated as follows:
CFE = Net profit - Transfer to legal reserve + Excess capital
Your CFE must consider the yearly transfers to the legal reserve until the maximum threshold has been reached. As required by law, a portion of the annual net profit must be transferred to the legal reserve until the reserve has reached a maximum threshold in terms of paid-in capital.
Example 1. In Italy, a portion of 5% of the annual net profit must be transferred to the legal reserve, until this reserve is equal to 20% of share capital. Example 2. In the United Arab Emirates, 10% of annual net profits must be transferred to the legal reserve, until this reserve is equal to 50% of paid-in capital. Example 3. In Egypt, 5% of annual net profits must be transferred to the legal reserve, until this reserve is equal to 50% of paid-in capital.
When valuing a financial services firm, you must ascertain that the company holds sufficient capital to comply with all of the regulatory requirements to which it is subject. These requirements may include, among others:
Minimum capital adequacy ratios (Basel III)
Maximum debt-to-equity ratio
Share capital-to-total assets ratio
Current assets-to-current liabilities ratio
Any capital in excess of the minimum amount that the company is legally required to hold on its books is assumed to be distributable to shareholders.
In case negative CFE are expected across the projection period, offset them by using any excess cash available at the valuation date. Surplus liquidity may include, among others:
cash and bank balances,
retained earnings, and
Free Cash Flows to Equity
The equity-side DCF is based on Free Cash Flows to Equity, or cash flows available for distribution to the business's equity capital providers. FCFE are calculated as follows:
FCFE = FCFF - debt repayment/(issuance)
In case negative FCFE are expected across the projection period, offset them by using any excess cash available at the valuation date. Surplus liquidity may include, among others:
cash and bank balances,
retained earnings, and
The TV can be estimated by capitalizing TV CFE (or FCFE) based on the Gordon Growth Model, as illustrated below:
Undiscounted TV = TV CFE / (Ke - g)
100% Equity value
The value of a 100% equity stake in the business is equal to the PV of the CFE (or FCFE) expected across the projection period and (if applicable) the terminal period. The PV is estimated by discounting the CFE (or FCFE) to the present (i.e. to the valuation date) at your Ke.
You may choose one of two kinds of period discounting:
the mid-year discounting, which assumes that the CFE (or FCFE) occur at the middle of each period, or
the end-of-year discounting, which assumes that the CFE (or FCFE) occur at the end of each period. Although more conservative compared to mid-year discounting, as it yields a lower valuation (ceteris paribus), it may also undervalue a business that generates cash flows at the beginning or throughout the whole period.
When valuing financial institutions, considering that dividends are distributed to shareholders once a year, you may adopt a period discounting that reflects the distribution date of the specific business you are valuing.
Pro-rata equity value
If you are valuing an equity stake different from 100%, simply apply the specific % equity stake you are valuing to the 100% equity value estimated as above.
NB: this is based on the assumption that the CFE/FCFE considered in your DDM/DCF are majority cash flows (i.e. not already pro-rated, but related to a 100% equity stake).
We hope you found this article useful. Make sure to download our FCFE DCF and DDM Excel model templates:
In the Input tab you can update/select the key assumptions, including valuation date, discount rate, g and period discounting type. This tab also includes checks on the sensitivity tables.
Our FCFE DCF template includes an adjustment to equity value for any surplus cash available as at the valuation date (e.g. retained earnings, distributable reserves, cash and bank balances).
Lastly, the template includes 2 versions of the DDM:
DDM with Excess capital - this is the model to use when valuing banks and financial institutions subject to Basel III regulatory framework.
DDM with regulatory requirement - this model includes a limitation to the distribution of cash flows to equity holders based on the maximum regulatory D/E ratio that certain financial institutions must comply with (e.g. leasing companies).
Both DDMs include assumptions on the legal reserve: as mentioned earlier, a portion of the annual net profit must be transferred to the legal reserve, until this reserve is equal to a specific % of share capital.
For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!