At the most recent run of my LBO class, someone asked me this question,
"What is the difference doing a DCF using the WACC and a DCF in an LBO model?"
If we consider the same company in both cases i.e. the free cash flows (to firm), FCFF are the same, isn't the DCF like an LBO? In a typical DCF valuation, the weighted average cost of capital (WACC) is usually applied as the discount rate on FCFF. This discount rate comprises two main components - the cost of equity and the cost of debt.
Why does capital come with a cost?
Nothing is free in this world. The people who choose to fund your venture or your business are giving up something - more specifically, the option of being able to put their money elsewhere and getting more than what they had in the beginning.
Some common examples are: interest income earned from putting a cash deposit with a bank, government and corporate bonds, or even just buying a stock that pays dividends. By choosing to invest with you, these people are giving something up, and that lost opportunity comes at a price, which loosely translates to the cost of capital.
Every business is built and funded on either debt or equity. Conventional wisdom tells us that borrowing cash is cheaper than issuing equity because lenders typically get more security over the assets in the business and also priority in repayment from any cash flows generated. Because lenders do not partake in profit sharing of the business, they get no economical upside in the event the company becomes wildly profitable.
Equity holders (or shareholders) on the other hand, have a vested interest in the profits of the company, prorated to their share of capital contribution. They get paid only after the company's borrowings are repaid and therefore take on relatively more significant risk in their investment.
The optimal capital structure
Depending on the nature of the business and its underlying industry dynamics, each company has a "magic" number for debt and equity in order to get the lowest possible cost of financing. This allows them to maximize the business value. This magic number is the optimal capital structure.
In asset heavy industries whereby the companies have fairly resilient cash flows, the optimal capital structure will lean towards a greater proportion of debt - for example, in real estate, this refers to the core and core+ properties. For early stage enterprises, especially technology based startups, the optimal capital structure will consist of largely equity.
In reality, every company will have a different benchmark for what is optimal. A business which has a strong and proven track record of operations may have more debt in its capital structure because of its favourable credit rating and therefore access to cheaper debt, as contrasted to a younger and much less established firm.
We try to generalize an optimal cap structure across companies within the same sector because we expect the revenue dynamics and operating cash flow margins to be fairly similar.
Now, in a DCF model...
The discount rate represented by the WACC is a mix of debt and equity equivalent to the firm's target optimal capital structure. When we do a DCF based on the WACC, the resulting number yields the fair value of the business.
For the layman, fair value means: What the average or "marginal" investor should pay to acquire the business in order to get an appropriate risk-adjusted return had he/she had invested in all the public listed stocks in the target company's home market.
The risk/return-adjustment mechanism here is the beta, which is loosely speaking - calculated from - the correlation between the movement of similar companies' share prices against the broader market index. As we use the broader market index as the basis for justifying risk/returns, any minor deviation of a company's share price from this index is implied as "risk" (for more technical information on beta read this).
Because every investor has a different expectation on the equity returns (or the cost of equity), the output of a DCF using the WACC as the discount rate does not translate to how much an investor should offer to buy a company. The WACC gives you the fair value, but in reality, you can always choose to offer something higher or lower. Whether or not the seller agrees to the valuation is entirely up to negotiations and other qualitative factors influencing the target company.
All things being equal and agreeable...
Let's assume that the fair value is the offer price. The DCF on FCFF of the business results in the enterprise value ("EV") of the company. Loosely translated, this refers to the price of ALL operating assets in the company.
"Why don't we do the DCF on the FCFE (equity cash flows)?"
In theory, you can. But in the case of most buyouts, the incoming investor assumes responsibility for financing the deal i.e. they will assemble the best possible configuration of debt and equity to buy over the shares from the sellers, and repay / re-finance most or all of the legacy debt in the business.
If the buyers are creditworthy, they stand to increase the amount of borrowings obtainable from the banks, allowing the deal to be financed with the lower amount of equity capital.
In an LBO...
The incoming buyer (usually a PE fund) will test and push the limits of the cost of capital (the WACC) to achieve the highest return on equity possible. Discussions around the future cash flows of the business often result in lengthy negotiations between the buyer and lending banks. Some of these conversations entail iterative spreadsheet calculations that ideally would solve for the maximum amount of debt that will support the financing of the deal.
What the buyer is really trying to achieve here is to find the magic number for the debt that will allow for getting the HIGHEST equity return (or equity IRR). In most PE funds, this number is at least 20%, depending company and region.
The simple mechanics.
For example: If the returns for investing in this business is 10 percent, and assuming the investor doesn't borrow any cash to finance the deal, he/she would get a return of 10 percent. This 10 percent is also sometimes called the unlevered IRR. Unlevered means that the acquisition was purely financed with equity money and no bank borrowings were involved - obviously not a very wise and efficient use of money to the seasoned finance professional.
In order for the investor to achieve a higher return, he/she would try and minimize the amount of equity by looking for alternative sources of funds - such as debt. However, this would only make sense if the cost of debt is lower than 10 percent. Anything form of financing which costs more than 10 percent and the investor is better off using his/her own money.
Now, let's assume that approximately half of the total investment was funded with senior secured debt at a rate of 5 percent. The banks which are lending to the buyer at this stage not only have the first right to claim the assets in the event the business goes into distress, they also have priority over the cash flows generated by the company. The risk of this investment is relatively low as compared to pure equity, hence the 5 percent.
Based on the structure above, this would result in an equity return of 15 percent based on:
Unlevered IRR of 10% = (50% x 5%) + (50% x 15%)
Now, 15% may sound like a decent return but most PE funds are also subject to hurdle rates (typically in the ballpark of 8%), leaving them with only 7% after returning principal + hurdle to their LPs. Naturally, one way to overcome this is to try and get more cheap debt to minimize the equity outlay.
Because every financial institution is subject to their own credit risk matrix and lending exposures, the amount of "lend-able" senior secured debt (based on 5.0% interest rate) will be limited.
The hunt for more capital.
At this point, the PE fund tries to source for alternative sources of financing junior to the 5 percent debt. But this will come at a higher cost because the rights /security to assets and first priority to cash flows in the business have already been claimed by senior debt lenders. This alternative sources of financing would be subordinated. In order to entice this pool of subordinated lenders, the buyer has to make the cost of debt more attractive by increasing the interest rate.
For illustrative purposes, let's say this is going to cost 8 percent and the investor is able to syndicate 50% of it. The resulting calculations would give an additional uplift, bringing the equity IRR to 22 percent as compared to the original 15 percent.
15% return = (50% x 8%) + (50% x 22%)
You now get the idea...
Is 22 percent enough you say? Can we find additional sources of capital which are cheaper? This shouldn't be difficult.
But at this point, both the company cash flows and debt capital markets are going to be fully stretched, and it might be even more challenging to find a sufficient pool of investors who are willing to finance the deal at this level of risk. Some alternative sources of capital at this stage would come from either mezzanine investors or bridge loans.
The mathematics outlined above has been done on an illustrative basis to demonstrate how 'cheaper' bank debt and alternative financing sources can allow an investor to maximize the equity IRR in an LBO. While this may look simple, the complexities lies in the following:
FCFF considerations. In engineering the returns above, we have totally ignored the potential volatility in free cash flows, which could significantly influence equity IRR. This is why stable and visible cash flows are important in any LBO deal.
Depth of liquidity. The pool of available capital shrinks dramatically as we move from senior debt to subordinated debt to quasi-equity financing. As such, the term sheet for alternative financing will start looking a lot like equity further down the debt waterfall.
Cultural factors. The size and structure of the debt package is also partly driven by how sophisticated and comfortable debt investors are with the company and the jurisdiction that it operates in, including other factors such as cash repatriation and withholding taxes. This could also explain why many online LBO structures and templates are usually based on transactions done in the US and Europe. While the loan and corporate bond markets are fairly vibrant in Asia, quasi-equity financing structures still lag those in more mature capital markets.
Discount rate is investor-driven. Every investor has different expectations on returns, which implies the discount rate is subject to bias.
The CAPM model for deriving cost of equity is historical-looking and based on the perspective of a fully diversified investor. As such its relevance to the future and the target company must be taken with a pinch of salt.
Don't neglect the importance of analyzing future cash flows when using the income approach. Discount rate isn't everything.
Most analysts and associates that I know tend to get very caught up in the math and precision of calculating the discount rate when it comes to doing discounted cash flow valuation.
I have a healthy respect for the work and research that has gone into developing the industry standard for the discount rate or WACC (weighted average cost of capital) - which is extensively used by most people in the world of finance. However, in reality, I don't see why any investor should dwell too much on the accuracy and precision of the discount rate - especially when it comes to valuing deals in emerging markets.
Warren Buffet summarizes this aptly:
"Volatility is not a measure of risk. And the problem is that the people who have written and taught about volatility -- or, I mean, taught about risk -- do not know how to measure risk. And the nice about beta, is that it's nice and mathematical, and wrong in terms of measuring risk. It's a measure of volatility, but past volatility does not determine the risk of investing."
WACC as a discount rate
It reflects returns expected by all the stakeholders in the business. Debt holders get their returns in the form of interest and principal, while equity holders (shareholders) get their returns through dividends or whenever they sell their shares in the company.
The model behind quantifying risk and returns are incredibly correlated with share price movements as public markets provide the most visible and transparent form of valuation.
The theory is that: The share price of a company generally moves in tandem with the overall market. The riskier the company, the more the prices deviate from the benchmark indices. Risk in this case is driven by the industry dynamics as well as the amount of debt the company holds. More debt means more risk and therefore more share price deviation. The beta in the capital asset pricing model tries to quantify this.
There are a number of factors that go into the calculation of the beta:
Choice of company and market benchmark to compute the data points
Relevance of the company being selected for the comparison
Sample duration (1 year or 5 years?)
R-squared of the dataset
Assuming that you can accurately triangulate the above datasets, the outcome of the analysis is still inherently based entirely on historical data, which we already know, cannot be used as an accurate basis for predicting the future.
Comparison is the name of the game in valuation.
The industry-standard for deriving the discount rate involves comparisons with market benchmarks such as government bond rates, indices and comparable companies. In layman terms, what this means is:
"If I invest in a similar bond or financial instrument and get a X% return, why should I invest in you for the same?"
The discount rate for companies are priced at a premium because they are perceived to have higher risk than a certain market benchmark. In most cases, this is pre-defined as the expected returns from putting capital to work in a mature and diversified financial market with the following attributes:
Little or no history of defaults on sovereign bonds;
Triple-A rated by credit agencies
A stable political governance framework (a possibly contentious assumption under today's incumbent president) and;
The existence of a highly liquid and transparent equity capital market.
The price movements in the markets are also dominated by different investor profiles: Hong Kong has been traditionally seen as the capital markets gateway for companies with significant exposure to Greater China, while Singapore is noted for its position as a "safe haven" for wealthy asset managers hungry for yields, making the listing of real estate investment trusts ('REITS') hugely popular with the its exchange.
Likewise, the companies listed on the ASX, TYO and KRX are also largely shaped by the their home country's trade and industry dynamics. The resulting beta calculated from each of these markets will be to a certain extent, driven by the largest companies listed on the respective exchanges.
An appropriate benchmark for a mature market?
Most firms continue to use the US market as the benchmark. Research states that this is approximately 5.23%. Is a "mature market" in Asia - one which has stable financial and geopolitical regime - be compared and likened to the US? Can we equitably also say that the returns for investing in a mature Asian market are also 5.23%?
Take Hong Kong for example: It is a key and unarguably mature financial center in Asia, constantly perceived as a gateway to China. In the last couple of years, the city has also been caught in the epicentre of social unrests stemming largely from geopolitical factors. How does one marry the two to derive the equity risk premium in a market such as HK? Can we appropriately coin HK as a stable equity market? For a foreign business looking to enter Asia/China, would you use the mature market risk premium as the basis for your budgeting calculations?
Risk is ultimately a game of probability and uncertainty, and not volatility.
Uncertainties are driven by external factors such as geopolitical events; while internal factors refer to the company's business plan which drives the visibility of future cash flows. In a period of significant uncertainties, the application of the discount rate becomes less relevant.
Additionally, every investor out there has different appetite for risk, and these are shaped by their degree of understanding and comfort levels in the business and the market it operates in.
Every investor who receives a pitchbook of a company profile knows that the valuation number in the deck is whatever the banker wants to portray in order to win the mandate. The discount rate is irrelevant. A smart investor knows that validating the DCF valuation presented by the banker takes more than just a meeting but a deep dive into the operating drivers and free cash flows.
Rather than spend time dissecting and defending the WACC, you are better off analyzing the company's underlying fundamentals.
Most business meetings involving pricing comes down mostly to market multiples: P/E ratios, EBITDA multiples, EV/Sales. These ratios are intuitive, easily applied and comparable across geographies and businesses. It may not be rocket-science accurate but at least everyone sitting in the boardroom has sufficient understanding of the literature to make a decision.
In some cases, valuation can also be totally irrational. Investors will acquire a business 'at all costs' to gain a foothold into the lucrative markets of Asia regardless of what the discount rate shows. It makes the WACC calculation sound like a bunch of pig latin but that's the reality of asset pricing, especially in emerging markets.
There are still many merits to understanding a company's cost of capital (read also my article on DCF and LBO). Cost of capital is important in capital budgeting and knowing the limits of your borrowing capacity.
Unless the most important stakeholder in the room (which most of the time happens to be your client) asks for a scientific breakdown of the WACC, you'll find that most of the time, the discussions around valuation are going to be on cash flows and market multiples.
Schrödinger stated that if you place a cat and something that could kill the cat (a radioactive atom) in a box and sealed it, you would not know if the cat was dead or alive until you opened the box, so that until the box was opened, the cat was (in a sense) both "dead and alive". This is used to represent how scientific theory works. No one knows if any scientific theory is right or wrong until said theory can be tested and proved.
In business valuation, the pricing estimates done by analysts can be thought of both right and wrong, until proven by the market via an actual transacted deal between a buyer and seller.
Disclaimer: I've never had much luck with stocks, which is sometimes quite the irony.
I had spent countless hours before formally entering my corporate finance career learning the technicalities and ropes of valuation in hopes of being able to price a company correctly. Even after that, I've spent even more time working on countless models, valuing and running scenario analyses for different companies. Yet, in my poor judgement and over-compensated experience in investment banking, I could never get the pricing of businesses right - at least 90% of the time.
In one meeting, I clearly remembered showing a company profile to a client which clearly showed that its share price was trading at historical lows. We were pitching them as a potential acquisition target. Because of its share price (and on hindsight, possibly also the lack of sufficient earnings consensus data), the forward price-to-earnings multiple was so low that mathematically, it was a no-brainer that the acquisition - regardless of how it was funded - would be earnings accretive. Fortunately the client didn't buy them (both the company and the idea) and the stock went into administration / receivership less than a year later.
And you thought bankers had all the brains in the finance world.
Asset pricing is full of bias
For publicly listed companies, so many factors go into the pricing of their stock. Bankers and analysts run their DCF models and communicate valuation to potential investors based on their house view of "realistic growth" - which is pretty much predicated on and driven by the calculated guesses of the target company's CEO and CFO, people whom we trust are in the best positions to comment on an appropriate growth of the business. There's nothing wrong with trusting their numbers, except that this is subject to both experience and motivational bias. Who is to say the numbers are wrong?
"This country needs a vaccine and you are going to have it by end of the year" - says Trump in a CNBC article.
So when someone in a position of power says something like this above, I wonder if the intelligent analysts around the world are going to factor in a scenario of a year-end vaccine in their models.
Trust but verify
If you were smarter or came from the industry, you might be able to validate information coming out from management. Otherwise, you're pretty much left to the mercy of the company's guidance and/or research data done by external parties. Those same data are being gathered by humans on the ground and put together in a systematic and presentable way to be sold at a fee to investment banks and advisory firms. The excel valuation model that you do is basically a output from a "black box" of mathematical functions based on a series of numbers backed by those research. You can run the financial model a hundred times over, but yet you'll never be able to predict and foresee if a business is really valued that much. Why?
Beyond the spreadsheet
The common approaches to valuation for a growth company i.e. the market and income methods - are based almost solely on a single or few data points - next year's and subsequent five years financial estimates. Those future estimates of cash flows often do not take into consideration other critical factors such as:
Cash collected (or more importantly - uncollected) from customers: a commonly overlooked metric in due diligence, found under the detailed notes of trade receivables in the financial statements
Quality of revenues: whether customers really continue to buy the company's products over the longer term (for e.g. Apple)
Management integrity and fraud: which has come under much spotlight recently especially with a number of US-listed China stocks such as iQiyi, TAL and Luckin.
Geopolitical shocks: as what we are experiencing now with COVID-19, US-China trade tensions, food security, North Korea, changes in political leadership in different countries, etc
All these are compounded by the fact that you are projecting free cash flows over 5-7 years and then applying a "terminal value" to arrive at a valuation. If you do the math, this "terminal value" often takes up 60-70% of the total business value, which means: After pulling all nighters and sitting through detailed interviews sessions with the management on their 5 year plan, and doing extensive research on what drives the industry, you are basically throwing more than half your weight and work into two BIG woozy variables - the long term sustainable growth rate and the weighted average cost of capital.
Apart from the need to have some basis for negotiating deals, I don't believe in the practical application of terminal value to estimate the price tag of a business.
Information is the one big thing that drives the price of a stock. Any unsophisticated retail investor can price a stock even without a properly functioning financial model. If there is proprietary information on a company, not known to the public and is expected to positively impact its outlook, there is a window of opportunity for the investor to profit from it. I am not talking only about proprietary information not only in the form of "insider news" but also proprietary intelligence, analysis and field research. At the end of the day, it is essentially about data collection and scrubbing.
The closer you are to the source, the more confident you become about the credibility of that information - this is information proximity bias. But it does not automatically imply correct-ness. Your belief in that information is personally shaped by your knowledge in the subject matter and the level of trust you (and only you) have in the source.
Many punters and investors get their hands burnt by relying on market rumours without first doing their homework - both in the form of understanding the company and perhaps more importantly, validating the source of that information.
Whenever I receive unsolicited stock rumours and tips nowadays, I tend to assume that this information is already stale i.e. If someone is telling me that this company worth shorting or taking a long position, there is a high chance that this person has already taken a position, and it is also likely that the person before has also done the same, so on and forth i.e. two to three degrees away.
There are no free lunches.
Perhaps more important than the integrity of information itself is to ask:
What does this person stand to gain from sharing-revealing-publishing this piece of news?
Movements in the share prices of companies are very difficult to predict and understand. Many stay-at-home traders and professionals alike use technical analysis such as charts and patterns to try and explain why share prices move in a certain way. Some even claim to be able to feel the market sentiment. This ideology in itself is very complex for me. Not only is it self-fulfilling on a certain level but also potentially dangerous because it could ultimately lead you to believe that your way of thinking, your ideology is correct.
The thing is: No one can really predict how stock prices will move. It's 50-50 every day. It's either up or down. And those are the odds that you deal with every day.
Beyond charts, patterns and fundamental analysis, the movement in share prices are also driven by huge chunks of shares being exchanged by big institutional players such as hedge funds and asset managers. For larger companies, sometimes a dedicated team can be staffed to perform "treasury operations" which simply means buying and selling its own shares in the market - a 'loose' way for a company to control its share price in order to prevent sudden spikes.
The power of publicity.
The news and media are also very important catalysts to a company's share price. This also includes analyst coverage and recommendations on a stock. Because the information is in public, any revelation in the business will often result in significant share price movements. Perhaps the most obvious examples of these are investor activism and short seller attacks on public companies. Your DCF models, charts and expert research just aren't going to cut it if the information doesn't get picked up by the media.
At the end of the day, business valuation and trading equities are a very personal thing. Every one sitting behind the desktop sees the same information and the same world in very different ways. Their views are inevitably shaped by their backgrounds and experiences. Also, the first-hand information of one person is another person's second-hand information. Like it or not, the sentiments and confidence of both parties looking at that same piece of information, is going to be somewhat different. And as a result of that, their decisions to buy or not to buy are also based largely on their own analysis and best judgement.