The two main different approaches to a DCF valuation are in regards to what we can value. We can choose to value the equity of stock or the whole firm. In valuing equity or a Free Cash-Flow to Equity model (FCFE), we only value the equity - and with it compute the cost of equity when looking at the discount rate, but not the cost of debt.
In the second approach, the Free Cash Flow to the Firm (FCFF) model, we compute the Weighted average of the cost of equity and debt to get a market value of the cost of capital - which in turn constitutes our discount rate. So, which approach is better? FCFE has fewer inputs and can be more easily computed than FCFF, but requires a higher dose of precision. When talking about precision in means using appropriate values (market vs book) and making sure not to double count items.
The FCFF model allows for more maneuvering and changing of more assumptions. It is important to note, that if done right, both valuations will give a similar estimate. That is one way to see if it is appropriate to use the simpler method, for a certain firm. If these numbers do not converge, then we need to consider the structure and underlying assumptions of the firm and go with the more complex model or an entirely different approach - like a high growth firm valuation.
The Role of Leverage in a DCF
In our first segment, we will look at where leverage (debt) appears in a DCF valuation. For that, we look at a financial balance sheet and see that debt is located on the liability side of the statement. Let's look at table 1, and go through each statement separately.
Table 1. Composition of a Financial Balance Sheet.
Assets
Liabilities
The expected value of investments already made
Assets in place
Debt
Borrowed money
Expected change in the value of future investments
Growth assets
Equity
Owner’s funds
As we can see, there are 4 main items on the sheet. Two of those are included in the computation of the cost of capital for a firm’s valuation.
Those are:
The cost of debt is the interest rate that long term lenders demand today. What premium should I demand given the default risk and the length of the loan
Drivers:
The Perception of the Default Risk;
The possible tax benefits from interest expenses - tax benefits come from the marginal rate. The cost of equity (Hurdle rate) is the equity return investors demand. How much must the return be given the risk of my investment?
Drivers:
The Perceived Risk of Equity;
Both of these estimates are included in the computation WACC (Weighted Average Cost of Capital), which is one of the fundamental parts of a DCF valuation. The WACC is the weighted average of the Cost of Capital (weighted by its drivers).
The cost of capital is the overall (degree) cost of funding the firm.
Drivers:
- Cost of equity
- Cost of debt
It is ultimately defined by the consolidated risk of the firm.
After that, we need to add the weights into the equation. They need to be market value weights - and not book value. The way to think about the market value weights is that they reflect the cost of acquiring the entire business today.
This shows us where debt (leverage) plays a role in the DCF statement. Now we need to look at the type of role it plays, and its extent.
Leverage mainly plays a role in the risk of a firm, and therefore is accounted for at the discounted rate. The riskier the asset - the greater the discount rate. This is the simple part.
The more nuanced part is coming up with a good estimate for risk.
We will see that risk is present in multiple ways in a DCF analysis, and one major point is making sure that we separate the risk rates in their appropriate categories and not double count them.
The Involvement of Leverage in Risk
Types of risk included in the cost of capital:
Business risk: It is different for each industry and is driven both by price and earnings variability. Business risk is alleviated by proper diversification, in which case it correlates with the risk of the general market (Beta of 1).
BETAS - two ways to calculate: Run a linear regression of the returns of the stock against a market index. Notice, this beta is backward-looking, based on past events/earnings. Estimate the % of involvement in different industries of the company, and pull a weighted average of the betas in those sectors.
Example: Apple Inc. has a certain % of earnings from manufacturing phones, and another % from selling apps in the IOS Store. To estimate a beta we, look at the betas of all companies manufacturing phones, and selling apps, and weigh the averages by the % involvement for Apple Inc in both industries.
Leverage Risk:
The amount of leverage drives the cost of capital and is influenced by taxes, default risk and agency problems. There are three numbers that need to be estimated in order to get the cost of capital:
Debt ratio: the proportion of debt and equity - reflects the weights of the weighted cost of capital.
Beta Effect: The more interest payments you have, it makes you need to upwards adjust your business rush by the debt to equity ratio. Cost of debt, which is set based on the perceived default risk. You need to estimate a default spread for your company based on either its bond ratings or financial ratios.
Country Risk (as measured by): Sovereign ratings and default spread. You can use a country's default spread, from its sovereign rating, as a measure of country risk.
Sovereign credit default swaps. It offers a market-based estimate of sovereign risk. Country risk premiums. A scaling factor added on top of default spreads, that reflects the risk of equities vs government bonds.
Scaling Factor: divide the volatility of an emerging market equity index by the volatility of emerging market bonds.
Currency Risk: Do not mix country and currency risk. You can value a British company in US dollars, but that does not make the country risk from the UK firm go away. Currencies matter because they have different expectations of inflation embedded in them.
You need to start by estimating the risk-free rate, which may be difficult in emerging markets since even the government bond rates have default risk embedded in them. A way to control this is to take the 10 years government bond rate and net out the default spread for that country. This shows us what the risk-free rate would be if there was no default risk.
Alternative approach: Estimate the cost of capital in your preferred currency (a stable currency). Add on (incorporate) the differential inflation between that currency and your target currency.
Example for the US:
(LC = local currency)
Of all the drivers, we see that leverage risk is highly intertwined with a firm’s beta estimate - which is part of the business risk. This type of risk can be alleviated by adopting a diversification approach to an investment portfolio. And with this assumption in mind, we need to focus on the magnitude of the leverage risk, which shows us how much can a firm cope with financial stress and to which extent does it have default risk. Both of these factors are emphasized when determining the discount rate in a DCF.
Strategy for Valuation and Management
In general, leverage negatively influences the final value of the stock. A quick screen of the debt to equity ratio can indicate if we should take the simpler approach or incorporate leverage into our DCF valuation.
The relationship between the effect of leverage on the final value is not linear since higher debt to equity ratios increase the strain on the firm and result in a higher discount rate in a DCF.
For the firm, a good mix of debt to equity is dependent on the stability of revenues, the tax incentives of the country(es) it operates in, hurdle rates and the default risk.
From a corporate aspect, there are both good and bad reasons to include financing from debt in a firm.
The Benefits Include:
It is a disciplinary tool since management will have to put more focus on profitable projects that are above the hurdle rate.
The country of incorporation may incentivize leverage by including (more) tax benefits. More debt makes the firm a bad target for a hostile takeover.
The Risks Include:
- Bankruptcy risk increases, especially in volatile economies.
- The more levered a firm, the higher the cost of capital becomes.
- The interests of investors and lenders will clash.
In closing, the difference between levered and Unlevered DCF valuation is impacted by the amount of debt that a firm holds. We should first screen for the debt to equity ratio, before picking the DCF approach in valuation, if you are a developer you can use a Free financial API where you can directly access this ratio via any programming language to screen for this ratio and see in detail the difference between levered and Unlevered DCF and then the impact on companies valuation.