Discounted Cash Flow Model
Competitive Advantage
The term competitive advantage is a business concept that is related to advantages that a firm enjoys over its competitors, thus assisting it greater sales and higher profit margins. Hence, higher is the intensity and sustainability of the competitive advantage of a firm, more difficult will be for the competitors to neutralize the advantage. Some of the common types of competitive advantage are customer loyalty, cost structure, marketing cycle, brand value et cetera. Important to note, competitive advantage are of two types, comparative advantage and differential advantage. Comparative advantage deals with cost advantage with the company that allows it to produce goods at lower rate than its competitors, eventually leading to higher profit margins for the firm. Differential advantage, on the other hand, is achieved when a product or service of a firm are perceived in a better way by the customers, thus giving it a upper hand in the market.
How competitive advantage affects the valuation of a company?
The competitive advantage of a firm has a direct positive influence on its valuation. As we discussed in the introductory section, when a firm is able to earn profits that exceeds the industrial averages, it is said to have attained a competitive advantage. In other words, the firm has used utilized its resources and capabilities to an extent that creates a competitive advantage for it, that ultimately lead to higher valuation for the company. The diagram below indicates how a firm creates increases its value by performing a series of activity that promotes competitive advantage for it:
Thus, a firm, by creating values by performing a series of activities that enhances either the cost advantage or the differentiation advantage, eventually attains the competitive advantage that lead to value creation. However, as discussed by eminent economist, Michael Porter, in order to ensure that our activities creates value, it is very essential that the firm must have resources and capabilities that are superior to those of its competitors, because without any superiority in the resources or capabilities, it will be very easy for the rival company to replicate the actions, and competitive advantage will disappear soon.
Competitive Advantage-Citing example of Herbalife
In the world of health and fitness, herbal life has gained its own standing with a large base of loyal customers. The company has gained a differential competitive advantage through following factors:
Unique distribution network: Herbalife sells its product through a wide network of distributors that further ship the products to the customers. Many of the distributors are located even in remote areas, thus expanding the customer base to even far-flung areas.
Product Excellence: The branding of Herbalife products draws the attention of the consumers, which makes their products highly valued. All the products of the company enhance the health and nutrient consumption of the consumers, which brings an enormous change to a customers’ lifestyle.
Customer Excellence: Herbal life has a competitive advantage in the form of loyal customers which are well taken care of by the company, and the distributors, known as ‘Wellness Coach’’, that mentors the purchases of the customers to provide them an appealing experience with the company, something which their rivals lacks.
Thus, it is clearly evident that Herbalife is using its resources and capabilities in the most productive manner that provides it with competitive advantage over its rival that further assists in attaining higher revenue figures and enhanced value of the firm.
Do current valuation models incorporate competitive landscape, both now and in future?
The financial industry is dominatingly inclined towards using absolute methods, such as DCF Model where the intrinsic valuation of the company is found using the free cash flows which are calculated under the set of assumptions relating to the growth rate and some other factors, while no consideration is given to competitive landscape in any aspect. In contrast, one under-rated business model, Relative Valuation Model, is the only financial valuation model available that consider the competitive landscape, and compares the value of the firm to that of its competitors to determine the firm's financial worth.
Discounted Cash Flow Model
-Introduction
Discounted Cash Flow Model, popularly known as DCF Model in the investment community, is the most used valuation model by the analysts. Just like any other valuation model, DCF works on the assumption that markets are inefficient, and a valuation model can be incorporated to arrive at an actual intrinsic value of the stock.
-History
Although the usage of DCF model traces back to Egyptian and Babylonian mathematicians, but the model became after the stock market crash of 1929 that pushed the US economy to the ‘’Great Depression’’. The model was officially published in the late 1930’s in the books of Irvin Fisher and John Burr Williams, who for the first time expressed DCF model in economic terms.
-Why analysts and companies prefer DCF Model?
i)DCF model is completely based on underlying fundamentals of the security or the asset, hence, it is leased exposed to market moods and perceptions.
ii) This is the only valuation model that forces the analysts or other users to think about the business of the company being evaluated, i.e. going through the company’s fundamentals which are used in the valuation process, analysts get to know the characteristics of a firm, and its business.
iii) At the time of acquisition, DCF valuation turns out to be a boon for the acquirer company as it directly indicates the value of asset they are purchasing under the set of assumptions used by them.
-How the model works?
In discounted cash flow model, a stock value is estimated by discounting the present value of cash distributed to the shareholders(in the form of dividends) or by discounting the present value of cash available to the shareholders after the firm meets its necessary capital expenditures and working capital expenses(free cash flow to equity). Below discussed are the steps involved in the DCF valuation approach:
i)Projection of future cash flows:
The first step in the DCF valuation process is related to projection of cash flows under the valid assumption of growth rates. Here, cash flows can be dividends, free cash flow to firm(FCFF) or free cash flow to equity(FCFE), and the selection depends upon the analysts as which cash flow model he wants to discount to arrive at the intrinsic value of the firm. Thus, once he estimates the current multiples of the firm, he incorporates the appropriate growth rates into the current multiples to project future cash flows. Moreover, the growth rate is not required to be constant throughout the period of analysis, and analysts are free to choose different growth rate for different periods.
ii) Estimate the discount factor
Once the analyst is ready with projected cash flows of the firm, the next step is to estimate the discount factor so as to calculate the present value of the projected cash flows. Important to note, every DCF model requires the use of different discount factor. (Goedhart and Eagle, 2010) For instance, while Dividend Discount Model(DDM) and FCFE model uses cost of equity of the firms as the discount factor, FCFF model uses the weighted average cost of capital(WACC) to discount the projected cash flows.
Below is the snapshot of FCFF model used to calculate intrinsic value of the firm:
(Daves et all, 2004)
iii) Calculating Intrinsic value and compare with market price
The final step in any of the DCF model is to calculate the intrinsic value per share, and compare it with the current market price. Thus, if the intrinsic value is lower than the market price, the stock is rated to be overvalued. On the other hand, if the intrinsic value is above the market price, the stock is rated to be undervalued.
Citing Herbalife DCF Model
Referring to the Discounted Cash Flow Model of Herbalife at Thinknum.com, we found that the analyst has discounted the free cash flow using the discount rate of 15.68. Below discussed are the assumptions employed to calculate the intrinsic value of the company:
a)Growth Rate: The analyst has used two stage growth model, where beginning from 2015 till 2020, he has assumed the revenue to increase by 10% per annum, while the terminal value growth rate is assumed to be 2% only.
b)Change in Capital Expenditure and Working Capital: The authors here have assumed that capital expenditure and working capital will be in proportion to the revenue figures
c) Discount Factor: Also known as Weighted Average Cost of Capital(WACC), the same has been calculated as follows:
WACC: Cost of Equity*Weight of Equity+ Cost of Debt(1-tax rate)*Weight of debt
= .139*1.30+ 0.08*-.3042
= 15.68%
Here:
i) Cost of Equity: Risk free rate + Beta(Expected Market Return-RFR)
= 1.80+1.95(8-1.80)
= 13.89%
ii) Cost of Debt= 8%(net of tax effect)
d) Terminal Value: Interestingly, the analyst has calculated the terminal value an year before 2020, i.e. in 2019, using the following formula:
Terminal Value: FCFF(1+g)/(WACC- Growth Rate)
= 37.88(1.02)/(.1568-.020)
= $282.38
*Here, growth rate refers to terminal year growth rate
d)Intrinsic Value: Finally, after discounting the projected free cash flows and the terminal value, the intrinsic value of the firm was calculated to be $26.18, indicating the stock to be highly overvalued comparing with the current market price of $44.69
Discounted Cash Flow Model- Herbalife
Continuing with the discounted cash flow model for Herbalife on Thinknum.com, we are now proposing our model where we will change the terminal growth rate of the company from 2% to 5%, while all the other variable growth rate assumptions such as revenue growth rate, Capital expenditure in proportion to revenue and working capital in proportion to revenue will remain unchanged. Under the new assumption, the terminal value of the company will be:
Terminal Value: FCFF(1+g)/(WACC- Growth Rate)
= 37.59(1.05)/(.1568-.050)
= $369.56
Works Cited
Comeptitive Advantage. n.d. 10 April 2015 <http://www.investopedia.com/terms/c/competitive_advantage.asp>.
Competitive Advantage. n.d. 10 April 2015 <http://www.quickmba.com/strategy/competitive-advantage/>.
Corporate Valuation: A Guide for Managers and Investors, Phillip Daves, Michael Ehrhardt, and Ronald Shrieves (2004) South-Western Cengage Learning
Demarzo, Jonathan Berk and Peter. Corporate Finance. New York City: Penguin, 2014.
Discounted Cash Flow. n.d. 11 April 2015 <http://www.investopedia.com/terms/d/dcf.asp>.
Herbal Life Marketing Plan. n.d. 10 April 2015 <https://prezi.com/0uuv0eqhzdzj/herbalife-marketing-plan/>.
Summary of DCF Method. n.d. 11 April 2015 <http://www.valuebasedmanagement.net/methods_dcf.html>.
Valuation: Measuring and Managing the Value of Companies, 5th edition, Tim Koller, Marc Goedhart, and David Wessels (2010) John Wiley & Sons, Inc, Hoboken, New Jersey
