DCF for my self-learning journey

For my portfolio, I decided to record my understanding of the DCF valuation.

In this article, we assume that a Korean company acquires an Indonesian automobile part manufacturing company.

Step 1: Data preparation of PL

Here is a sample PL model.

Assumptions:

1. Sales increase by 8% per year
2. COGS is 60% of sales.
3. OPEX is 25% of sales.
4. Operating profit is 15% of sales.

Step 2: Calculate the free cash flow (FCF)

Here is a sample FCF calculation model.

Assumptions:

1. Corporate incomet tax (CIT) is 22% in Indonesia. (OP 22% -1)
2. Depreciation is 8,000 million rupiah per year hypothetically.
3. Capital expenditure is 500 million rupiahs in 2024 and 20 million rupiah from 2025 on.
4. Change in working capital is also set hypothetically. (The negative figure means the increase in working capital compared to the previous year.)

Step 3: Calculate WACC (Weighted Average Cost of Capital)

To calculate WACC, it is necessary to calculate the cost of equity and the cost of debt first.

a. Cost of equity

The cost of equity refers to the financial returns shareholders who invest in the company expect to see.

Notes:

1. Risk-free rate

The risk-free rate is the rate of return of an investment with zero risk.

In calculating WACC, the risk-free rate refers to the yield rate of the 10-year bond of Japan as of December 29, 2023.

Reference: https://www.investing.com/rates-bonds/japan-10-year-bond-yield-historical-data

2. Equity risk premium

The equity risk premium refers to the excess returns over the risk-free rate that investors expect for the incremental risks of the stock market.

3. Beta (ß)

Beta is a concept that measures the expected move in stock relative to movements in the overall market. As comparable companies, I chose PT Astra Otoparts Tbk (AUTO.JK) and PT Selamat Sempurna Tbk (SMSM.JK) from the Indonesian stock exchange market (IDX).

The detailed calculation of Beta is described in a separate article.

4. Size premium

The size premium is the additional risk premium required by investors for companies that are smaller than the weighted average of the entire equity market. Usually, to obtain the size premium of Japan or the U.S., it is necessary to purchase a report. Therefore, in this article, 6% is set as the size premium of Japan hypothetically.

5. Capital cost before adjustment

The capital cost before adjustment of the country risk premium is the sum of [1] — [5].

6. Country risk premium

The country risk premium is the additional return or premium demanded by investors to compensate them for the higher risk associated with investing in a foreign country than in the domestic market. The country risk premium of Indonesia can be found in the reference below.

Reference:https://pages.stern.nyu.edu/~adamodar/

7. Capital cost after the adjustment of CRP

Based on [1] — [6], the cost of capital turns out to be 14.37%.

b. Cost of debt

The cost of debt is the rate of return that lenders require to take on the risk of providing debt financing to a borrower.

Notes

8. Interest rate on debt

I decided to use the average interest rate on working capital loans per type of bank. Its calculation is described in a separate article.

Reference: https://www.bi.go.id/SEKI/tabel/TABEL1_26.pdf

9. Default spread

I referred to the default spread updated by Professor Damodaran on January 5, 2024. (https://pages.stern.nyu.edu/~adamodar/)

10. Interest rate after adjustment of the default spread

The adjusted interest rate considering the default spread turns out to be 10.63.

11. Corporate income tax rate

The CIT rate in Indonesia is 22% as of December 2023.

12. Cost of debt

As a result, the cost of debt is calculated with the following formula.

Cost of debt = 10.63% * (1–22%) = 8.29%

The cost of equity and the cost of debt have been calculated.

c. WACC

Now, we are going to calculate WACC.

Notes

13. E ratio & 14. D ratio

The E ratio and the D ratio are calculated in the following formula, respectively.

E ratio = Equity / (Debt + Equity)

D ratio = Debt / (Debt + Equity)

In the formula above, the equity is based on the market value of the comparable companies’ shares and debt refers to the interest-bearing liabilities.

Based on the stock price as of December 29, 2023, of the two comparable companies, the E ratio turns out to be 92% and the D ratio is 8% accordingly.

15. WACC

WACC = Equity cost E ratio + Debt cost D ratio

WACC has been calculated, but it is not the end.

16. Inflation rate in Japan

I referred to the IMF’s website to obtain the expected inflation rate in Japan.

The figure in this article is the average of the inflation rate from 2024 to 2028.

[embed]Report for Selected Countries and Subjects Edit descriptionwww.imf.org

17. Inflation rate in Indonesia

In the same way, the expected inflation rate in Indonesia can be obtained in the link below.

The figure in this article is the average of the inflation rate from 2024 to 2028.

[embed]Report for Selected Countries and Subjects Edit descriptionwww.imf.org

18. WACC after the inflation adjustment

Finally, considering the inflation rates, WACC is calculated as 14.99%.

WACC after adj = (1 + [15]) / (1 + [16]) (1 + [17]) — 1*

Step 4: Calculate the present value of FCF

As described in Step 2, the free cash flow (FCF) from 2024 to 2028 has been calculated and the FCF after 2028 (beyond the forecast period) can also be calculated with the formula below.

*FCF beyond forecast = FCF of 2028 (1 + Growth rate)**

Next, we assume that the total amount of FCF for each year arrives at the midpoint of the year. This is called the “mid-year convention”. Therefore, the discount period of 2024 is 0.5, and then that of 2025 is 1.5, and this pattern lasts until 2028.

The discount rate for each year can be calculated in the following formula.

Discount rate = 1/(1+WACC) ^ Discount period

Based on FCF, the discount period, and the discount rate, the present value of FCF is calculated for 2024–2028.

In the period beyond forecast, the terminal value is calculated in the formula below. (DR is a discount rate and GR is a growth rate.)

Terminal value ＝FCF beyond forecast/(DR-GR)

By using the same discount rate as 2028, we can calculate the present value of terminal value beyond the forecast period.

Step 5: Calculate the value per share

1. Enterprise value

Based on the calculated FCF in Step 4, we sum up the present value of FCF of the forecast period first, which is 65,465 million rupiah.

By adding the present value of FCF beyond the forecast period, the total amount of the present value of FCF is 172,847 million rupiah, which is called the “enterprise value (EV)”.

2. Corporate value

a. Formula

Corporate value = EV — NOA — Interest-bearing debt

b. Non-operating assets

NOA means non-operating assets. Non-operating assets are assets that are not considered to be part of a company’s core operations.

Non-operating assets are assets that are not considered to be part of a company’s core operations. The typical examples of NOA are idle equipment and vacant land. Those assets should be excluded in calculating the corporate value.

c. Interest-bearing debt

The interest-bearing debt should also be excluded in calculating the corporate value.

d. Stock acquisition rights

If there are any stock acquisition rights granted to specific shareholders, that should be also excluded in calculating the corporate value.

Based on a-d, the corporate value is calculated as 123,847 million rupiah.

Step 6: Equity value

The equity value is often considered equivalent to the corporate value.

However, it is important to consider the minority discount and illiquidity discount in calculating the equity value. Even though it is controversial, we assume 20% for the illiquidity discount as the deal is for private shares. Based on this assumption, the equity value is calculated as 99.078 million rupiah.

Step 7: Value per share

By dividing the equity value by the number of shares, the value per share is calculated as 10 million rupiah. This result is merely the theoretically calculated value per share based on the DCF method. The actual acquisition price of shares will be determined in the deal negotiation.