Company valuation is requisite to identify the deviation of the intrinsic value of an asset from its market price. The Discounted Cash Flow method is a frequently used method to determine intrinsic value. It determines the intrinsic value based on the discounted future cash flow of the asset and works in two stages. The first stage refers to an explicit forecast of the cash flow followed by the second stage which captures the cash flow beyond the forecast period with a terminal value. The cash flow is usually discounted at the Weighted Average Cost of Capital which consists of the cost of debt and cost of equity. The latter is mainly determined by the systematic risk, measured with a beta factor.
The aim of the present thesis is to analyze beta factor and terminal value as the key input factors of the Discounted Cash Flow model. A comprehensive overview of the different estimation methods of beta factor and terminal value will be provided and critically reviewed. To illustrate the valuation procedure and to analyze the impact of both parameters on the intrinsic value, a case study of Microsoft Corporation is conducted.
The findings of the literature and the case study demonstrate that the main challenge of the Discounted Cash Flow model is the determination of terminal value and beta factor since both parameters can be estimated with different methods that lead to different results. Moreover, the case study provides evidence that the intrinsic value is sensitive to the input factors of terminal value and to the discount rate which is primarily determined by the beta factor.
The results indicate that analysts who apply the Discounted Cash Flow model should be aware that this model is mainly based on assumptions and therefore can lead to different results. The dependence of intrinsic value on the terminal value and the beta factor stresses the importance of a critical examination of these both parameters and requires a need for further investigation.
Table of Contents
1. Introduction
1.1 Problem Definition
1.2 Objective and Organization of the Thesis
2. Discounted Cash Flow Method
2.1 Growth Pattern
2.2 Cash Flow Projection
2.3 Discount Rate
3. Beta Factor
3.1 Level of Beta Factor and its Economic Significance
3.2 Estimation of Beta Factor from Historical Returns
3.2.1 Regression Analysis
3.2.2 Practical Problems
3.2.3 Adjusted Beta
3.3 Alternative Methods of Estimation Beta Factor
3.3.1 Accounting Beta
3.3.2 Bottom-up Beta
3.3.3 Time-varying Beta
4. Terminal Value
4.1 Perpetuity Growth Method
4.1.1 Gordon Growth Model
4.1.2 Key Value Driver Formula
4.2 Exit Multiple Method
4.2.1 Equity Price Multiples
4.2.2 Enterprise Value Multiples
4.3 Comparison of Terminal Value Methods
5. Case Study: Microsoft Corporation
5.1 Company Overview
5.2 Database
5.3 Valuation of Microsoft Corporation
5.3.1 Discount Rate
5.3.2 Cash Flow Projection
5.3.3 Terminal Value
5.3.4 Intrinsic Value
5.4 Sensitivity Analysis and Critical Review
6. Conclusion and Outlook
Research Objectives and Key Topics
The primary objective of this thesis is to critically analyze the beta factor and terminal value as key input parameters within the Discounted Cash Flow (DCF) model. By investigating various estimation techniques for these parameters, the research aims to illustrate how sensitive the intrinsic value of a company is to changes in these assumptions and to identify the primary challenges involved in the valuation process.
- Theoretical evaluation of the Discounted Cash Flow (DCF) model and its valuation components.
- Deep analysis of beta factor estimation methods, including regression, bottom-up, and adjusted beta techniques.
- Comprehensive review of terminal value approaches, specifically the perpetuity growth and exit multiple methods.
- Practical application of the DCF model through a detailed case study of Microsoft Corporation.
- Sensitivity analysis of the valuation results to demonstrate the impact of parameter variation.
Excerpt from the Thesis
3.1 Level of Beta Factor and its Economic Significance
The beta factor is a measure of the systematic risk which indicates how sensitively the return of an investment security (i.e. stock) reacts to changes in the market. It records the change in the return of a security caused by changes in the return on the market portfolio. That means that it indicates the statistical relationship between the fluctuation in the return of a security and the fluctuation in the return of the market. Thus, the beta factor measures the risk of a security relative to the market portfolio. The systematic risk results from the market and it is caused by factors that affect all securities equally. Those market factors are for example economic changes, macroeconomic indicators, or natural disasters. In contrast to unsystematic risk, the systematic risk cannot be eliminated by diversification.
The beta factor is useful in understanding how volatile a security is compared to the market and if it moves in the same direction as the market. As already mentioned, the beta factor of the market portfolio is exactly one. If the beta factor of the asset is greater than one, the asset will have greater systematic risk than the market portfolio. This is called an aggressive asset since it is more volatile than the overall market. For example, a beta factor of 1.5 implies that the price of a security will increase by 1.5% if the market increases by 1%. Vice versa if the market decreases by 1%, the price of the security will decrease by 1.5%. The asset has a greater systematic risk than the market because the price goes further up and down than the market. On the other hand, a higher systematic risk leads to a higher return. The return of an asset is not affected by its variance but by the covariance of the return on the asset with the return on the market portfolio.
Summary of Chapters
1. Introduction: Introduces the importance of distinguishing market price from intrinsic value and outlines the significance of the DCF model in financial valuation.
2. Discounted Cash Flow Method: Provides the theoretical foundations of the DCF approach, explaining different valuation stages and the necessity of cash flow projections.
3. Beta Factor: Examines the role of systematic risk, detailing various techniques to estimate the beta factor and the necessity of adjustments for better accuracy.
4. Terminal Value: Discusses the significance of the terminal value and compares the perpetuity growth method against the exit multiple approach.
5. Case Study: Microsoft Corporation: Applies the theoretical frameworks discussed in previous chapters to calculate the intrinsic value of Microsoft Corporation.
6. Conclusion and Outlook: Summarizes the key findings regarding the sensitivity of valuation models to input parameters and suggests areas for future research.
Keywords
Discounted Cash Flow, DCF, Intrinsic Value, Beta Factor, Terminal Value, Systematic Risk, Capital Asset Pricing Model, CAPM, WACC, Growth Pattern, Sensitivity Analysis, Microsoft Corporation, Equity Valuation, Corporate Finance, Estimation Methods
Frequently Asked Questions
What is the core focus of this research?
The research focuses on the Discounted Cash Flow (DCF) model, specifically evaluating how the determination of terminal value and the beta factor significantly influences the resulting intrinsic value of an asset.
Which specific parameters are analyzed in depth?
The study deeply analyzes the beta factor, which measures systematic risk for the cost of capital, and the terminal value, which represents the cash flow beyond the explicit forecast period.
What is the primary objective of this thesis?
The objective is to critically review different estimation techniques for the beta factor and terminal value and to demonstrate the impact of these input factors on the overall company valuation using a practical case study.
Which methodology is employed in this work?
The work combines a literature review of valuation theories with a quantitative case study, using financial data and specific DCF modeling techniques to assess Microsoft Corporation.
What topics are covered in the main body of the work?
The main body covers the theoretical framework of the DCF method, detailed methods for calculating beta factors (regression, bottom-up), terminal value calculation techniques, and a practical application on Microsoft Corporation including sensitivity analyses.
What defines the core characteristic of the valuation in this work?
The valuation is characterized by its reliance on key input factors (beta and terminal value) that are subject to estimation assumptions, which the author evaluates critically regarding their impact on the final valuation outcome.
How is the terminal value determined for Microsoft in this case study?
The study uses both the traditional Gordon Growth model and the exit multiple method to calculate the terminal value, allowing for a cross-check of the results.
Does the work address the limitations of the beta factor?
Yes, the thesis addresses limitations such as the instability of historical returns and the inability to use regression analysis for non-listed companies, proposing adjusted betas and bottom-up approaches as alternatives.
- Citar trabajo
- Marie Happe (Autor), 2020, Analysis of Terminal Value and Beta Factor in the Discounted Cash Flow Method, Múnich, GRIN Verlag, https://www.grin.com/document/951091
