Discussion paper operating assets value under discounted cash flow method

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Discussion Paper : Operating Assets Value
under Discounted Cash Flow Method
Note: A discussion via emails in 2012 with Keith Allman, Enstruct Principal Trainer and Director
at Deutsche Bank (New York, USA)
‎Karnen:
Hi Keith,
I would like to ask you since I cannot get a straight answer in all the valuation books that I have
read. In the company share valuation where we apply DCF Method and the resulting value that I
have got, many oftentimes will ask : what happens to the operating asset value?
For Non-Operating Assets the valuation books will usually guide us to add the market value of
those non-operating assets onto the present value of DCF-based company value, before we
subtract the company's debt, to get total company value (including non-operating assets).
Sukarnen
DILARANG MENG-COPY, MENYALIN,
ATAU MENDISTRIBUSIKAN
SEBAGIAN ATAU SELURUH TULISAN
INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa
diposting melalui website
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For example, the operating assets consist of land and building (the case for manufacturing
company), shop houses (the case for distributors, where they run their business in country using
shop houses, probably pretty much like Starbuck, where they own the property), land and
building (the case for waste management company, where the permit to manage the waste is
directly linked to the ownership of building and land). With a high inflation in emerging markets,
all those land and building or properties have (sales) value much higher than the equity value
we have obtained from application of DCF. Meaning, that the business value is lower than the
asset value. The owner is better off selling the operating assets than selling the business.
So how to address such question?
Keith:
Hi Karnen,
I can briefly guide you on how I would look at this situation, since the fund I work at encounters
similar emerging market characteristics. The answer to your question lies in the terminal value
method used for your DCF. Normal DCF uses FCFs each period combined with some type of
terminal value. Typical terminal value methods are perpetuity growth or relative valuation
methods using the final projected period. These imply that the company will continue to
operate.
Going back to the question of operating assets, the minute you assume that they are sold the
business suffers or goes out of business in a full sale. It would be very wrong to assume a
terminal value where the business is valued in perpetuity and then also to give value to an asset
sale. You could not operate the business at the same level or at all with an operating asset
sale. You can however assume that you operate the business, generate FCFs and then at
some point sell the business. In this case your terminal value is calculated by an estimate of the
operating asset sale value in the future.
In general, while operating assets might have a lot of value built into them, particularly
land/buildings, it is of no use to an investor unless it is monetized. The problem though is once
it is monetized the business will suffer or cease. If you find yourself in a situation where your
client has a business where you do a DCF and find that the FCF plus terminal value is less than

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an operating asset sale it may mean that it would be worth them selling the business (of course
you‎will‎have‎to‎consider‎reinvestment‎risk…what‎will‎they‎do‎with‎the‎proceeds‎otherwise?).
Karnen:
Dear Keith,
I have read carefully what you suggested here, yet I am not too sure whether I could really
concur with you.
Since‎valuation‎in‎many‎engagements‎is‎to‎find‎“fair‎market‎value”‎as‎its‎standard‎of‎value,‎then‎
somehow I believe the value derived from the application of DCF method is not quite giving us
the fair market value (we take out the discussion of controlling premium or discount for lack of
marketability for privately held company). For example, as a knowledgeable and willing seller,
we logically are only willing to sell our business at value higher than that is given by DCF, if we
know that current market value of operating assets higher than DCF-computed value, with the
ceiling price = DCF-computed value (=business value) + current market price of operating
assets (assuming no non-operating assets). What I am trying to say, the value that we have
from DCF is a business value, which is the INTERACTION of all resources to bring cash flows
to‎the‎company‎creditors‎+‎shareholders.‎It’s‎a‎synergistic‎value,‎not‎the‎underlying‎assets‎or‎
resources value.
I usually use this illustration to make my points: assuming we could put a value/price to our
human organs and there is a human organ market, then, the value/price of one human organ,
for example, kidney, will not be the same, between its price/value to the whole body (its
capability to work together with other human organs to make the body function properly) and its
price/value to outside party that wants to buy that kidney for certain medical purpose.
So‎the‎value‎derived‎from‎DCF‎is‎similar‎to‎the‎value‎of‎that‎kidney‎to‎someone’s‎whole body,
which reflects the combined value of all of its assets. Let alone, we know that a company does
not create value simply by holding assets. It is only through a judicious combination of
expenditure decisions, and its combined effect of each of these resource allocations that gives
rise to an income stream, and thereby to a value for the company as a whole.
From DCF-derived value, we will get a synergistic value of all assets. Then now what happens
to the current market value of operating assets? We do know that an individual asset may have

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a market price, but its value to the company will depend inextricably upon its relationship with all
other resources deployed by the company. Now we have a problem, there are two values for
individual assets, (i) first, its value to the company (see illustration of kidney above), and (ii)
second, its value to the market (see illustration of kidney above, assuming we have human
organs market).
Up to this point, it is hard now for me to reconcile the value from DCF with the current market
value of operating assets, since all prominent valuation books that I read, they do not indicate
that the current market value of operating assets is treated as an add-on to the DCF-value. DCF
is surely only a spreadsheet tinkle, by factoring a reality check into it, yet, at the end, we need to
ask ourselves, do they make sense? Will there be a seller that is willing to sell its business
without‎adding‎up‎the‎current‎market‎price‎of‎the‎company’s‎operating‎assets?‎If‎that‎seller‎is‎
me, then, my answer is straight, No. I will only be willing to sell my business + operating assets,
at value = DCF-calculated value (assuming the market multiple results support DCF-calculated
value) + current price of operating assets.
I do not understand why such important stuff is never shown up in all valuation books.
As a compromise, usually this is what I am doing for valuation of the company which is heavy
with operating assets. I combine the value that I get from DCF application (income approach) +
adjusted asset value (asset-based approach, by which, each individual operating assets are
marked to market price). Each approach is weighted 50:50, or other weigh suitable to the
valuation situation.
We could extend easily our discussion to the patent/brand/trademark value, which somehow
necessary to be added on to the DCF value. I believe that the share price quoted in the stock
market for a company with strong brand name, somehow, the analyst has factored their
estimate of the brand value into the share price.‎ If‎ that’s‎ the‎ case,‎ then‎ for‎ a‎ privately‎ held‎
company valuation, we need to do the same. Since it will be relatively difficult to project more
“water”‎into‎the‎cash‎flows‎in‎the‎forecast‎period‎coming‎from‎the‎use‎of‎brand,‎if‎there‎is‎a‎
market for that brand, the easier way, is just to add the market price of that brand into the DCF
value.
Yet, bottom line, I am still not being able to find a sound theoretical reference to support my
compromise above.

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Keith:
A few quick points:
1) Overall perspective: Valuation has a spectrum of methods and viewpoints depending on
situation (e.g. private/public purchase, LBO, acquisition with synergy, liquidation, etc.) DCF is
one tool out of many to assess value. There are many other theories related to valuation:
relative value, option value, liquidation value, etc. You may even have hybrid approaches
where DCF is used for intermediate cash flows and an EBITDA multiple is used for terminal
value. On its most basic level a pure DCF with a perpetuity terminal value is giving you the
intrinsic valuation of the company. On the other end of the spectrum is relative value giving you
a market value. Typically when I value a company I check both to see if there is a large
difference and then understand why.
2) In regard to your disagreement on the market practice of not adding operating asset value to
DCF. It seems like an egregious error to me to go against this for a DCF model. The free cash
flows being generated are from operating assets. By adding value from the operating assets
plus the free cash flows they generate you are inflating value. FCF is specifically calculated in a
way to reflect the EXCESS cash flow that can be spun out of the business for debt and equity
holders. I don't see how you can spin out this value and keep the cash flows intact. I do see a
way in attributing value in the terminal value as mentioned before (there are many write ups on
valuing operational assets as if they were utilized for the rest of their useful life). That being
said, perhaps DCF is not the best method of valuation for your companies. Perhaps a hybrid
approach is where the owner operates the business and then sells it off. In that sale
assumption you can build in operating asset value or relative valuation theories. For instance
you‎do‎not‎have‎to‎do‎a‎perpetuity‎growth…you‎could‎do‎an‎EBITDA‎multiple‎sale‎that‎might‎
reflect a higher multiple than industry given brand value, etc.
3) Speaking of brand value, there are a number of ways to incorporate that into DCF. It all
goes back to the assumptions you put in. For instance you might assume higher prices for their
products than industry standard, or a better ability to pass on costs through inflation, etc. Your
assumptions can incorporate this. You can also do what I mentioned above and add a premium
to your multiple if you take a relative valuation terminal value.
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