273: M7 - Discount Cash Flow

Question 1

Discounted Cash Flow Analysis

Answer 1

we will apply the skills developed in the previous modules to forecast and calculate the future cash flows we expect a company to produce in perpetuity.

From an academic perspective, a DCF is considered to be a more fundamentally sound method of valuation when compared to the other methodologies we have examined (comparables and dividend discount models)

Question 2

Free Cash Flows (FCFE)

Answer 2

For an equity investment, free cash flows (FCFE) are the cash generated by a company that are available for distribution to equity shareholders. The free cash flow generated by a firm is not readily available information. It is therefore the responsibility of an analyst to calculate either the free cashflow available to the firm (FCFF) or the free cashflow available to equity holders (FCFE).

Question 3

Enterprise Value

Answer 3

Enterprise Value = Market Value of Equity + Market Value of Debt - Cash

Question 4

Market Value of Equity

Answer 4

Market Value of Equity = Enterprise Value - Market Value of Debt + Cash

Question 5

Intrinsic Value per equity share

Answer 5

Intrinsic Value per equity share = market value of equity / shares outstanding

Question 6

how an analyst would calculate the free cash flow generated by a firm

Answer 6

Using the Income Statement as a starting point the following formula indicates the adjustments that are required to determine the free cash flow generated by the firm. You will notice that interest expense has been eliminated from the calculation as we are agnostic with respect to how the assets were financed. Our interest is focused on the company’s ability to use its’ assets to generate free cash flow.

Question 7

Free cash flows are calculated on an … basis …

Answer 7

Free cash flows are calculated on an annual basis using a pro-forma set of financial statements forecast into the future. The value of the firm is then the discounted value of all future free cash flows.

Question 8

Weighted average cost of capital

Answer 8

WACC is the average of the expected return to common equity, preferred equity and debt weighted by the proportion of capital raise via each method

Question 9

Our solution on how far to forecast free cash flows and how to terminate the process

Answer 9

Our solution on how far to forecast free cash flows and how to terminate the process is to rely on industry standards, industry standards recommend that an analyst forecast free cash flows 5 years into the future or until such time that the company can be considered a mature company.

Tha maximum number of forecast years is normally capped at 10 years

At maturity we must calculate the value of the remaining cash flows in perpetuity and we refer to that value as the terminal value.

Question 10

Income Statement Forecast Steps

Answer 10

1) Forecast EBITDA
2) Forecast Unlevered Net Income

Question 11

To obtain Free Cash Flow we need to …

Answer 11

To obtain FFCF we need to adjust for depreciation, capital expenditures, and net working capital

Question 12

Net working captial (NWC)

Answer 12

The definition of net working capital (NWC) is the difference between a company’s current assets and current liabilities on its balance sheet. It measures the ability of a company to meet it’s obligation over the near term.

NWC = Accounts Receivable + Inventory - Accounts Payable

Question 13

Capital Expenditures

Answer 13

To determine the total capital expenditures for a period an analyst will refer to the company’s statement of cash flows under the investing activities section.

Question 14

Capital Expenditures and Depreciation

Answer 14

Over time, total capital expenditures and depreciation have to equal each other. A growing company will typically have capital expenditures that, on an annual basis, are greater than the recognized depreciation. However, once a company has reached maturity, the two items should converge.

Question 15

Given how difficult it is to forecast and the declining accuracy of forecasts over time, at some point the forecasting process has to be ____________________.

Answer 15

Given how difficult it is to forecast and the declining accuracy of forecasts over time, at some point the forecasting process has to be terminated.

Question 16

Terminal Value

Answer 16

Industry standards suggest that the forecast period is normally terminated at 5 years when a company has reached maturity and the expected go forward growth rate is limited to the growth of the underlying economy. However, as a going concern, clearly there is considerable value remaining from the ability of the company’s assets to continue generating cash flow. This remaining value in perpetuity is referred to as the terminal value.

Question 17

Terminal Value: Perpetuity Method

Answer 17

From an academic perspective, the perpetuity method is the preferred methodology as it represents the true intrinsic value of the firm. Using this methodology the assumption is that the free cash flow generated by the company following the forecast period will grow in perpetuity at a rate that is less than or equal to the growth rate of the underlying economy. Forecasting a growth rate greater than the growth rate of the economy will ultimately lead to a situation where the company is larger than the economy which is clearly impossible. The formula used to determine the terminal value in perpetuity is a modification of the growing perpetuity formula where rr is the WACC and gg is the terminal growth rate.

Terminal value is highly sensitive to its denominator

Question 18

Terminal Value: Exit Multiple Method

Answer 18

The exit multiple method of calculating terminal value is much more prevalent in practice. With this methodology, at the conclusion of the forecast period, the value of the firm is calculated by applying a valuation multiple, usually EV/EBITDA, to the forecast metric. The academic argument against this methodology is that the resulting valuation is predominantly a comparable valuation as opposed to a true intrinsic valuation. Essentially, the analyst is just postponing the relative valuation by the forecast period.The argument in favour of this methodology is that it provides a better estimate of the value for a potential sale of the company given that the metrics represents what investors are willing to pay.

Question 19

What does an analyst do to gain insight on a significant impact on the resulting valuation

Answer 19

To gain insight into the impact of the assumptions, it is standard practice for the analyst to conduct a sensitivity analysis. Common items that are investigated include the following: Terminal Growth Rate, Terminal Multiple, Cost of Capital and Revenue Growth Rate.