DCF Flashcards
Why do you build a DCF analysis to value a company?
You build a DCF analysis because a company is worth the Present Value of its expected future cash flows:
Walk me through a DCF analysis.( Summary)
1) You start by projecting the company’s Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx.
2) Then, you discount the cash flows using the Discount Rate, which is the Weighted Average Cost of Capital
3) Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after the projection period into perpetuity.
4) You then discount the Terminal Value to Present Value using the Discount Rate and add it to the pv of the discounted cash flows from the projection period.
5) Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.
How to calculate unlevered CF
unlevered CF- represents company’s recurring CF that’s available to all investors, your projection structure starts from Revenue then you subtract cogs to get operating profit then you subtract operating expenses (make sure D&A is not embedded). This gives you EBITDA, then you subtract D&A to get EBIT. Now at this point you want to get NOPAT as a proxy for EBIAT so multiply (1- tax rate). Now you add back non cash adjustments, namely Depreciation & Amortization and subtract capex and change in net working capital
Non cash adjustments:
Since cant use net income because it only pairs with equity value and unleverd cf is recurring cf that’s available to all investors- you need to adjust net income for all the non cash charges to arrive at fcf. which will adjust cf from accrual basis to cash basis
ONLY PROJECTING RECURRING CF related to core business operations .don’t include others because its non recurring (gain/losses, impairments, writedowns) –
Why isn’t sbc included in NCA
o SBC is recurring but not included because its not a true non cash expense since it creates additional shares and dilutes equity investors
Special cases in NCA
deferred rent/commissions if related to core business & RECURRING
What is NWC?
- If the company spends extra cash as it grows, the Change in Working Capital will be negative; if it generates extra cash flow as a result of its growth, it will be positive. It’s related to whether a company records expenses and revenue before or after paying or collecting them in cash. For example, retailers tend to have negative values for the Change in Working Capital because they must pay for Inventory upfront before they can sell products
Calculating Levered Free Cash Flow
Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 – Tax Rate), and you also factor in changes in Debt principal…….
WACC Calculation
% equity x (cost of Equity) + % Debt x (after tax cost of debt) + %PS *(cost of PS)
What weightings do you use for WACC?
Weightings you could use target, optimal or current structure. I normally use current structure so I would use debt to total capitalization and equity to total capitalization
Pre-tax Cost of Debt
YTM on debt, coupon rates on bonds, or interest expense over total debt
After tax-cost of debt
Pre-tax Cost of Debt*(1-tax rate) – do this because the interest expense on debt is tax deductible
Cost of preferred stock
% dividends/ preferred stock value
Cost of equity:
CAPM
What is CAPM
CAPM (The reasons behind using a model such as the CAPM is that investors need to be compensated for taking risk. The model says that for any level of risk (beta), the return needs to exceed the return of a risk-free asset by a certain amount and that the more risk is assumed, the higher return is required)
What is CAPM formula
Rf + MRP*ReLevered Beta + size premium
Risk free rate
yield on the country it operates treasury bonds
MRP
reference from Ibbotson
o Market risk premium is the additional rate of return over and above the risk-free rate, which the investors expect when they hold on to the risky investment.
Size premium
o Size premium – reference from ibbotson– risk based company size ( smaller companies have more risk)
o Levered beta
how volatile a stock is compared to the market which includes business risk and leverage risk
Why do you unlever and then relever beta?
o To remove leverage risk and isolate business risk for peer companies you unlever beta and then relever it to reflect leverage risk for your company
Formulas for leverd/unlevered beta
o Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 – Tax Rate) + P/E)
o Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 – Tax Rate)+ P/E)
Gordon Growth Method
Final year FCF*(1+terminal FCF growth rate)/ (discount rate – growth rate)
Multiples Method
: you apply a Terminal Multiple (EV/EBITDA for CCA) to the company’s EBITDA in the final year of the forecast period
