DCF Analysis - Walking Through and Explaining It 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:
Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)
However, it’s not as simple as using that formula because a company’s Cash Flow Growth Rate and Discount Rate change over time.
In a DCF analysis, you divide the company into two periods: One where the assumptions change (the explicit forecast period) and one where they stay the same (Terminal period)
You then forecast the company’s cash flows in both periods and discount them to their present value based on the appropriate discount rate.
Walk me through a DCF analysis
4 steps
A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value.
- Project the company’s Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx
- You discount the cash flows using the discount rate, usually the Weighted Average Cost of Capital, and sum up everything
- You estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity. You discount the Terminal Value using the Discount Rate and add it to the sum of the company’s discounted cash flows.
- Finally, you compare this to the company’s Current Value, usually its Enterprise Value, though you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.
What does the Discount Rate mean?
The discount rate represents the opportunity cost for the investors - what they could earn by investing in other, similar companies in this industry.
A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate implies lower risk and lower potential returns.
A higher Discount Rate makes a company less valuable because it means the investors have better opportunities elsewhere; a lower Discount rate makes a company more valuable.
What methods are used to calculate Terminal Value in a DCF and which method is better?
You can use the Multiples Method or the Gordon Growth Method
Ultimately, the Gordon Growth Method is better because growth always slows down over time; all companies’ cash flows eventually start growing more slowly than GDP.
What are some signs that you might be using the incorrect assumptions in a DCF?
- Too much value from the PV of the Terminal Value
- Implied Terminal Growth Rates or Terminal Multiples That Don’t make sense
- You’re Double-Counting items
- Mismatched Final Year FCF Growth and Terminal Growth Rate.
If your DCF seems off, what are the easiest ways to fix it?
The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes more value, and so that there’s more time for FCF growth to slow down and approach the Terminal Growth Rate.
How do you interpret the results of a DCF?
You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.
Does a DCF ever make sense for a company with negative cash flows?
Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company is cash flow negative right now, the analysis could work if it starts generating positive cash flow in the future
If the company has no plausible path to positive cash flow or you can’t reasonably forecast cash flow, then the analysis doesn’t make sense.
Will you get the same results from an Unlevered DCF and a Levered DCF?
No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on the company’s Debt, whereas the Levered DCF does.
That alone will create a difference, but the more volatile cash flow in a Levered DCF and the difficulty of picking “equivalent” assumptions in both analysis will also create differences.
Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?
The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results than the other methods.
With the other methods, you have to project the company’s cash and debt, net interest expense, and mandatory debt repayments, all of which require more time and effort.
Why is the APV analysis flawed
It doesn’t factor in the main downside of Debt: Increased chances of bankruptcy. You can try to include this with risk, but no one agrees on how to estimate it numerically.
How do you move from Revenue to Free Cash Flow in a DCF?
From levered free cash flow
Subtract COGS and Operating expenses from Revenue to get to operating income
then, multiple operating income by 1-tax rate, add back depreciation and amortization, and then factor in the change in working capital. Finally subtract capital expenditures.
If a 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.
