DISCOUNTED CASH FLOW Flashcards
What is a DCF?
A DCF is a valuation methodology premised on the principle that the value of a company can be derived from the present value of its projected free cash flows (FCFs).
What type of assumptions do a company’s FCFs depend on?
Assumptions on Financial Performance such as:
Sales, Growth Rates, Profit Margins, Capital Expenditures, and Net Working Capital NWC
What type of valuation does a DCF yield and why is this important?
The valuation implied by a DCF is its intrinsic value, opposed to its market value. This serves as an important alternative (as market valuations can be distorted by a number of factors including market aberrations) or when no (or limited) pure play peer companies or acquisitions exist.
How long are FCFs projected out for a DCF?
The company’s FCF is projected for a period of around 5 years. This may be longer depending on sector, stage, or predictability of financial performance. It is critical to ensure relative confidence in predictable financial performance as the valuation depends heavily on the assumptions taken.
Why do we also use a terminal value in a DCF?
Given the inherent difficulties in accurately projecting out a company’s financial performance, a terminal value is used to capture the remaining value of the target beyond the projection period (Going Concern Value)
What is the key pro and con of a DCF?
Assumptions.
Pro: the use of defensible assumptions regarding financial performance, WACC, and terminal value helps shield the target’s valuation from market distortions that occur periodically. It also provides flexibility in changing underlying inputs and examining alternate scenarios.
Con: A DCF is only as strong as its assumptions and hence if assumptions fail to adequately capture the realistic set of opportunities and risks facing the target it will produce a meaningless valuation.
What are the steps in a DCF analysis?
- Study the target and determine the key performance drivers
- Project the Free Cash Flow
- Calculate the Weighted Average Cost of Capital
- Determine the Terminal Value
- Calculate the Present Value and Determine Valuation
Walk me through a DCF valuation.
There are typically 5 steps to a good DCF:
- Like all valuation exercises, you first want to study the target and determine the key performance drivers. As the DCF depends heavily on reasonable and predictable financial performance metrics, understanding the company and its sector is crucial to generating a meaningful set of assumptions and subsequently valuation.
- Next we project the unlevered FCF of the company, which is the cash generated by a company after paying all operations expenses and taxes, as well as funding capex and working capital, but prior to paying any interest expense, for a period of typically 5 years. This is driven by the assumptions conducted in step one.
- Thirdly, we determine WACC, which is the discount rate we use to calculate the present value of the FCF and terminal value. WACC is conceptually the overall cost of financing for the firm and is the weighted average of the required return on invested capital (debt and equity) in the company. It is commensurate with its business and financial risks. WACC is dependent on capital structure as debt and equity have significantly different tax ramifications and risk profiles.
- Fourthly, we determine the terminal value to quantify the remaining value of the target after the projection period. It is important for the target’s financial data represent a steady state or normalized level of financial performance (rather than cyclical high/low). There are 2 methods to calculate TV: exit multiple method (EMM) and perpetuity growth method (PGM). EMM calculates the remaining value of the target after the projection period on the basis of a multiple of the target’s terminal year EBITDA (or EBIT). The PGM calculates terminal value by treating the target’s year FCF as a perpetuity growing at an assumed rate.
- Lastly, we discount the target’s FCF and Terminal Value back to the present using the WACC and sum them together to derive the enterprise value. As a DCF incorporates numerous assumptions about key performance drivers, WACC, and terminal value, it is used to produce a valuation range rather than a single value. The range is driven by varying key inputs through sensitivity analysis.
How do we calculate Unlevered FCF?
EBIT - Taxes (at marginal rate) ------------------------ = Earnings before interest after tax (EBIAT) \+ D&A - Capital Expenditures - Increase in Working Capital (or + Decrease in WC) ------------------------ = FCF
What are some considerations for projecting FCF?
- Historical Performance - typically 3 year period serves as a good proxy for projecting future performance
- Project Period Length - typically 5 years is used to allow for predictability of financial performance. For mature companies, five-years projection period typically spans a business cycle and allows sufficient time for realization of initiatives. However for early stage companies of rapid growth, it may be appropriate to build a longer projection model (10years or more) to allow the target to reach a steady state level of cash flow. The longer period is often used for businesses in sectors with long-term contracted revenue streams (Natural Resources, Satellite, or utilities).
- Alternative Cases - developing alternate cases allows the banker to switch functions in the model to highlight adjustments to the base-case (adjusting projections and other assumptions)
- Projecting Financial Performance without Management Guidance - Without access to initial projections, bankers must be able to drive defensible projections based on historical financial performances, sector trends, and consensus estimates.
When would you use a longer projection period for DCF?
For early stage companies of rapid growth, it may be appropriate to build a longer projection model (10years or more) to allow the target to reach a steady state level of cash flow.
The longer period is often used for businesses in sectors with long-term contracted revenue streams (Natural Resources, Satellite, or Utilities).
What are some key points in projecting Revenue / Sales?
Use Equity Research for first few years. Then, derive growth rates from alternative sources - industry reports, consulting studies.
otherwise, step down growth rates incrementally in future years of the projection period at a reasonable long-term growth rate by the terminal year (2-4%)
What are some key points in projecting Revenue / Sales for highly-cyclical businesses?
For highly cyclical businesses, sales are more volatile and peak-to-trough. Terminal Value of the company MUST be normalized, therefore, early year projections may peak, then decline, then normalize by terminal year.
How do you get from EBIT to EBIAT?
Tax-effected EBIT (or EBIAT or NOPAT) =
EBIT * (1 - Tax Rate)
How do you calculate Net Working Capital (NWC)
NWC = (Accounts Receivable + Inventory + Prepaid Expenses + Other Current Assets ) LESS (Accounts Payable + Accrued Liabilities + Other Current Liabilities)
What does an increase in NWC mean?
This is when current assets increase by more than current liabilities and is typical for a growing company, which tends to increase its spending on inventory to support sales growth. Similarly A/R tends to increase with sales growth.
How are Accounts Receivable projected?
Using DSO (days of sales outstanding) to gauge how well a company is managing the collection of its A.R by measuring the number of days it takes to collect payment after the sale of a product or service.
DSO = [(A.R) / Sales ] x 365
How is Inventory projected?
Using DIH (days inventory held), representing the number of days it takes to sell the inventory.
DIH = [ Inventory / COGS ] x 365
Also could use Inventory Turns
COGS / Inventory
What is WACC?
WACC is the weighted average of the required return on the invested capital (both debt and equity) in a given company. It conceptually is the overall cost of financing for the firm and is commensurate with its business and financial risks. WACC is dependent on capital structure as debt and equity have significantly different tax ramifications and risk profiles.
What are the formulas for WACC?
WACC = (1-Tax) * (cost of debt) * (% of Debt) + (cost of equity) * (% of equity)
How do you determine the Target Capital Structure for the company?
WACC is predicated on choosing a target capital structure for the company that is consistent with its long-term strategy. The banker can examine the company’s current and historical debt-to-total capitalization ratios as well as that of its peers. Public comps can provide a meaningful baseline to benchmark. Existing structure is generally used as long as it is within the range of the comparables.
What is the optimal capital structure for a company?
The optimal capital structure is defined as the financing mix that minimizes WACC and therefore maximizes a company’s theoretical value.
