Discounted Cash Flow (DCF) Analysis

Question 1

What is the premis of a DCF analysis

Answer 1

the value of a company equals the present value of its projected free cash flow

Question 2

Name the four pros of a DCF analysis; describe

Answer 2

Cash flow based
Market indepedendent
Self sufficient
Flexibility

Question 3

Name the four cons of a DCF analysis; describe

Answer 3

Dependence on finanical projections
Sensitivity to assumptions
Terminal value
Assumes constant capital structure

Question 4

Name the five steps in a DCF analysis

Answer 4

1. Study the target and determine key performance drivers
2. Project free cash flow
3. Calculate WACC
4. Determine TV
5. Calculate the present value and determine valuation

Question 5

1. Study the target and determine key performance drivers

Answer 5

Learn as much as possible about target and its sector
Key performance drivers: sales growth, profitability, FCF generation
Information sources include SEC filings (10k,10Q,8k) equity research reports, earnings call transcripts and investor presentations

Question 6

2. Project free cash flow

Answer 6

Unlevered free cash flows
Driven by assumptions of future performance gleaned from historical performance and guidance
Typically projected for a period of five years

Question 7

Unlevered free cash flow =

Answer 7

cash generated after paying all cash operating expenses and taxes, including funding of capex and working capital, but prior to payment of interest expense

Question 8

3. Calculate WACC

Answer 8

Wacc is the rate used to discount the projected FCF and terminal value
Reflects target’s business and financial risks
Dependent on capital structure

Question 9

What does WACC measure

Answer 9

the cost of each new dollar of capital raised

Question 10

WACC is the minimum return that a company must earn on its existing assets to…

Answer 10

satisfy its existing asset base to satisfy its providers of capital

Question 11

4. Determine TV

Answer 11

Final year of projection period (step 2) should represent a “steady state”
Terminal value captures value of FCF beyond projection period
Two main methods: exit multiple and perpetuity growth
Represents a substantial portio of target value in a DCF analysis

Question 12

5. Calculate the present value and determine valuation

Answer 12

Discount FCF and terminal value to the present, sum to calculate the enterprise value
Implied equity value and share price can be derived from calculated enterprise value
Execute a sensitivity analyisis over key assumptions (WACC, exit multiple/perp growth, sales growth rates, margins)
Compare valuation results to comparable/precedent results