Discounted Cash Flows Approach

Question 1

Definition of DCF

Answer 1

A method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate.

In other words, DCF is a present value calculation of the future cash flows expected to accrue to a given business.

Question 2

When to use a DCF method?

Answer 2

1) Business is a going concern but has a finite life (project, contract, license arrangement, etc.)
2) When the business is forecasted to experience a change for a number of years before achieving a sustainable operating level.

Question 3

What are “Terminal” and “Residual” values in a DCF scenerio?

Answer 3

Terminal Value: If a project is expected to operate beyond the cash flow projections, at a more sustainable way, the subsequent results are capitalized as at that point in time and discounted to PV.

Residual Value: If the business is expected to terminate at the end of the cash flow projection period, an estimate of the”residual value” at that time is made and discounted to PV.` This includes any cashflows that are achieved following the life of the business, such as a sale of the busiensses assets.

Question 4

What questions should be asked when determining if Management Forecasts can be trusted for a DCF valuation?

Answer 4

1) What process was used to create the forecast?
2) Does mgmt have a bias / incentive to have higher / lower forecasts?
3) Who prepared the forecast? are they qualified? what infor did they have access too? etc?
4) How have past forecasts by mgmt compared to actual results? Do they have a history or accurately forecasting?
5) Are the assumptions made reasonable? Based on historic results and industry information? Are changes in things like growth rate, margins, etc realistically justified? Are variable expenses increasing at the same rates as revenue increases?

Question 5

What is the Single Period Gordon Model? What is it used to find? What is the formula?

Answer 5

A method of determining the terminal value (normalized cash flows in perpetuity following the forecasted period of a project or busienss).

Formula:

   k - g

NCF = net cash flow in the year preceding the terminal period.
g = long term growth rate.
k = discount rate.

The above formula provides the CAPITALIZED value from the terminal period of cash flows. However, it still must be discounted to PV.

Question 6

Discount formula

Answer 6

Mid-year discounting:

1 --------- (1 + k) ^t-0.5

Question 7

The process to the DCF Method

Answer 7

1) Determine which approach to use.
- Going concern with finite life or project that will normalize after a specific growth period.
- Reliable forecasts are available.

2) Assess the legitimacy of the forecast provided. Is it usable, and are there adjustments that need to be made to any growth rates, margins, balance sheet projects (AR as % of Sales for example), etc.

2) Complete normalizing adjustments.
- complete other standard normalizing adjustments, such as bringing salaries to market rates, etc.

3) Find EBITDA
- because this is a Cash Flow method, deprecation is removed from the equation.

4) Determine the Terminal Value
- this is typically based on Net Cash Flows, but could also be based on another figure, such as Rev, GM, or EBITDA. It depends on if the question mentions that the normalized growth rate is based on Revenue, GM, EBITDA or cash flows.
- To find the terminal value starting point, increase the final year in the projection of the Net Cash Flows (of rev, gm, etc) by the growth rate: NCF x (1+g).

5) Add back income taxes
6) Reduce by Sustaining Capital Investment less Tax Sheild.

7) Increase / Reduce by Changes in NWC.
If the requirement for NWC increases, Cash flows will decrease (because less cash is available for discretionary spending). If NWC requirement decreases, discretionary cash flows increase. The changes from month to month are to be applied to the after-tax and after-sustaining capital cash flows.

8) Capitalize the Terminal Value
- Once you have determined the discretionary cash flows of each year, including the terminal year, the terminal value is to be capitalized.
- The multiple used to capitalize the terminal value is:

      1 ---------------- (WACC - g)

9) Determine the discount factor for each year
- for each year of the forecast, apply a mid-year discount factor using the following formula:

     1 ---------------- (1 + WACC)^t-0.5

• the discount factor for the Terminal Value should be the same as the discount factor applied to the final year in the forecast.
• this will find the PV of net cash flows, which are to be added together to find the Sum of Cash Flows.
  10) Add back PV of Existing Tax Shield.
  11) Add back Redundant assets and remove interest baring debt (loans, bank indebtedness, etc).
  12) Apply a +/- 10% to final figure to create a range of values for the enbloc FMV of equity.