pillars of wall street - valuation fundamentals - fundamental valuation - DCF Flashcards
DCF
intrinsic valuation methodology based upon company’s future cash flows and terminal value
sum all future free cash flows and terminal value and discount them back to the present value at the weighted average cost of capital
pros of DCF
theoretically the most sound method if you are confident in projections
useful when there are no pure play comparable companies for the company you are attempting to value
allows expected operating strategy to be incorporated into the model
allows flexibility via sensitivity analysis
cons of DCF
present values are highly sensitive to key assumptions like WACC, growth rates, margins, exit multiples)
accurately forecasting financial performance is challenging, especially many years down the line
values obtained can vary widely and therefore have limited usefulness
steps to calculate DCF
1 - calculate unlevered free cash flows
2 - calculate WACC
3 - calculate terminal value (2 methods to do this)
4 - calculate enterprise value by determining present value of all future cash flows + terminal value
5 - solve for equity value and share price
unlevered free cash flows
these are the cash flows available after paying all cash operating expenses and taxes, as well as funding of short and long term investments in the operation of the business
they are independent of capital structure and therefore available to all capital providers
FCFs can be paid to both equity and debt holders and are before interest payments, debt principal repayments, dividends and share buybacks
weighted average cost of capital
company’s cost of capital
represents blended required return of all stakeholders (equity and debt)
represent risk factor by which future FCFs are discounted
WACC = [Ke * E/(D+E)] + [Kd * D/(D+E) * (1-T)]
where Ke = cost of equity Kd = cost of debt E = market value of equity D = market value of debt T = marginal tax rate
easier way to think about WACC formula = it’s the cost of a form of financing (equity or debt) * the amount of that form of financing that exists in the company’s capital structure
calculating the debt and equity components of DCF
model a capital structure that is consistent with the long-term strategy of the company
for public companies, generally will use current market values of debt and equity:
market value of equity = the market cap.
market value of debt = use the book value of the debt as proxy for market value; but this won’t work if the company’s credit rating has changed drastically or risk-free interest rate has changed drastically; in these cases, use the market value of the debt instead of the book value because book value is no longer indicative
for private companies, use figures from comparable companies
calculating cost of debt (Kd)
return required by company’s debt holders i.e. the cost of issuing debt
but true cost of debt to company is not same as debt holders’ required return due to the fact that interest expense is tax deductible; this is why we have (1-T) in equation for WACC; point is that issuing debt actually costs company less than what you would think because they get tax benefits for the interest they pay to debt holders
methods for determining Kd:
for publicly traded companies, use the company’s bond prices; you could also ask the debt capital markets desk at your investment bank for the credit spread over the risk-free rate; you could also use effective interest rate
for private companies, look at interest rates of comparable companies
effective interest rate
= (interest expense from income statement) / (average debt)
used as sanity check to see if historic cost of debt is similar to future cost of debt
calculating cost of equity (Ke)
required annual rate of return expected by company’s equity investors
harder to calculate than Kd because two different equity investors might expect different return for same stock
most common model used is CAPM
Ke = Rf + B * (Rm - Rf)
Ke = cost of equity Rf = risk-free rate (usually US 10-yr treasury) B = beta Rm = market rate of return Rm - Rf = market risk premium
beta
measures stock’s reaction to movements in equity markets
beta = 1 –> expected return of stock = return on market portfolio
beta < 1 –> expected return of stock < return on market portfolio
beta > 1 –> expected return of stock > return on market portfolio
terminal value
captures value of company’s steady state cash flows after forecast period
steady state means company has matured to the point that it is no longer growing quickly; how do you know a company has matured? growth in top line of a company is similar to overall gdp growth of an economy; also, capex is similar to rate of depreciation, meaning company isn’t investing heavily in new projects
typically 60-80% of company’s value
terminal year financial performance must represent normalized levels as opposed to cyclical high or low for the company
two popular methods:
exit multiple method
perpetuity growth method
exit multiple method
terminal value = multiple * financial metric
most widely used
assumes company is worth a multiple of an operating metric (typically EBITDA) at the end of the forecast period
use either company’s current LTM multiple or use LTM multiple of trading comparables as guidance
multiple should reflect steady state growth and margins
perpetuity growth method
terminal value = FCFn * [ (1+g) / (WACC - g) ]
where
n = terminal year of forecast period
g = perpetuity growth rate
WACC = weighted average cost of capital
assumes company’s FCF in last forecast year grows at constant rate indefinitely
growth rate typically in 2-4% range and should not exceed growth rate of economy
seems way easier than exit multiple method
LTM
last twelve months
