Introduction to Discounted Cash Flow Analysis

Introduction to
Discounted Cash Flow Analysis
What is a DCF?
 Value can be derived from the present value of its
projected free cash flows
 Intrinsic Value ≠ Market Value
 Assumptions:
Growth rates (i.e. sales)
Profit margins
Net Working Capital requirements
When do we use a DCF?
 No “true” comparable companies
 Times of economic turmoil
 Flexibility in assumptions
 Fundamental approach
Process of a DCF
Analyze Target and Determine Drivers
2. Project the Free Cash Flow (FCFs)
3. Calculate Weighted Average Cost of Capital (WACC)
Capital Asset Pricing Model (CAPM)
4. Calculate Terminal Value (TV)
5. Calculate Present Value (PV)
Disclosure: This presentation will go over the basics of each step and will not analytically delve into the development of each calculation.
Target Analysis (Step 1)
 Public
 SEC filings, earnings call transcripts, analyst research and
Management Discussion and Analysis portion of the 10-K and
 Private:
 Confidential Information Memorandum (CIM), analyst research,
trade journals and SEC filings
 Business model
 Financial profile
 End markets
 Competitors
Driver Analysis (Step 1)
 Sales Growth
 Internal: new facilities, new products, capital efficiency
improvements, costumer contract expansion
 External: acquisitions, end market trends, regulatory changes
consumer buying patterns
 Profitability
 Management, brand, customer base, marketing, technology
 Free Cash Flow Generation
 CAPEX (i.e. owning vs. leasing)
Projecting Free Cash Flows (Step 2)
 Historical Performance
 Projection Period Length (~5-10 years)
 Best Case, Base Case, Worst Case
 Projections:
 Sales, COGS and SG&A, EBITDA, EBIT, Tax, D&A, CAPEX,
EBIAT /NOPAT= EBIT – Marginal tax rate (~35-40%)
NWC = Current Assets – Current Liabilities
Calculating WACC (Step 3)
 Represents the weighted average of the required return
on the invested capital
Debt and Equity have different risk and tax benefits/detriments
 Determine target capital structure
 Debt-to-total capitalization [D/(D+E)]
 Equity-to-total capitalization [E/(D+E)]
Calculating WACC (Step 3)
(Cost of Equity)
(Cost of Debt)
Calculating WACC (Step 3)
 Estimate Cost of Debt (rd)
 Credit Profile at target capital structure
 Bonds: current yield on all outstanding issues
 Credit Facilities: analyzed by DCM team internally
 Tax-effect your cost of debt by marginal tax rate
 Estimate Cost of Equity (re) – CAPM
 Annual rate of return that equity investors expect to receive
 Use CAPM to find this rate
re = rf + βL * (rm - rf )
Disclosure: Did not discuss process of unlevering and relevering beta for sake of simplicity
Calculating WACC (Step 3)
(re) +
D = market value of debt
E = market value of equity
rD = discount rate for longterm debt
re= discount rate for equity (from CAPM)
Calculating Terminal Value (Step 4)
 Captures the value beyond the projected period
 Steady state; accounts for ~75% of valuation
 Exit Multiple Method (EMM)
 Based on the current LTM trading multiples of comps
 Must normalize to account for peaks and troughs in industry
TV = EBITDAn * Exit Multiple
 Perpetuity Growth Method (PGM)
 Treats company’s terminal year FCF as a perpetuity growing at an
assumed rate. (Must be cautious when choosing growth rate)
TV =
FCFn * (1 + g)
(re -g)
Calculating Present Value (Step 5)
 Time value of money
 Discount Rate:
 Fractional value representing the present value of a dollar
received at a future date given an assumed discount rate
Discount Factor =
(1 + WACC)n
PV of FCFn = FCFn *Discount Factor
Final Valuation
 Enterprise Value
 Discount and sum the present values of the FCF for each
period and the TV
 Equity Value
Implied Equity Value = Enterprise Value – (Net Debt + Preferred Stock +
Non-controlling Interest)
 Share Price
Share Price =
Implied Equity Value
Fully Diluted Shares Outstanding
Works Cited
Pearl, Joshua, and Joshua Rosenbaum. Investment
Banking Valuation, Leveraged Buyouts and
Mergers & Acquisitions. Hoboken: John Wiley &
Sons, 2009. Print.

similar documents