Discounted Cash Flow

Analysis
Agen
da
• Main concepts in a DCF
• Advantages & disadvantages of a
DCF valuation
• Comprehensive DCF analysis
example
• Sample DCF interview questions
Main concepts in a DCF
valuation
What is a DCF
valuation?
• DCF analysis is based on the idea that anything is worth the present
value of its future cash flows
CF1 CF2 CF3 CF4

CF5 2016 2017 2018 2019 2020

• Projection period & terminal period

CF1 CF2 CF3 CF4
2016 2017 2018 2019 Peri
CF5
2020 od
Terminal

• Money today is worth more than money tomorrow

$1 $1.03 $0 $1
When you receive money
Year 0 Year 1 Year 0 Year matters
1
Present value (PV)
Present value of future cash flows = CFX
/(1+Discount rate)x
• Discount rate = Expected rate of return
$10 $10 $10
0 0 0
Year Year 1 Year
0 2
Discount rate =
10%

• Year 0 = Year 0 =
$100/(1+10%)0 $100 Year 1
• Year 1 =
= $90.91
$100/(1+10%)1
Year 2 =
• Year 2 =
$100/(1+10%)2 $82.64
Value of
Investment
 6 steps in a DCF
analysis
1. Project a company’s free cash flows (FCF)
2. Calculate the company’s discount rate (WACC)
3. Discount and sum the company’s FCF
4. Calculate the company’s terminal value
5. Discount the terminal value to its present value
6. Add the discounted free cash flows to the
discounted terminal value
Free cash
flow
Free cash flow
• FCF = how much after-tax cash flow the company generates on a
recurring basis, after taking into account non-cash charges, changes in
operating assets and liabilities, and required CapEx
Calculating Free Cash Flow
Revenue Unlevered FCF – Excludes net interest expense
Less: Cost of Goods Sold and mandatory debt repayments
Less: Operating Expenses
EBIT Levered FCF – Includes net interest expense
Less: Taxes NOPAT and mandatory
Plus: D&A debt repayments
Less: Change in NWC
Less: CapEx

Unlevered Free Cash Flow

 Free cash flow
(example)
• Revenue = $5,626.3
• Depreciation = $146.2
Revenue $5,626
.3
Less: Cost of Goods 3,43
• Amortization = $62 Sold 2
• COGS = $3,432 Less: Operating 1,50
Expenses 8
• Operating Expenses = EBIT 686.6
$1,508
Less: Taxes 192.2
• Beginning NWC = NOPAT 494.4
$31.3
Plus: D&A 208.2
• Ending NWC = $83 Less: Change in NWC 51.7
• Capital Expenditures = Less: CapEx 398.1
$398.1 Unlevered Free Cash 252.8
• Tax Rate = 28% Flow
Projection period
1. Revenue growth
2. Operating margin
3. Apply the effective tax rate to calculate NOPAT
4. Non-cash charges (as a percentage of revenue, or CapEx)
5. Changes in NWC (as a percentage of sales)
6. CapEx (as a percentage of sales)

**This method of projecting free cash flow is purposefully simplified, in

the real world you will receive projections from management, creditors,
equity research analysts, etc.
WACC
analysis
WAC
C
Why discount FCF and terminal value?
• Time value of money
• Expected rate of return from investors in the company

The discount rate also reflects the “riskiness” of the company

• Risk is correlated with return (Higher risk = higher expected rate of
return, and vice versa)

WAC = (Cost of debt) * (% of debt) * (1 – Tax

C rate)
+ (Cost of preferred stock) * (% of
preferred stock)
+ (Cost of Equity) * (% of equity)
 Steps in a WACC
analysis
1. Estimate capital structure and determine the weights of each
component: w , w , w
d p e

2. Estimate the opportunity cost of each of the sources of financing: kd,

kp, ke and adjust for the
effect of taxes when appropriate
3. Calculate WACC by computing a weighted average of the estimated
after-tax costs of capital sources used by the firm

WACC = kd(1 – Tax Rate)wd + kpwp + kewe

Analyze the capital
structure
equity
Total debt = 18,513
Liabilities & stockholder's

Current liabilities
Total preferred stock
Current portion of long-term 513
debt
Accounts payable 3,766 = 800 Total equity =
Other current liabilities 3,403
Total current liabilities 11,491 23,611
Long-term liabilities
Long-term debt 18,024
Deferred income taxes 4,508 Wd = 18,513/(18,513
Other liabilities 3,403
Total long-term liabilities 25,935 + 800 + 23,611) =
43.13%
Stockholder's equity
Common stock 23,611
Retained earnings 14,636
Preferred equity 800 Wp = 800/(18,513 +
Total stockholder's equit 39,0
47 800 + 23,611) =
1.87%
The cost of debt
Kd – We use yield to maturity (YTM) Use a financial calculator –
on publicly traded bonds

N = 50
Example –
PMT = 45
A company has a bond issue
currently outstanding with 25 FV = 1000
years left to maturity. The coupon PV = -908.75
rate is 9% and they are paid semi-
annually. The bond is currently CPT I/Y = 5% (This is what you
selling for solve for)
$908.72 per $1000 bond.
YTM = 5*2 = 10%
What is the pre-tax kd?
The cost of preferred
stock
Kp – Preferred stock generally pays a
constant dividend every period
(perpetuity), so we take the
perpetuity formula, rearrange and
solve for kp
• P0 = Div/r
• Kp = Divp/Pp
Example –
Alabama Power Company pays a Kp = $1.33/$24.96 =
5.3% annual dividend on a $25 par 5.33%
value, or $1.33 per share.
On February 26, 2014, these
preferred shares were selling for
$24.96 per share.
The cost of equity
Ke – Most common approach: Example –
Capital Asset Pricing Model
(CAPM) Yield on 10-year U.S. treasury

CAPM – Used to estimate a bond = 1.762% Ibbotson market

company’s Ke based premium (2015) = 5.9%
on the risk-free rate + a
premium for equity risk A company with beta = 1.3
Ke = rf + b * (rp)
• rf : risk-free rate, 10-year U.S. Ke = 1.762 + 1.3 * (5.9) = 9.432%
treasury bond
• b: beta, captures risk of a
security relative to
the market
• rp = risk-premium, expected
Calculate the
WACC
Example
–
WACC = Wd * (1 – tax rate) * Kd + Wp * Kp
+ W e * Ke
Wd = WACCd = 43.13% * (1 – 35%) *
43.13% 10% = 2.8%
Wp = WACCp = 1.87% * 5.33% = 0.1%
1.87%
WACCe = 55% * 9.432% = 5.19%
K
Wde =
= 10%
55%
Kp = WACC =
8.1%
5.33%
Ke =
9.432%
Terminal
value
 Exit multiple
method
• Calculates the remaining value of a company’s FCF produced after the
projection period on the basis of the multiple of its terminal year EBITDA
(or EBIT)
• Multiple is typically based on the current LTM trading multiples for
comparable companies
• Important to use both a normalized trading multiple and EBITDA as current
multiples may be affected by sector or economic cycles
• Needs to be subjected to sensitivity analysis
Terminal value = EBITDAn * Exit Example –
multiple Terminal year EBITDA = $500m; Exit
multiple = 9.0x
Terminal value =
$4.5bn
Gordon growth method
Calculates terminal value by treating a company’s terminal year FCF as a
perpetuity growing at an assumed rate
• Perpetuity growth rate is typically chosen on the basis of the company’s
expected long-term industry growth
rate
• Tends to be within a range of 2% – 4% (i.e. nominal GDP growth rate)

Terminal value = FCFn * Example –

(1+g) / (r – g) Terminal year FCF = $18m; g =
3.2%; r = 11% Terminal value = 18 *
(1 + 3.2%)/(11% – 3.2%)
Terminal Value =
$238.2m
Discount FCF &
terminal value
PV of FCF
Projection 2017E 2018E 2019 FCF1 = 3,602/(1+.09)1 = $3,304.59
period 45,879 47255 E
Revenue 4867
3
Less: COGS 28,921 29789 30682
Less: Operating 12,340 12710 1309
Expense 4,618 4,757 2 FCF2 = 3,612/(1+.09)2 = $3,040.15
EBIT 4,89
9
Less: Taxes 1616 1665 1715
NOPAT 3,002 3,092 3,185
Add: D&A 1,200 1,200 1,200 FCF3 = 3,825/(1.09)3 = $2,953.60
Less: Change in NWC 600 680 560
Less: CapEx 0 0 0
Unlevered FCF 3,602 3,612 3,825
Period 1 2 3 Sum of Discounted FCF =
$9,298.34
Tax-rate = 35%
WACC = 9%
PV of terminal
value
Terminal Value
Exit multiple method
PV of terminal value =
58,788/(1+9%)3
Terminal year EBIT = $45,395.12
4,899
Exit multiple
12.0x
Terminal value PV of terminal value =
58,788 55,736/(1+9%)3
= $43,038.42

Gordon growth method

Terminal year FCF
3,825
Growth rate
 Summ
ary
1. Project a company’s free cash flows (FCF)
2. Calculate the company’s discount rate (WACC)
3. Discount and sum the company’s FCF
4. Calculate the company’s terminal value
5. Discount the terminal value to its present value
6. Add the discounted free cash flows to the
discounted terminal value
Advantages & disadvantages of
DCF analysis
 Advantages &
disadvantages
Advantages –
• Flexible, adaptable analysis
Disadvantages –
• Cash flows from forecasts
• Incremental effects of changes in • Possible bias
expected growth rates, margin • Reliability
improvements, synergies, expansion
plans, etc. • Subjective valuation
• Objective calculation (through • Based on numerous assumptions
present value) • Highly sensitive to changes in:
• Requires scrutiny of key drivers of • FCFs = growth rates & margin
assumptions
value
• Estimated terminal value
• Always obtainable • Assumed discount rate (beta, market
DCF results should be presented as aconditions)
range of estimated value,
not as a single estimate!
Comprehensive
example
Project FCF
Historical Projected
2006 2007 2008 2009E 2010E 2011E 2012E 2013E
Sales $4,483 $4,699 $5,384 $5,626 $5,885 $6,162 $6,457 $6,774

EBITDA 641 632 834 894.6 960.4 1031.5 1108.1 1190.8

Less: (147) (138) (161) (178) (237) (301) (370) (445)
Depreciation (33) (35) (35) (30) (30) (30) (30) (30)
Less: 461 459 638 686 693 700 708 716
Amortization (129) (129) (179) (192) (194) (196) (198) (200)
EBIT 332 330 459 494 499 504 510
Less: Taxes 515
NOPAT 208 267 331 400
475
Plus: Depreciation & (398) (414) (431) (449)
amortization Less: Capital (469)
(52) (52) (54) (56)
expenditures
(57)
(Increase)/decrease in
253 300 351 405
NWC Unlevered free 464
cash flow
Calculate
WACC
Assumptions –

10-year treasury
Compute weights of capital structure
Wd = 107.6/(107.6 + 208)
= 34%
3.75%
Market risk premium

Total debt 107.6 Compute cost of equity

Total equity 208 Ke = 3.75% + 0.97 * 5.00%
=
Beta 8.6%
0.97
Estimated cost of debt 7.75%
Tax-rate 35% WACC =Wd * (1 Compute
– tax rate) WACC
* Kd +
We * Ke 34% * (1 – 35%) *
7.75% + 66% * 8.6%
WACC =
7.39%
Calculate terminal
value
Exit multiple method –
Terminal year EBITDA
Gordon growth method –
Terminal year FCF 464
1190.8 Growth rate 3.20%
Exit multiple Terminal value 11,440
13.0x
Terminal value
15,480 Terminal value = FCF * (1 + g)/(WACC
– g)
= 464 * (1 + 3.2%)/(7.39%
– 3.2%)
= 11,440
Discount FCF &
terminal value
Discounted FCF =
FCFn/(1+WACC)n
Exit multiple method –
Discounted TV =
FCF1 = 253/(1+7.39%)1 = $15,480/(1+7.39%)5
= $10,838.34
$235.22 FCF2 =
Gordon growth method –
300/(1+7.39%)2 = $259.99
Discounted TV =
FCF3 = 351/(1+7.39%) =3
$11,440/(1+7.39%)5
$283.02 FCF4 = = $8,009.58
Enterprise value by exit multiple = $1,408.2 + $10,838.34
405/(1+7.39%)4 = $304.60
Sum of FCF = = $12,246.54
FCF5 = 464/(1+7.39%)5 =
$1408.02 Enterprise value by Gordon growth = $1408.02 + $8009.58
$325.20 = $9,417.6
Implied enterprise value range is $9,417.6 – $12,246.54
Sample DCF interview
questions
Explaining a DCF
• What’s the basic concept behind a discounted cash flow analysis?
• Walk me through a DCF
• If I’m working with a public company in a DCF, how do I move from
enterprise value to its implied share price?
 Calculating free cash
flow
• Why do you add back non-cash charges when calculating free cash
flow?
• How do you calculate free cash flow?
• As an approximation, do you think it’s okay to use EBITDA – Changes
in NWC – CapEx to approximate unlevered free cash flow?
• If you use levered free cash flow, what do you use as the discount
rate?
 Discount rates and
WACC
• How do you calculate WACC?
• How do you calculate the cost of equity?
• How you calculate beta?
• Why do you have to un-lever and re-lever beta when you calculate it
based on the comps?
• Can beta ever be negative? What would that mean?
• How do you determine a firm’s optimal capital structure? What
does it mean?
 Terminal
value
• How do you calculate the terminal value?
• What’s an appropriate growth rate when calculating the terminal
value?
• How do you select the appropriate exit multiple when calculating
terminal value?
• What’s the flaw with basing the terminal multiple on what the public
comps are trading at?