Discounted Cash Flow Analysis

Agenda• 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

• Projection period & terminal period

• Money today is worth more than money tomorrow

2020

CF3 CF4 CF5CF1

2016

CF2

2017 2018 2019

Terminal

Period2020

CF3 CF4 CF5CF1

2016

CF2

2017 2018 2019

Year 0 Year 1Year 0 Year 1

$1 $1.03 $0 $1 When you receive money matters

Present value (PV)Present value of future cash flows = CFX /(1+Discount rate)x

• Discount rate = Expected rate of return

Discount rate = 10%

• Year 0 = $100/(1+10%)0 Year 0 = $100

• Year 1 = $100/(1+10%)1 Year 1 = $90.91

• Year 2 = $100/(1+10%)2 Year 2 = $82.64

Value of Investment = $273.55

$100 $100 $100

Year 0 Year 1 Year 2

6 steps in a DCF analysis1. 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

Revenue

Less: Cost of Goods Sold

Less: Operating Expenses

EBIT

Less: Taxes

NOPAT

Plus: D&A

Less: Change in NWC

Less: CapEx

Unlevered Free Cash Flow

Calculating Free Cash Flow

Unlevered FCF – Excludes net interest expense and mandatory

debt repayments

Levered FCF – Includes net interest expense and mandatory

debt repayments

Free cash flow (example)• Revenue = $5,626.3

• Depreciation = $146.2

• Amortization = $62

• COGS = $3,432

• Operating Expenses = $1,508

• Beginning NWC = $31.3

• Ending NWC = $83

• Capital Expenditures = $398.1

• Tax Rate = 28%

Revenue $5,626.3

Less: Cost of Goods Sold 3,432

Less: Operating Expenses 1,508

EBIT 686.6

Less: Taxes 192.2

NOPAT 494.4

Plus: D&A 208.2

Less: Change in NWC 51.7

Less: CapEx 398.1

Unlevered Free Cash Flow 252.8

Projection period1. 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

WACCWhy 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)

WACC = (Cost of debt) * (% of debt) * (1 – Tax rate)

+ (Cost of preferred stock) * (% of preferred stock)

+ (Cost of Equity) * (% of equity)

Steps in a WACC analysis1. Estimate capital structure and determine the weights of each component: wd, wp, we

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 structureTotal debt = 18,513

Total preferred stock = 800

Total equity = 23,611

Wd = 18,513/(18,513 + 800 + 23,611) = 43.13%

Wp = 800/(18,513 + 800 + 23,611) = 1.87%

We = 23,611/(18,513 + 800 + 23,611) = 55%

Liabilities & stockholder's equity

Current liabilities

Current portion of long-term debt 513

Accounts payable 3,766

Other current liabilities 3,403

Total current liabilities 11,491

Long-term liabilities

Long-term debt 18,024

Deferred income taxes 4,508

Other liabilities 3,403

Total long-term liabilities 25,935

Stockholder's equity

Common stock 23,611

Retained earnings 14,636

Preferred equity 800

Total stockholder's equity 39,047

The cost of debtKd – We use yield to maturity (YTM) on publicly traded bonds

Example –

A company has a bond issue currently outstanding with 25 years left to maturity. The coupon rate is 9% and they are paid semi-annually. The bond is currently selling for $908.72 per $1000 bond.

What is the pre-tax kd?

Use a financial calculator –

N = 50

PMT = 45

FV = 1000

PV = -908.75

CPT I/Y = 5% (This is what you solve for)

YTM = 5*2 = 10%

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 5.3% annual dividend on a $25 par value, or $1.33 per share.

On February 26, 2014, these preferred shares were selling for $24.96 per share.

Kp = $1.33/$24.96 = 5.33%

The cost of equityKe – Most common approach: Capital Asset Pricing Model (CAPM)

CAPM – Used to estimate a company’s Ke based on the risk-free rate + a premium for equity risk

Ke = rf + b * (rp)

• rf : risk-free rate, 10-year U.S. treasury bond

• b: beta, captures risk of a security relative to the market

• rp = risk-premium, expected rate of return required by investors above risk-free rate

Example –

Yield on 10-year U.S. treasury bond = 1.762%

Ibbotson market premium (2015) = 5.9%

A company with beta = 1.3

Ke = 1.762 + 1.3 * (5.9) = 9.432%

Calculate the WACCExample –

Wd = 43.13%

Wp = 1.87%

We = 55%

Kd = 10%

Kp = 5.33%

Ke = 9.432%

WACC = Wd * (1 – tax rate) * Kd + Wp * Kp + We * Ke

WACCd = 43.13% * (1 – 35%) * 10% = 2.8%

WACCp = 1.87% * 5.33% = 0.1%

WACCe = 55% * 9.432% = 5.19%

WACC = 8.1%

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 multiple Example –

Terminal year EBITDA = $500m; Exit multiple = 9.0x

Terminal value = $4.5bn

Gordon growth methodCalculates 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 * (1+g) / (r – g) Example –

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 FCFFCF1 = 3,602/(1+.09)1 = $3,304.59

FCF2 = 3,612/(1+.09)2 = $3,040.15

FCF3 = 3,825/(1.09)3 = $2,953.60

Sum of Discounted FCF = $9,298.34

Tax-rate = 35%

WACC = 9%

Projection period 2017E 2018E 2019E

Revenue 45,879 47255 48673

Less: COGS 28,921 29789 30682

Less: Operating Expense 12,340 12710 13092

EBIT 4,618 4,757 4,899

Less: Taxes 1616 1665 1715

NOPAT 3,002 3,092 3,185

Add: D&A 1,200 1,200 1,200

Less: Change in NWC 600 680 560

Less: CapEx 0 0 0

Unlevered FCF 3,602 3,612 3,825

Period 1 2 3

PV of terminal valueTerminal Value

Exitmultiplemethod

Terminal year EBIT 4,899

Exit multiple 12.0x

Terminal value 58,788

Gordon growth method

Terminal year FCF 3,825

Growth rate 2.00%

Terminal value 55,736

PV of terminal value = 58,788/(1+9%)3

= $45,395.12

PV of terminal value = 55,736/(1+9%)3

= $43,038.42

Summary1. 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 & disadvantagesAdvantages –

• Flexible, adaptable analysis

• Incremental effects of changes in expected growth rates, margin improvements, synergies, expansion plans, etc.

• Objective calculation (through present value)

• Requires scrutiny of key drivers of value

• Always obtainable

Disadvantages –

• Cash flows from forecasts

• Possible bias

• Reliability

• Subjective valuation

• Based on numerous assumptions

• Highly sensitive to changes in:

• FCFs = growth rates & margin assumptions

• Estimated terminal value

• Assumed discount rate (beta, market conditions)

DCF results should be presented as a range of estimated value, not as a single estimate!

Comprehensive example

Project FCF

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: Depreciation (147) (138) (161) (178) (237) (301) (370) (445)

Less: Amortization (33) (35) (35) (30) (30) (30) (30) (30)

EBIT 461 459 638 686 693 700 708 716

Less: Taxes (129) (129) (179) (192) (194) (196) (198) (200)

NOPAT 332 330 459 494 499 504 510 515

Plus: Depreciation & amortization 208 267 331 400 475

Less: Capital expenditures (398) (414) (431) (449) (469)

(Increase)/decrease in NWC (52) (52) (54) (56) (57)

Unlevered free cash flow 253 300 351 405 464

Historical Projected

Calculate WACCAssumptions – Compute weights of capital structure

Wd = 107.6/(107.6 + 208) = 34%

We = 208/(107.6 + 208) = 66%

Compute cost of equity

Ke = 3.75% + 0.97 * 5.00%

= 8.6%

Compute WACC

WACC =Wd * (1 – tax rate) * Kd + We * Ke

34% * (1 – 35%) * 7.75% + 66% * 8.6%

WACC = 7.39%

10-year treasury 3.75%

Market risk premium 5.00%

Total debt 107.6

Total equity 208

Beta 0.97

Estimated cost of debt 7.75%

Tax-rate 35%

Calculate terminal valueExit multiple method – Gordon growth method –

Terminal value = FCF * (1 + g)/(WACC – g) = 464 * (1 + 3.2%)/(7.39% – 3.2%)

= 11,440

Terminal year EBITDA 1190.8

Exit multiple 13.0x

Terminal value 15,480

Terminal year FCF 464

Growth rate 3.20%

Terminal value 11,440

Discount FCF & terminal valueDiscounted FCF = FCFn/(1+WACC)n

FCF1 = 253/(1+7.39%)1 = $235.22

FCF2 = 300/(1+7.39%)2 = $259.99

FCF3 = 351/(1+7.39%)3 = $283.02

FCF4 = 405/(1+7.39%)4 = $304.60

FCF5 = 464/(1+7.39%)5 = $325.20

Sum of FCF = $1408.02

Exit multiple method –

Discounted TV = $15,480/(1+7.39%)5

= $10,838.34

Gordon growth method –

Discounted TV = $11,440/(1+7.39%)5

= $8,009.58

Enterprise value by exit multiple = $1,408.2 + $10,838.34

= $12,246.54

Enterprise value by Gordon growth = $1408.02 + $8009.58

= $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?