Discounted Cash Flow (DCF)


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Discounted Cash Flow (DCF) - part 1

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Discounted Cash Flow is probably the valuation method most tested in investment banking interviews. That's probably because a DCF valuation is the most thorough method. In short, a DCF valuation results in an intrinsic value of a company, based not on the market but on a company's cash flows.

In order to complete a DCF, you need the following:

Historical income statement, balance sheet and cash flow statement.
Financial projections from management and/or industry experts

DCF Methodology (high level)

Discount unlevered Free Cash Flow (FCF) @ Weighted Average Cost of Capital (WACC)
Typical starting point for calculating unlevered FCF is EBIT
Calculate terminal value; remember to discount to present
Add PV of FCF and Terminal Value to arrive at the Enterprise Value
Subtract net debt to get Equity Value
Divide equity value by shares outstanding to get equity value per share

Unlevered Free Cash Flow
The term unlevered means before the effect of debt. Simply, it means that interest is NOT subtracted in your FCF calculation. Levered FCF means that interest is subtracted.

How to Calculate Unlevered Free Cash Flow

	Line Item	Source
	EBITDA	IS
-	Depreciation	IS, CFS, footnotes
=	EBITA	IS
-	Taxes (at effective rate)	Footnotes, estimate
=	Net Operating Profit After Taxes (NOPAT)
+	Deprecation	IS, CFS, footnotes
-	Increase in Working Capital Investment	CFS
-	Capital Expenditures	CFS
=	Unlevered Free Cash Flow

Terminal Value

Terminal Value is a lump sum value that captures all FCF generated by the company beyond the annual projection period. When forecasting a company's earnings, the idea is that during the forecast period, cash flows are not yet steady. During the period, revenues are rising (hopefully) above normal, capital expenditures are being made along with other changes to the company's operations. However, at a point in time, the company will begin to grow at a constant rate (theoretically). Typically, a forecast period of five years is chosen, but theoretically, the forecast period should be the length of time needed to arrive at a steady cash flow stream.

Once a company reaches a steady state, it would be silly to forecast earnings for each year a hundred into the future. Instead, you can calculate a terminal value which is the value of company beyond the forecast period. This value is calculated, discounted to the present and then added to the present value of the company's FCF to arrive at an enterprise value.

Example
Let's say that our forecast period is five years. In this case, we would calculate the company's FCF for the next five years based on projections made, and discount each year's cash flow at WACC to the present. Then, we would calculate the terminal value after the fifth year. This represents the terminal value of the enterprise after the fifth year, so it would have to be discounted five years (also at WACC), to the present. Adding the two values together results in an enterprise value.

Methods to Calculate Terminal Value

1. Perpetual Growth Model

FCFn * (1+g) / (r-g)
n = Final year of forecast period
g = Growth rate of company beyond forecast period. This is typically set at the rate of GDP.
r = Discount rate (WACC)

More academically sound method
Assumes firm will be owned forever

2. Terminal multiple/ exit multiple method

A more common method, this method applies a multiple to the company's financials to arrive at a terminal value. This method is simple to apply but flawed since it requires applying market-based relative valuation to help determine intrinsic value

Example
A firm with an EBITDA of $100 million is in an industry where the average company trades at 10 times (10x) EBITDA. Thus, the terminal value is $100 million times 10, or $1 billion.

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