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Corporate Valuation - Discounted Cash Flow (DCF) Analysis

Welcome to the Knowledge Check. If you have prior knowledge of Corporate Valuation Discounted Cash Flow (DCF) Analysis, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that youre about to encounter. You may think you dont know much about this area, but you might surprise yourself!

Question 1 of 5
Discounted cash flow analysis is typically based on which of the following types of projected free cash flow? Neutral Absolute Levered Unlevered Correct. You will learn about the fundamentals of DCF analysis in Topic 1, Overview of DCF Analysis.

Question 2 of 5
Which one of the following is NOT a component of the weighted average cost of capital? Tax rate Cost of debt Market value of equity Market value of current assets Correct. You will learn about the components of WACC in Topic 2, Weighted Average Cost of Capital (WACC).

Question 3 of 5
Which of the following statements about terminal value is true? Terminal value estimates when a company will no longer exist. Terminal value provides an estimate of the cost of capital for a firm.

Terminal value provides an estimated valuation of a business at a future period beyond the forecasted free cash flows. All of the above None of the above

Question 4 of 5
Which of the following is the correct formula for calculating enterprise value in a DCF valuation? Enterprise value = PV of free cash flows + PV of terminal value Enterprise value = PV of free cash flows - PV of terminal value Enterprise value = PV of free cash flows x PV of terminal value Enterprise value = PV of free cash flows / PV of terminal value Correct. You will learn how to calculate enterprise value in Topic 4, Deriving a Discounted Cash Flow Valuation.

Question 5 of 5
True or False? Valuation ranges for the same company derived from public comparables, acquisition comparables, and DCF analyses always produce the same result. True False Correct. You will learn about the valuation ranges in Topic 5, Summarizing Valuation Ranges. On completion of this tutorial, you will be able to: describe the theoretical basis of a discounted cash flow (DCF) analysis, including the advantages and other considerations estimate and calculate a discount rate (typically, the weighted average capital of cost) used to present value cash flows calculate the terminal value of a company through two popular methodologies (exit multiple and perpetuity growth) perform a discounted cash flow valuation summarize valuation ranges with comparables analyses and DCF

Prerequisite Knowledge Prior to studying this tutorial, you should have a sound knowledge of financial statements, financial statement analysis, and corporate valuation as described in the following tutorials: The Balance Sheet The Income Statement The Cash Flow Statement Financial Statements Ratio Analysis

Corporate Valuation An Overview Corporate Valuation Public Comparables Analysis Corporate Valuation Acquisition Comparables Analysis

What is a Discounted Cash Flow Analysis?


In figuring out what a company is worth, many practitioners choose to use relative valuation techniques, such as public and acquisition comparables analyses, to determine how a company is valued compared to other similar companies. A DCF analysis is used to estimate the intrinsic value of a company. Intrinsic value can be thought of as a companys theoretical value, assuming that the value of the company is determined by the present value of its future cash flows. There is a particular type of cash flow used in a DCF analysis - the DCF is based on the projected unlevered free cash flows. The word unlevered implies that these cash flows are independent of capital structure, that is, the cash flows are before principal and interest payments to debt holders or dividend payments to equity

holders. The word free means that these cash flows have already covered capital expenditure, working capital, and the investment needs of the business. Therefore, the cash flows are available to all capital structure holders of a company.

capital structure

Capital structure refers to how a business is financed and typically relates to the choice between debt or equity sources of finance.

Warren Buffett on Intrinsic Value


In a 1994 letter to the shareholders of Berkshire Hathaway, the world-renowned investor Warren Buffett had the following to say on intrinsic value: We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is allimportant and is the only logical way to evaluate the relative attractiveness of investments and businesses. Source: http://www.berkshirehathaway.com/letters/1994.html

Performing a DCF Analysis


To perform a DCF analysis, the following components are required: a discount rate used to calculate the present value of the cash flows the present value of the unlevered free cash flows the present value of the terminal value

Because the DCF utilizes a cash flow that is independent of capital structure, the present value of the unlevered free cash flows and present value of the terminal value yield the enterprise or firm value of a company.

Later in this tutorial, we will cover the derivation of equity value and equity value per share from the enterprise value calculated in a DCF analysis.

DCF vs. Comparables Analysis


When will a DCF be more useful than comparables analysis? There are certain cases where it may be difficult to find a good peer group. For instance, if a company is a small, niche manufacturer of a unique product then it may be hard to find companies for a comparables analysis. A company might be the 'first of its kind' where no other company has ever provided the same product or service. In such cases, you should still try to find the closest group of comparables, but consider placing more weight on the DCF.

DCF Analysis
A DCF analysis is based on the projected unlevered free cash flows. Which of the following is true in relation to this statement? The word projected means that there could be a possible bias in the valuation. The word unlevered implies that these cash flows are dependent on capital structure. The word free means that these cash flows do not take capital expenditures, working capital, and investment needs of the business into account. Correct. A DCF valuation is based on projected or forecasted cash flows. These projections typically come from a number of sources and, depending on the source, there could be a possible bias.

Other Formulas for WACC

You may also have seen other formulas for WACC. Which is the correct one? There may be modifications on WACC if the company has preferred stock. In this case, you would need to estimate that cost of capital and market value to give it a proper weighted average.

WACC
A common representation of the WACC formula is:

WACC Components
Lets examine each component of WACC: Cost of equity

Cost of debt

Market value of debt and equity

Click each component for details. When you have finished, click the Forward arrow to continue.

Do Market Risk Premiums Vary By Country?


Because equity market returns and risk-free rates vary from country to country, market risk premium estimates will be different for each country. Practitioners will therefore try to find and use estimates for the market risk premiums appropriate for a specific country.

Which US Treasury is Commonly Used as the Risk-Free Asset?


In the US, the 10-year note is normally used since it is the most widely traded long bond. The 30-year bond was historically the risk-free benchmark prior to the suspension of new issues of 30-year Treasury bonds in October 2001. In February 2006, however, the US Treasury began re-issuing the 30-year bond and it may soon replace the 10-year bond as the risk-free benchmark.

Formula for CAPM

Formula for CAPM is:

Cost of Debt

The cost of debt is the cost to the company of raising debt capital. It can be thought of as the risk-free rate of borrowing plus a spread based on the credit rating/credit profile of the company. Ideally, the cost of debt is observable in the market if the companys debt is publicly traded. Since the cost of debt reflects a longer-term cost of borrowing, it is typical to look at the yield to maturity from a long-term bond of at least ten years. This yield is normally quoted as a spread over a risk-free benchmark (such as a government security). If a company does not have publicly traded debt, there are several ways to estimate the cost of debt. Obtain a quote from debt capital markets professionals if you are working in a financial institution. Such a quote, usually a spread over a risk-free benchmark, will be based on risk/credit profile of the company. Examine the companys debt footnote (in 10-K filings or annual reports). The weighted average cost of debt based on coupon rates may yield a rough estimate, but be careful: Have interest rates changed since the issuance? Has the companys credit profile changed? Did the company have a recent debt issuance? What was the interest rate? Ask whether a comparable company has publicly traded debt or a recent debt issuance. As with any relative analysis, be careful of conclusions: How similar are the risk/credit profiles of the companies?

After the cost of debt has been estimated, it should be tax-effected, usually at the marginal tax rate. The cost of debt is examined on an after-tax basis because interest expense is tax deductible (assuming the company generated enough profits to utilize the interest tax shield), so the true cost of borrowing is the after-tax interest expense.

marginal tax rate

The marginal tax rate refers to the amount of tax paid on an additional dollar of income - tax obligations increase as taxable income rises.

Market Value of Debt and Equity

The market value of equity (E) is calculated in a similar manner to a public comparables analysis: share price times the number of diluted shares outstanding. For the market value of debt (D), practitioners typically use the book value of debt as a common, practical proxy for market value. Caution should be exercised, however, as any recent substantial changes in the risk-free rate or changes in a companys credit profile can mean that the market value of debt will differ dramatically from the book value.

Calculating the Cost of Equity


The following information is available about a company:

What is the cost of equity under CAPM, correct to one decimal place? %

Incorrect. The CAPM formula for the cost of equity is:

Click the Back arrow to try again.

Calculating WACC
The following information is available about a company:

Utilizing the cost of equity given above, calculate the WACC. Remember to use the after-tax cost of debt. Input your answer correct to two decimal places.

Incorrect. The WACC is calculated as follows:

Click the Back arrow to try again.

Other Possible Non-Cash Items


Remember to consider changes in any asset or liability that impacts cash flow. Changes in deferred taxes are typically analyzed when significant to the cash flow generation of a company.

Alternative Way of Calculating Unlevered Free Cash Flow


An alternative way to calculate unlevered free cash flow begins with net income. The formula is:

This approach would yield the same answer as working down from EBITDA as long as you use the same tax rate.

Components of a DCF Analysis


To perform a DCF analysis, the following components are needed: a discount rate used to calculate the present value of the cash flows the present value of the unlevered free cash flows the present value of the terminal value

Forecasting Expected Cash Flows


Now that we have calculated the unlevered free cash flow, the next step is to forecast the expected cash flows generated by the business. In selecting the appropriate forecast period, common practice is to consider when the company will reach a condition called ' steady state'. This is a condition where cash flows can be 'sustained forever' (stable growth). Usually, a company in steady state is viewed as having a growth rate that does not exceed the economy's growth rate. Generally speaking, practitioners will have forecast periods ranging from 5 to 20 years, and and sometimes extending out to 20 years. However, it is difficult to say exactly when a company will reach steady state. This will depend on the industry that the company operates in. For example, does this company operate in a growth sector or in a mature industry? If it is in a growth sector, it may take longer for a company to reach 'steady state'. Another factor is the stage the company is at in its lifecycle. For example, Apple and Microsoft may compete broadly in the same industry but Microsoft is more mature and closer to a steady state of growth than Apple is.

Typical Conditions of Steady State


Some typical conditions of steady state are:

sustaining capital investment (that is, capital expenditure replaces asset base reductions through depreciation) steady state working capital needs no deferred taxes

Discounting Projected Unlevered Free Cash Flows


The following exercise shows the process of discounting projected unlevered free cash flows (all figures are in millions of US dollars).

What is the present value (as of January 1, 20X1) of the unlevered free cash flows assuming a discount rate of 9.5%?

Question on Discounting Projected Unlevered Free Cash Flows

What is the present value (as of January 1, 20X1) of the unlevered free cash flows, assuming a discount rate of 10.5% this time? Input your answer correct to the nearest whole number. USD million

Incorrect. The PV of the unlevered free cash flows is calculated as:

You can also use the following spreadsheet to perform the calculation: Click the Back arrow to try again.

Terminal Value
Because it is usually impractical to extend the projections beyond a reasonable forecast period, a terminal value is used to capture the value of the company beyond the forecast period. There are two methods commonly used: Exit multiple method

Perpetuity growth method

Click each method for details. When you have finished, click the Forward arrow to continue.

Because both the exit multiple and perpetuity growth rate terminal approaches are commonly used, proficiency in each approach is essential when performing discounted cash flow valuations.

Components of a DCF Analysis


To perform a DCF analysis, the following components are needed: a discount rate used to calculate the present value of the cash flows the present value of the unlevered free cash flows the present value of the terminal value

Perpetuity growth method


The formula for terminal value used in perpetuity growth method:

Deriving a DCF Valuation Example


From our earlier example, the present value of the cash flows was USD 118m and the present value of the terminal value (under the EBITDA exit multiple method) was USD 409.6m. The same company has USD 75m of net debt and 15 million diluted shares outstanding. Considering this information, lets calculate the enterprise value and the equity value. The enterprise value is calculated as follows: PV of free cash flows + PV of terminal value = USD 118m + USD 409.6m = USD 527.6m The equity value is calculated as follows:

Enterprise value - net debt = USD 527.6m - USD 75m = USD 452.6m

Example of Discounting Projected Unlevered Free Cash Flows


The present value (as of January 1, 20X1) of the unlevered free cash flows assuming a discount rate of 9.5% is:

Example of Exit Multiple Method


The present value of the terminal value is:

Question on Valuation Ranges


Which of the following statements is true? When performing a DCF analysis and deriving an equity value per share, you should calculate a precise, single value. When comparing valuation ranges, the acquisition comparables valuation range should typically be below the public comparables and DCF valuation. When comparing valuation ranges, the public comparables and the DCF valuation ranges may be seen to overlap loosely. Correct. Because both of these methodologies value a business on a standalone basis, this result is fairly common when the public comparables are reasonably valued compared to expected cash flow generation by the business. However, there are also situations where the DCF and the public comparables values may differ a little.

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