DCF DCF Modeling Modeling

Copyright 2008 by Wall Street Prep, Inc. Copyright 2008 by Wall Street Prep, Inc.
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Table of contents
SECTION 1: OVERVIEW
DCF in theory and in practice
Unlevered vs. levered DCF
SECTION 2: MODELING THE DCF
Modeling unlevered free cash flows
Discounting to reflect stub year and mid-year adjustment
Terminal value using growth in perpetuity approach
Terminal value using exit multiple approach
Calculating net debt
Shares outstanding using the treasury stock method Shares outstanding using the treasury stock method
Modeling the weighted average cost of capital (WACC)
Sensitivity analysis using data tables
Modeling synergies
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DCF in theory and in practice
The DCF valuation approach is based upon the theory that the value of a business is the
sum of its expected future free cash flows, discounted at an appropriate rate.
Discounted cash flow (DCF) analysis is one of the most fundamental, commonly-used
valuation methodologies. It is a valuation method developed and supported in academia
and also widely used in applied business practices.
There is no consensus on implementation controversies predominantly over the
estimation of the cost of equity.
DCF in theory
DCF in practice
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estimation of the cost of equity.
Extremely sensitive to changes in operating, exit and discount rate assumptions.
That said, there are general rules of thumb that guide implementation.
The prevalent form of the DCF model in practice is the two-stage DCF model.
Stage 1 is an explicit projection of free cash flows generally for 5-10 years.
Stage 2 is a lump-sum estimate of the cash flows beyond the explicit forecast period.
In addition to the two-stage DCF, there are multi-stage manifestations of the DCF model
(3-stage, high-low models, etc.) designed to more clearly identify cash flows generated at
different phases in a firms life cycle.
We will focus on the two-stage model in this course, given its prevalence in practice.
Two-stage DCF model is prevalent form
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Value
t
=
FCF
t
(1 + r)
t
t=1
t=n
Stage 2: Terminal value
We cannot reasonably project cash flows
beyond a certain point.
As such, we make simplifying assumptions
about cash flows after the explicit projection
period to estimate a terminal value that
represents the present value of all the free
cash flows generated by the company after
the explicit forecast period.
Stage 1: Free cash flow projections
What is the projected operating and
financial performance of the business?
Typical projection period is 5-10 years
How do we calculate free cash flows
Two-stage DCF model

DCF in theory and in practice

For illustrative Purposes Only
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(1 + r)
t=1
Value
t
=
FCF
t+1
r g
Analysts use both the perpetual growth and
exit multiple methods to estimate terminal
value
Exit EBITDA x multiple Value
t
=
Discount rate
Both stages should be discounted to the
present using a rate that appropriately
reflects the cost of capital (much more
on this later)
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Unleveled free cash flows must be projected and then appropriately discounted to
determine a present value of the company under analysis.
Since firms do not report this figure of free cash flows, analysts must make adjustments
to information provided in the reported financial statements.
Modeling unlevered free cash flows
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Start with EBIT
The typical starting point for calculating unlevered free cash flows is
operating income (operating profit before interest and taxes, or EBIT)
reported on the income statement.
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Free cash flow calculation Historical Projections
EBIT
(Operating income)
Income Statement (10-K
/ 10-Q / PR / Company)
Use normalized EBIT
Analyst research
Company
Internal projections
EBIT (1 tax rate)
(Tax-effected EBIT, EBIAT or NOPAT)
Use effective tax rate Use marginal tax rate
Plus: Depreciation and amortization
Less: Increases in working capital assets
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Plus: Increases in working capital liabilities
CFS / IS / Footnotes Analyst research
Company
Internal projections
Modeling unlevered free cash flows
Arriving at unlevered free cash flows from EBIT:
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Plus: Increases in working capital liabilities
Less: Increases in deferred tax assets
Plus: Increases in deferred tax liabilities
Less: Capital expenditures
Less: Other required investments
Internal projections
Equals: Unlevered free cash flows
Footnote calculating levered free cash flows
When valuing financial institutions, levered FCFs are projected to
arrive at equity value directly. Projected income and cash flow
streams are after interest expense and net of any interest income:
Net income
- Increases in working capital
+/- Deferred taxes
+ D&A
- Capital expenditures
+/- Net borrowing
Levered FCF
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Reference from core model
Always remember to:
Footnote assumptions in detail
Test your assumptions
Use consistent cash flows and costs of capital
Modeling unlevered free cash flows
For illustrative Purposes Only
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Calculation
= days post-deal date / 365
Input WACC of 10% for now.
We will calculate wacc shortly.
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Discounting to reflect stub year and mid-year adjustment
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Discount free cash flows back to the present
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Mid-year adjustment
Terminal value using growth in perpetuity approach
For illustrative Purposes Only
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Mid-year adjustment
The mid-year adjustment
also applies to the growth in
perpetuity formula, which
otherwise assumes all future
cash flows are generated at
year-end.
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Calculating net debt
Net Debt is defined as:
Short-Term Debt
+ Current Portion of LT Debt
+ Long-Term Debt
Why? Understand that we just calculated expected cash
flows generated from the operating assets of the business
the cash flows related to non-operating assets (i.e.
interest income) were not reflected in the FCF calculation.
From enterprise value to equity value
Now that we calculated enterprise value (read the DCF value of operations), our focus
shifts to calculating equity value.
Add non-operating assets
First, all non-operating assets (typically excess cash and other investments) must be
added to the enterprise value.
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Equity
Value
Net Debt
+ Long-Term Debt
+ Minority Interest
+ Preferred Stock
+ Leases
(Cash + Investments)
Net Debt
interest income) were not reflected in the FCF calculation.
Instead the book value of these assets (as identified on
the most recent 10-K or 10-Q) is typically used as a proxy
for the intrinsic value of these assets (the book value of
cash is, after all, typically the market value of cash, right?)
Subtract non-equity claims
Next, all non-equity claims (debt and equivalents) must be
subtracted to identify what the equity in the business is.
Include all non-equity claims on the business that have
not been accounted for in the calculation of FCF.
Common items are debt, preferred stock, minority
interests, leases.
Use the book values of these items as proxies for the
market value unless instructed otherwise.
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Calculating net debt
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Total $ proceeds
In-the-$ shares x avg. strike price
Calculate option proceeds using the
SUMPRODUCT function
Total shares repurchased
Shares outstanding using the treasury stock method
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Total shares repurchased
Proceeds / current share price
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Modeling the weighted average cost of capital (WACC)
For illustrative Purposes Only
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Modeling the weighted average cost of capital (WACC)
For illustrative Purposes Only
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Modeling the weighted average cost of capital (WACC)
For illustrative Purposes Only
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Modeling the weighted average cost of capital (WACC)
For illustrative Purposes Only
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Now we can relever the weighted
average industry beta
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Modeling the weighted average cost of capital (WACC)
and calculate the cost of equity
For illustrative Purposes Only
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Modeling the weighted average cost of capital (WACC)
and the weighted average
cost of capital
For illustrative Purposes Only
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Modeling synergies
For illustrative Purposes Only
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