STREETOFWALLS

ARTICLES

TRAINING

DISCOUNTED CASH FLOW

ANALYSIS
of Investment Banking Technical Training

In this Discounted Cash Flow chapter, we will cover four key

topics:

Discounted Cash Flow (DCF) Overview

Free Cash Flow

Terminal Value

WACC (Weighted Average Cost of Capital)

Discounted Cash Flow (DCF) Overview

WHAT IS DCF?

DCF is a direct valuation technique that values a company

by projecting its future cash flows and then using the Net

Present Value (NPV) method to value those cash flows. In a

DCF analysis, the cash flows are projected by using a series

of assumptions about how the business will perform in the

future, and then forecasting how this business performance

translates into the cash flow generated by the business—the

one thing investors care the most about.

NPV is simply a mathematical technique for translating

each of these projected annual cash flow amounts into

today-equivalent amounts so that each year’s projected cash

flows can be summed up in comparable, current-dollar

amounts.

WHY USE DCF?

DCF should be used in many cases because it attempts to

measure the value created by a business directly and

precisely. It is thus the most theoretically correct valuation

method available: the value of a firm ultimately derives

from the inherent value of its future cash flows to its

stakeholders.

DCF is probably the most broadly used valuation technique,

simply because of its theoretical underpinnings and its

ability to be used in almost all scenarios. DCF is used by

Investment Bankers, Internal Corporate Finance and

Business Development professionals, and Academics.

However, DCF is fraught with potential perils. The valuation

obtained is very sensitive to a large number of

assumptions/forecasts, and can therefore vary over a wide

range. If even one key assumption is off significantly, it can

lead to a wildly different valuation. This is quite possible,

given that DCF involves predicting future events

(forecasting), and even the best forecasters will generally be

off by some amount. This leads to the concept of “Garbage

in = Garbage Out”—if wrong assumptions are made, the

result will be wrong.

Additionally, DCF does not take into account any market-

related valuation information, such as the valuations of

comparable companies, as a “sanity check” on its valuation

outputs. Therefore, DCF should generally only be done

alongside other valuation techniques, lest a questionable

assumption or two lead to a result that is substantially

different from what market forces are indicating.

DCF ADVANTAGES AND DISADVANTAGES

PROs and CONs of Using DCF

PROs CONs

Theoretically the

most sound

method if the

analyst is Valuation obtained is

confident in his very sensitive to a large

assumptions number of

Not significantly assumptions/forecasts,

influenced by and can thus vary over a

temporary wide range

market Often very time-intensive

conditions or relative to some other

non-economic valuation techniques

factors Involves forecasting

Especially useful future performance,

when there is which is very difficult

limited or no

comparable

information

REMEMBER C.V.S.

When doing a DCF analysis, a useful checklist of things to

do has a mnemonic that is easy to remember: “C.V.S.”

Confirm historical financials for accuracy.

Validate key assumptions for projections.

Sensitize variables driving projections to build a

valuation range.

Note that the “C.V.S.” acronym for Comparable Companies

Analysis, discussed in the previous chapter, is slightly

different (in that acronym, “S” stands for “Select” rather

than “Sensitize.”)

KEY ASSUMPTIONS & PROJECTIONS:

When performing a DCF analysis, a series of assumptions

and projections will need to be made. Ultimately, all of these

inputs will boil down to three main components that drive

the valuation result from a DCF analysis.

Free Cash Flow Projections: Projections of the

amount of Cash produced by a company’s business

operations after paying for operating expenses and

capital expenditures.

Discount Rate: The cost of capital (Debt and

Equity) for the business. This rate, which acts like an

interest rate on future Cash inflows, is used to convert

them into current dollar equivalents.

Terminal Value: The value of a business at the end

of the projection period (typical for a DCF analysis is

either a 5-year projection period or, occasionally, a

10-year projection period).

The DCF valuation of the business is simply equal to the

sum of the discounted projected Free Cash Flow amounts,

plus the discounted Terminal Value amount.

There is no exact answer for deriving Free Cash Flow

projections. The key is to be diligent when making the

assumptions needed to derive these projections, and where

uncertain, use valuation technique guidelines to guide your

thinking (some examples of this are discussed later in the

chapter). It is very easy to increase or decrease the valuation

from a DCF substantially by changing the assumptions,

which is why it is so important to be thoughtful when

specifying the inputs.

The Discount Rate is usually determined as a function of

prevailing market (or known) required rates of return

for Debt and Equity, as well as the split between

outstanding Debt and Equity in the company’s capital

structure. These required rates of return (or discount rates

or “costs of capital”) are generally then blended into a

single discount rate for the Free Cash Flows of the company

as a whole—this is known as the Weighted Average Cost

of Capital (WACC). We will discuss WACC calculations in

detail later in this chapter.

Terminal Value is the value of the business that derives

from Cash flows generated after the year-by-year projection

period. It is determined as a function of the Cash flows

generated in the final projection period, plus an assumed

permanent growth rate for those cash flows, plus an

assumed discount rate (or exit multiple). More is discussed

on calculating Terminal Value later in this chapter.

TWO DIFFERENT DCF APPROACHES: LEVERED VS.

UNLEVERED CASH FLOWS

There are two ways of projecting a company’s Free Cash

Flow (FCF): on an unlevered basis, or on a levered basis.

A levered DCF projects FCF after Interest Expense (Debt)

and Interest Income (Cash) while an unlevered DCF

projects FCF before the impact on Debt and Cash. A levered

DCF therefore attempts to value the Equity portion of a

company’s capital structure directly, while an unlevered

DCF analysis attempts to value the company as a whole; at

the end of the unlevered DCF analysis, Net Debt and other

claims can be subtracted out to arrive at the residual

(Equity) value of the business.

An Unlevered DCF involves the following steps:

Project FCF for each year, before the impact from

Debt and Cash.

Discount FCF using the Weighted Average Cost of

Capital (WACC), which is a blend of the required

returns on the Debt and Equity components of the

capital structure.

Value obtained is the Enterprise Value of the

business.

By comparison, a Levered DCF involves the following steps:

Project FCF after Interest Expense (to Debt) and

Interest Income (from Cash).

Discount FCF using the Cost of Equity (the required

rate of return on Equity).

Value obtained is the Equity Value (aka Market

Value) of the business.

WHY USE UNLEVERED FREE CASH FLOW (UFCF) VS. LEVERED FREE

CASH FLOW (LFCF)?

UFCF is the industry norm, because it allows for an apples-

to-apples comparison of the Cash flows produced by

different companies. A UFCF analysis also affords the

analyst the ability to test out different capital structures to

determine how they impact a company’s value. By contrast,

in an LFCF analysis, the capital structure is taken into

account in the calculation of the company’s Cash flows. This

means that the LFCF analysis will need to be re-run if a

different capital structure is assumed.

In effect, UFCF allows the analyst to separate the Cash flows

produced by the business from the structure of the

ownership and liabilities of the business. In a UFCF the

Cash flows of the business are projected irrespective of the

capital structure chosen in a UFCF analysis; the exact

capital structure is not taken into account until the

Weighted Average Cost of Capital (WACC) is determined.

WHICH IS MO
MORE
RE SENSITIVE PART OF A DCF MODEL: FREE

CASH FLOWS OR DISCOUNT RATE?

FCF (and Terminal Value, which uses FCF as an input) are

the more sensitive. Be careful, therefore, when making key

Cash flow projection assumptions, because a small ‘tweak’

may result in a large valuation change. The analyst should

test several reasonable assumption scenarios to derive a

reasonable valuation range. Within FCF projections, the

best items to test include Sales growth and assumed

margins (Gross Margin, Operating/EBIT margin, EBITDA

margin, and Net Income margin). Also, sensitivity analysis

should be conducted on the Discount Rate (WACC) used.

DCF PITFALLS

Avoid these common pitfalls when building a DCF Model:

Making important assumptions based upon

insufficient research.

Lack of footnotes and details documenting the

thought process (and research process) behind the

assumptions chosen.

Taking an improper approach to deriving the Costs of

Capital for Debt and/or Equity (and/or WACC).

DCF STEPS

1. Project the company’s Free Cash Flows:

Typically, a target’s FCF is projected out 5 to 10 years

in the future. The further these numbers are

projected out, the less visibility the forecaster will

have (in other words, later projection periods will

typically be subject to the most estimation error).

2. Determine the company’s Terminal Value:

Terminal Value is calculated using one of two

methods: the Terminal Multiple Method or the

Perpetuity Method. (Note that if the Perpetuity

Method is used, the Discount Rate from the following

step will be needed.)

3. Determine the company’s Discount Rate:

Calculate the company’s Weighted Average Cost of

Capital (WACC) to determine the Discount Rate for

all future Cash flows.

4. Use Net Present Value: Discount the projected

FCF and Terminal Value back to Year o (i.e., back to

today) and sum these figures to determine the

Enterprise Value of the company.

5. Make Adjustments: If using an Unlevered Free

Cash Flow (UFCF) approach, subtracting out net debt

and other adjustments from Enterprise Value to

derive the Market Value of the company.

Here is a graphical representation of these DCF Steps:

SOURCES OF DCF INFORMATION

In order to project a company’s future Cash flows

reasonably well, the analyst will need to take into account as

much known information about the company (and several

market metrics) as possible. The following sources can help

provide needed information to produce a high-quality DCF

analysis:

Historical Financial Results:

The SEC (http://www.sec.gov/) has

company Annual Reports (10-K),

Quarterly Reports (10-Q), and

Investment Prospectuses (where

available).

Cost of Debt:

Use a weighted average of the Debt

interest rates in a company’s capital

structure to calculate the company’s pre-

tax Cost of Debt.

This information is almost always

available for each Debt instrument in a

Company’s Annual Reports (10-K) and

Quarterly Reports (10-Q).

Cost of Equity:

The Risk Free Rate:

The risk-free rate is needed in

determining the Cost of Equity,

and is estimated as a function of

the current long-term Treasury

Bond rate (assuming that the

company’s cash flows are being

projected in terms of US$). The

benchmark rate used is generally

that of the 10-year bond.

The Department of the Treasury

(http://www.treasury.gov/)

publishes U.S. treasury bond rates

on a daily basis.

For European companies, use the

relevant rate from Euro-

denominated government bonds.

Beta :

Beta is a measure of the

relationship between changes in

the prices of a company’s

securities and changes in the

value of an overall market

benchmark, such as the S&P 500

index.

Bloomberg, FactSet, Google

Finance, and Capital IQ all

publish historical and estimated

Beta figures for individual stocks.

If the Beta is not published, it can

be estimated by means of a simple

linear regression.

Market Risk:

The Market Risk Premium is a

measure of the degree to which

investors expect to be

compensated for owning risky

equity securities, rather than risk-

free, fixed-rate investments (such

as in government bonds). It is

calculated using the Capital Asset

Pricing Model, which assumes

that the ONLY source of risk that

demands compensation is overall

market risk (as measured by Beta)

rather than idiosyncratic (or

stock-specific) risk. This model is

generally used to determine the

Cost of Equity for a company.

Estimates of the Market Risk

Premium are available from

Morningstar, and can also be

estimated using historical returns

on government bond investments

vs. overall equity market

investments.

Financial Projections:

Management Estimates can be a useful

starting point for determining a company’s

expected performance and Cash flow

projections. However, keep in mind that these

projections are often on the optimistic side.

Sell-side Research Estimates also can provide

useful insight into a company’s path of

expected performance. Again, however, keep in

mind that sell-side analysts often have an

incentive to be optimistic in projecting a

company’s expected performance.

Internal Estimates (from the investment bank

you work for) can be the most useful source of

information for projecting a company’s

expected Cash flow—particularly if these

estimates were not used as part of a sell-side

advisory engagement (wherein the purpose of

the analysis would be, at least in part, to

advocate for a higher selling price for the

client). If using internal estimates, be sure to

note how they were generated and for what

purpose.

Free Cash Flow (FCF)

In projecting Free Cash Flow for a business, remember

“C.V.S.”, and that Garbage In = Garbage Out:

Confirm historical financials for accuracy.

Validate key assumptions for projections.

Sensitize variables driving projections to build a

valuation range.

In order to calculate Free Cash Flow projections, you must

first collect historical financial results.

KEY INPUTS TO FREE CASH FLOW (FCF)

Free Cash Flow (FCF) is calculated by taking the Operating

Income (EBIT) for a business, minus its Taxes, plus

Depreciation & Amortization, minus the Change in

Operating Working Capital, and minus the company’s

Capital Expenditures for the year. This derives a much more

accurate representation of the Cash that a company

generates than does pure Net Income:

PROJECTING FREE CASH FLOW (FCF)

KEY ASSUMPTIONS IN PROJECTING BUSINESS PERFORMANCE

The projected FCF in the nearest-out years (Year 1, Year 2,

etc.) will have the most impact on a company’s DCF

valuation. The good news is that these Cash flow figures are

the least difficult to project, because the closer we are to an

event, the more visibility we have about that event. (The bad

news, of course, is that any error in projecting these figures

will have a large impact on the output of the analysis.)

FCF is derived by projecting the line items of the Income

Statement (and often Balance Sheet) for a company, line by

line. As a result, the FCF results are sensitive to a variety of

assumptions about the future operations of the company’s

business, including the following:

Income Statement Items:

Revenue (Sales) Growth: Year-over-year

growth projections are the most common

mechanism, but the more granularity used, the

better. For example, being able to project out

unit growth and pricing per unit is better than

a simple year-over-year growth projection for

the Sales number as a whole.

Margins: Project Gross Margin and Operating

(EBIT) Margin based on historical patterns.

Consider inputs like commodity costs in Gross

Margin and SG&A (Sales, General, and

Administrative) expenses for Operating

Margin.

Balance Sheet & Statement of Cash Flow

Items:

Capital Expenditures (CapEx): Consider

both Expansion CapEx and Maintenance

CapEx. The difference delineates company

costs associated with buying new fixed assets to

facilitate growth in the business (Expansion

CapEx) from company costs associated with

adding to/maintaining the value of existing

assets required to service existing business

(Maintenance CapEx). Unfortunately, this

breakdown is generally unavailable in a

company’s financial reports.

Changes in Operating Working Capital

(OWC): Operating Working Capital is equal to

Current Assets minus Current Liabilities,

excluding Cash, Cash-like items (such as

Marketable Securities and Securities Available

for Sale), and Debt. It can be found by

incorporating the relevant line items from the

Balance Sheet. Use historical patterns and

common sense to evaluate this line item—most

OWC items are driven by Sales of the company.

Thus, growth in these items should at least to

some extent be a function of Sales growth.

Remember “C.V.S.” when projecting all of these items. The

assumptions driving these projections are critical to the

credibility of the output.

Confirm historical financials for accuracy.

Validate key assumptions for projections.

Sensitize variables driving projections to build a

valuation range.

PROJECTING BUSINESS PERFORMANCE

As mentioned, we first project the company’s Income

Statement. Below, we will walk you through a simple

example of how to do this.

Revenue: For simplicity, Revenue in our example is

projected out at an annual growth rate of 10%, which

is in-line with historical growth rates of the

hypothetical company. In order to increase accuracy

for this assumption, remember to study management

projections, sell-side projections, and internal

estimates. Also remember that more granularity,

where possible, is better.

Cost of Goods Sold (COGS): As Revenue grows,

we increased the gross profit margin by shrinking

COGS as a percentage of Revenue because of the

concept of economies of scale at the company (as the