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Carmel Stevens
6 years ago
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2 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 Modeling the weighted average cost of capital (WACC) Sensitivity analysis using data tables Modeling synergies

3 DCF in theory and in practice DCF in theory 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. DCF in practice There is no consensus on implementation controversies predominantly over the 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. Two-stage DCF model is prevalent form 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 firm s life cycle. We will focus on the two-stage model in this course, given its prevalence in practice. 3

4 DCF in theory and in practice Two-stage DCF model 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 Value t = t=n t=1 FCF t (1 + r) t 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. Analysts use both the perpetual growth and exit multiple methods to estimate terminal value 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) Value t = Value t = FCF t+1 r g Exit EBITDA x multiple 4

Since firms do not report this figure of free cash flows, analysts must make adjustments to information provided in the reported

5 Modeling unlevered free cash flows 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. 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. 5

6 Modeling unlevered free cash flows Arriving at unlevered free cash flows from EBIT: Free cash flow calculation Historical Projections EBIT (Operating income) EBIT (1 tax rate) (Tax-effected EBIT, EBIAT or NOPAT) Income Statement (10-K / 10-Q / PR / Company) Use normalized EBIT Use effective tax rate Analyst research Company Internal projections Use marginal tax rate Plus: Depreciation and amortization Less: Increases in working capital assets 2 CFS / IS / Footnotes Analyst research Company Plus: Increases in working capital liabilities Internal projections Less: Increases in deferred tax assets Plus: Increases in deferred tax liabilities Less: Capital expenditures Less: Other required investments 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 6

and costs of capital Reference from core model Input WACC of 10% for

7 Modeling unlevered free cash flows Always remember to: Footnote assumptions in detail Test your assumptions Use consistent cash flows and costs of capital Reference from core model Input WACC of 10% for now. We will calculate wacc shortly. Calculation = days post-deal date / 365 7

8 Discounting to reflect stub year and mid-year adjustment Discount free cash flows back to the present 8

applies to the growth in perpetuity formula, which

9 Terminal value using growth in perpetuity approach 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. 9

10 Calculating net debt 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. 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. 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. Net Debt is defined as: Short-Term Debt + Current Portion of LT Debt + Long-Term Debt + Minority Interest + Preferred Stock + Leases (Cash + Investments) Net Debt Net Debt Equity Value 10

11 Calculating net debt 11

12 Shares outstanding using the treasury stock method Total $ proceeds In-the-$ shares x avg. strike price Calculate option proceeds using the SUMPRODUCT function Total shares repurchased Proceeds / current share price 12

13 Modeling the weighted average cost of capital (WACC) 13

14 Modeling the weighted average cost of capital (WACC) 14

15 Modeling the weighted average cost of capital (WACC) 15

16 Modeling the weighted average cost of capital (WACC) Now we can relever the weighted average industry beta 16

17 Modeling the weighted average cost of capital (WACC) and calculate the cost of equity 17

18 Modeling the weighted average cost of capital (WACC) and the weighted average cost of capital 18

19 Modeling synergies 19

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Sample Questions and Solutions

Sample Questions and Solutions Public Comparables Question Facts for Company XYZ: Closing stock price is $18.00 1,000 shares outstanding, and 100 outstanding options outstanding with an average exercise