Discounted Cash Flow Analysis Deliverable #6 The discounted cash flow methodology derives the value of a company by calculating the present value of all future projected cash flows. Unlike comparable companies analysis or precedent transactions, which are relative or extrinsic measures of valuation, the DCF analysis is intrinsic in nature, because it is determined by considering factors internal to the target company. This primer will help you break down some of the terms used in the DCF analysis and provide you with some insight into the major steps in a DCF analysis. To fully understand the DCF analysis and the way the terms discussed in this primer interact, you should familiarize yourself with the BUFC valuation template. In short, this document is intended as a supplement to facilitate your understanding of what it means to do a DCF analysis, so that you can do one yourself. The primary steps in a DCF are: 1. Project company financials to build out income statement using operating metrics 2. Use these numbers to project out cash flows 3. Determine the WACC 4. Discount your projected cash flows using the WACC to determine EV 5. Move from EV to equity value and divided by FDSO to get a per-share target price. Before we discuss these steps, however, it is important to define a few terms that go into the DCF analysis. Sales Within financial services, you will most often be using someone else s projections for revenue, whether it s consensus estimates or an individual research report that equity research analysts at your bank have developed. While sales, or revenues, can be projected using consensus Wall Street estimates, the value add of BUFC is not in rehashing already existent research reports but rather in making our own predictions.. Your revenue numbers should be based on reasonable growth assumptions that you make based on your understanding of the company, its future initiatives, its growth prospects, and the overall growth outlook for the industry. It is, however, a good idea to compare your revenue projections to consensus estimates or the estimates of an equity research professional. These estimates can be found on FactSet or in research reports found on Thomson Reuters Investext. Another reason to use your own projections is that consensus estimates are usually only available for the next 2-3 years. Again, your growth assumptions should be backed up by your outlook for the company, however a safe assumption would be to steadily decrease the growth rate over your projection period (5 years in our case) until it reaches the projected growth rate of the industry. Gross Profit / Margin Gross profit is defined as revenue minus the cost of goods sold (COGS). You can project COGS as a percentage of revenue based on the 3-5 year average or the most recent year. Your projections may model in a reduction in this percentage to reflect decreasing per-unit costs or may include an increase in this percentage to adjust for rising per-unit costs. Which of these will be the case depends on your company and your industry. For example, a company that refines oil into gasoline likely has seen a reduction in its COGS percentage due to falling oil prices over the past 2 years. You would then calculate gross profit as revenue less COGS. We also speak of gross margin, which is gross profit as a percentage of revenue. You
can develop your projections using gross margin if you prefer, just remember that gross margin is equal to (1-COGS as a % of revenue). Operating Income Operating income is comprised of sales less cost of goods sold (COGS) and selling, general, and administrative expenses (SG&A). As you project out your revenue, COGS, and SG&A through the 3-5 year projection period, you will be able to calculate operating income using this formula. As with the previous line items, you should cross-reference your numbers against Wall Street research without relying on it. The assumptions you make about SG&A will be based on your company-specific research, including the color and guidance that management has given in investor presentations and earnings transcripts. If the company looks like it will remain relatively status quo, you can keep SG&A as a percentage of revenue constant. If management has indicated that they will be implementing various cost-saving or efficiency measures, you may be able to lower SG&A as a percentage of revenue over your projection period. Depreciation and Amortization Depreciation and amortization (D&A) relate to the decrease in value of tangible and intangible assets. As these are non-cash expenses, D&A must be added back to operating income to find free cash flow. D&A can be projected by using a percentage of either revenue or capex in the company s most recent fiscal year. You can also cross-reference your D&A projections against projections from sell-side equity research. Keep in mind that by the end of the projection period, D&A should probably not differ wildly from CAPEX. The intuition here is that CAPEX (in the form of maintenance CAPEX) is how companies replace the decrease in assets occurring through D&A. In the long-term, these values should be relatively similar. If D&A is much higher than CAPEX, you would need to explain why CAPEX could run much lower than D&A in the medium to long-term, as this would mean your company is depleting its asset base without replacing it. In short, would it be reasonable to assume that your company will be able to grow its revenue while its fixed asset base declines? On the other hand, if your CAPEX numbers are much higher than D&A, your company is engaging in an aggressive asset accumulation that should be mentioned or considered in the more qualitative aspects of your analysis. We will discuss D&A and CAPEX considered in more detail in the terminal value section. Capital Expenditures Capital expenditures (CAPEX) are funds used by a company to purchase, improve, expand, or replace physical assets such as buildings or machinery. You may project CAPEX by using a percentage of sales from the company s last fiscal year, which you may adjust up or down based on management guidance in company filings, investor presentations, or earnings transcripts. Many companies will also discuss planned CAPEX in the Management Discussion & Analysis (MD&A) section of their 10-K. As CAPEX is a cash expense, it will need to be subtracted from operating income to come up with free cash flow. Net Working Capital Net working capital (NWC) is a measure of how much current assets and current liabilities a company requires to fund its operations. Net working capital is calculated by subtracting current liabilities from current assets. Current assets are comprised of accounts receivable, inventory, and prepaid expenses and
other current assets. Current liabilities are comprised of accounts payable, accrued liabilities, and other current liabilities. You may project net working capital for each year by assuming a constant percentage of sales from the company s most recent fiscal year or an average over the past 3-5 years. For the purpose of calculating free cash flow, you will need to calculate change in net working capital, measuring how much excess cash is necessary each year. Change in NWC can be calculated by simply subtracting the NWC in the earlier year from the NWC in the later year. An increase in NWC means more cash is necessary and therefore it must be subtracted from operating income. A decrease in NWC means less cash is necessary to run the business and therefore must be added back to operating income. Taxes In theory, a US company should pay 35% of its earnings before tax (EBT) as taxes, as this is the statutory corporate tax rate. In practice, however, this is not always the case due to various factors such as negative EBT, net operating losses carried forward, and other complicated tax accounting. Given that these factors are difficult to explain and may be known only by management, the standard convention is to use the 35% statutory tax rate. So, if your target company generates positive EBT, apply a 35% tax rate. If your company has negative EBT, apply a 0% tax rate. Unlevered Free Cash Flow Unlevered free cash flows are the gold standard for the DCF analysis. This is the amount of cash that the company generate before pay its debt obligations. In contrast, levered cash flows are the cash flows after paying interest. As a summary of what we have discussed up to this point, unlevered FCF is given by: Sales Less: COGS Less: SG&A Operating Income (EBIT) Add: D&A (EBITDA) Less: Capex Less: Increase in NWC Less: Taxes Unlevered Free Cash Flow Cost of Debt The cost of debt is the yield that companies pay on their debt. Note that it is the yield that matters, not the amount of interest paid or the coupon rate. This is because the cost of debt should reflect the current cost of issuing new debt in the market, given by the yield rather than the coupon rate on outstanding debt. That being said, it is often difficult to find the yield of a company s debt. One way to do so is to use Bloomberg. Use the security finder function (SECF), search for your company s ticker, and filter for fixed income. This will show the outstanding bond or loans your company has and their key information such as coupon and yield. This is the most ideal scenario because you can find the yield of your company s various tranches of debt. Barring this, you can usually find the various forms debt issues, their coupon rates, and the outstanding amounts in your company s 10-K. In either of these cases, you will need to find a weighted average yield or interest rate for your company using this information. In some cases, the company will list its weighted average interest rate somewhere in the MD&A section, so you can cross-reference again this.
In addition, if your company has any preferred stock, you will need to find the cost of preferred equity. The cost of preferred equity is simply the dividend paid divided by the price of a preferred share. Like the other costs, it is expressed as a percentage. Cost of Equity The cost of equity is defined as the return on equity that shareholders expect from their investment and is often described as the required return on equity. Unlike the cost of debt, the cost of equity does not perfectly correlate to any cash payments, as companies are not required to pay out anything to their shareholders. Unlike debtholders, shareholders will not profit unless the company profits. This makes the cost of equity a bit more abstract that the cost of debt, but it is important nonetheless. In our case, the cost of equity is calculated using the capital asset pricing model (CAPM). The formula for this model is given by: C E = R f + β(r m R f ) + R S where C E is the cost of equity, R f is the risk-free rate, β is the beta of the stock relative to its index, R m R f is the market premium and R S is the size premium. For the risk-free rate, BUFC uses the current 10-year US Treasury rate, as Treasuries are safe, haven assets that are generally considered risk-free. You will sometimes see other assets, such as 20-year Treasuries used, but we will stick to the 10-year Treasury. Next, the beta of your company s stock. Beta is a measure of the volatility of your target company s stock. It is essentially a ratio that tells you how much your stock should move based on market moves. For example, if your stock has a beta of 1.0 to the S&P 500 and the market moves 10%, you would expect your stock to also move 10%. If instead your company has a beta of 0.5 to the Russell 2000 and the Russell is down 4%, you would expect your company s stock to be down only 2%. The intuition here is that a more volatile stock will have a higher required return in order to compensate investors for that additional risk. More formally, if you plot your target company s percentage return on a daily, weekly, or monthly basis on the y-axis against the percentage return of the index s percentage return on a daily, weekly, or monthly basis on the x-axis, the beta will be the slope of that regression line. Beta can be calculated over various periods of time and with various measures of periodicity (daily, weekly, monthly, etc.), but in BUFC we use a 5 year, weekly beta. Your measure of beta will also be affected by what index you benchmark against. While we are a small-cap fund and benchmark for risk management and reporting purposes against the Russell 2000, you should calculate your beta compared to the S&P 500 to facilitate the rest of the analysis. The reasons for this is the market risk premium. This is a measure of the excess returns that we expect the broader stock market, i.e., the S&P 500, to have above and beyond the risk-free rate. We have traditionally used 7.00% as the market risk premium and you should continue this practice for comparability s sake. This is based on a report from Ibbotson that analyzed historical returns and found that on average large-cap equity returns about a 7.00% premium to the risk-free rate. Now, you may be wondering why we would care about large-cap returns if we are a small-cap fund. We need to use the large-cap / broader market (S&P 500) market premium because we are employing a beta indexing against the S&P 500.
From there, you will add on a size premium that adjusts from the large-cap cost of equity based on the size of your company s market cap. This again comes from an analysis of historical returns by Ibbotson. Thus, the method we use is to think in terms of the broader market and then adjust for the small size of the companies we are analyzing, which are riskier and thus have a higher required return. Once we have our cost of equity in addition to our cost of debt, we can move on to the weighted average cost of capital. Weighted Average Cost of Capital (WACC) The weighted average cost of capital is exactly what it sounds likes, a weighted average of the various sources of capital that a firm employs. For example, a firm that uses 50% debt / 50% equity with a cost of debt of 6% and cost of equity of 10%, will have an overall WACC of 8%. Broadly, WACC is given by: W D C D + W P C P + W E C E = WACC where W D, W P, W E are respectively the weights of debt, preferred equity, and common equity in the company s capital structure and C D, C P, C E are respectively the costs of debt, preferred equity, and common equity for the company. The WACC is the overall cost of capital that a company faces based on its particular mix of financing sources across debt, preferred equity, and common equity. This is the discount rate we use to discount cash flows in our model. Terminal Value Having already projected out the company s free cash flow for the forecasting period, you must also come up with a value of all free cash flows beyond that period. This figure, the present value of all future free cash flows beyond the projection period, is called the company s terminal value. There are a few different methods to come up with the terminal value. The first method is to value the company as a perpetuity using the Gordon Growth Model. The model relies upon the assumption that free cash flow will grow at a constant rate forever. The formula for this method is: TV = (C Final Projection Year (1 + g))/(r g) where C, r and g represent the final projection year cash flow, discount rate and perpetuity growth rate, respectively. The most difficult aspect of this method is deciding on a long term growth rate. You can use a projected industry growth rate or tailor it for your company, however to remain conservative, you may also use the long term growth rate of the economy. The second method of deriving terminal value is called the exit multiple method. This method determines a terminal value through a multiple of an income or cash flow measure such as: net income, EBITDA, or free cash flow. The first step in this method is to come up with the exit multiple. This can be derived by taking the average multiple from a group of comparable companies. Once you have an exit multiple you multiply it by the income or cash flow measure in the terminal projection year to come up with terminal value. For example, if the EBITDA exit multiple was found to be 9.5, and the terminal projection year EBITDA was $1,000, the terminal value would be $9,500. The exit multiple method is generally used less than the
Gordon Growth Model as it is harder to project a multiple, however, for an accurate valuation it is recommended to use both methods and assign them weights. Steps in the DCF Analysis Moving back to our discussion of the process involved in a DCF, you should now have a sense of how to: 1. Use operating metrics to project out company financials 2. Move from company financials to unlevered cash flows using formulas above 3. Calculate WACC using formulas above The last two steps in the process are: 4. Discount the projected cash flows using WACC 5. Derive a per-share price by moving from EV to equity value and dividing by FDSO Once you have mapped out your company s cash flows, you need to discount all of them back to the present value using the WACC. You should add the terminal value to the last year s cash flow before discounting. To discount, you divide the cash flow by (1+WACC)^(# of years). For example, if you are mapping out cash flows for 2017-2021 and the cash flow for 2019 is $400mm, the PV of that cash flow will be given by 400/(1+WACC)^3. Once you have discounted all of these cash flows to the present value, the sum of them will be the enterprise value (EV) of the firm. There are additional nuances to this discounting process such as mid-year discounting and timing of cash flows that may complicate things, but the key is to make sure your timing of cash flows makes sense and you are applying the correct year to each discount factor. Now that you have your company s EV, you need to move to equity value. From here, subtract net debt, minority interest, and preferred equity to derive equity value. Last, divide equity value by the number of fully diluted shares outstanding (FDSO) to derive a projected share price. Please see the note below for information on how to find FDSO. Congratulations, you now have your per-share price derived from the DCF analysis. The last step is to make sure that this price makes sense. If it s much higher or much lower than the current share price, you will need to stop and think what might be driving this. Perhaps there is a mistake in the linkage of your Excel workbook or perhaps you forgot to fill in a particular line. Perhap it s as simple as a reversed sign. When in doubt, ask, but definitely take a stab at troubleshooting yourself.
Note on Calculating Fully Diluted Shares Outstanding (FDSO) Once you have the equity value of a company, it makes sense to divide that value by the number of shares of that company, in order to find the per-share price. However, there are two different values for the numbers of company shares: basic shares outstanding and fully diluted shares outstanding. Each of these values are used in different circumstances, but for our valuation purposes we will always use FDSO. So, what exactly is FDSO and why do we use it? FSDO is defined as basic shares outstanding + any new share issuances + in-the-money options + RSUs + PSUs. The primary purpose of this number is to provide a more conservative value using the number of shares that you expect there to be at the end of your valuation period. For example, in BUFC we are attempting to assign a 1-year target price to an individual stock. Thus, we need to find a number that approximates the number of shares that should exist one year from now. That s FDSO. Breaking down the formula above requires identifying the various components and where you can find them. First is basic shares outstanding. You can find this number on the first page of a company s 10-K or 10-Q. Because this number is only updated quarterly, you will need to add additional shares issuances the company has made since its last filing, if any. To know if they have issued additional shares, check the basic shares outstanding number on Yahoo Finance or Google Finance and if this differs from the number in the 10-Q, you will need to do more investigation into additional share issuances. Next are options. In your company s 10-K, you will find a table of options. These options will be divided into a variety of tranches based on their share prices. The options in each tranche are generally considered inthe-money if the current share price falls within or above each tranche. For example, you might see $10- $19.99, $20-$29.99, and $30-$39.99 as the three tranches for the share prices. If the share prices is $31.50, all three of these tranches would be considered in-the-money. For our purposes, we will consider options in-the-money if the 1-year target price falls within or above a particular tranche. The last step here is to add all of the shares in each in-the-money tranche into the formula above. Lastly, performance stock units (PSUs) and restricted stock units (RSUs) are shares associated with stockbased compensation. You can find this information in the 10-K, usually near the options table. Because we don t know the particulars of the compensation plan, we go with the conservatism principle and assume that the employees will meet their benchmarks and that the shares will be awarded. Thus, you add the amounts of RSUs and PSUs into the formula as well. While this process for determining FDSO works well in theory, there are some practical concerns. First, there will be circularity in your work. The amount of in-the-money options will be affected by the target share price you are predicting and vice-versa. In addition, we assumed that RSUs and PSUs will be executed, but this is not necessarily the case. As a result, FDSO is most applicable to the Treasury stock method (TSM) often used in investment banking. In these situations, there is often a defined purchase price you can work with, which eliminates any circularity. FDSO is not as applicable to public-information-only security analysis. For this reason, it will be acceptable to find FDSO using Yahoo Finance or other public information sources, without going through the process of looking through the company s 10-K.