Discounted Cash Flow Valuation Methods

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Discounted cash-flow (DCF)

DCF method entails estimating the free cash flow available to debt and equity investors (i.e., the annual cash flows generated by the business, and the terminal value of the business at the end of the time horizon) and discounting these flows back to the present using the weighted average cost of capital as the discount rate to arrive at a present value of the assets, DCF is often the primary valuation methodology in M&A, Comparable public company and comparable acquisition analysis are often used as confirming methodologies

DCF is the PV of 2 main types of free cash flows:

1.            Free cash flows to all capital providers (debt and equity)

2.            Free cash flows to equity capital providers

Fundamental in nature, DCF allows for questioning all of the assumptions and for performing sensitivity analysis. One can easily estimate equity value from firm value by subtracting the market value of debt today

1.            Project the free cash flows of a business over the forecast period. Typical forecast period is 10 years. However, the range can vary from five to 20 years

1.            Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range

2.            Estimate the terminal value of the business at the end of the forecast period

3.            Determine the value for the enterprise by discounting the projected free cash flows and terminal value to the present

4.            Interpret the results and perform sensitivity analysis

Calculation of free cash flow begins with financial projections; Comprehensive projections (i.e., fully-integrated income statement, balance sheet and statement of cash flows) typically provide all the necessary elements, Quality of DCF analysis is a function of the quality of projections, Confirm and validate key assumptions underlying projections, Sensitize variables that drive projections, Sources of projections include, Target company’s management, Acquiring company’s management, Research analysts, Bankers

DCF – FCF: What is it?

Free cash flow is un-levered cash available to creditors and owners after taxes and reinvestment, Un-levered means free from financing considerations, Contrast with Cash Flow from Operations (which consists of Net Income plus Depreciation and Amortization plus Deferred Taxes and Non-Cash charges), Free cash flows can be forecast from a firm’s financial projections, even if those projections include the effects of debt

DCF – FCF: How to calculate it?

Net Sales (Revenue) – Cost of goods sold (COGS) – Selling, general, and administrative (SG&A) =Earnings before interest, taxes, depreciation and amortization (EBITDA) – Depreciation & Amortization (D&A) = Earnings before interest and taxes (EBIT) – Taxes (tax rate*EBIT) =Net operating profit/loss after taxes (NOPLAT) + Depreciation & Amortization (D&A) – Capital Expenditure (Capex) – Change in Net working capital (NWC) =Free cash flow (FCF)

DCF – FCF: How to forecast?

Income Statement , Project growth in Net Sales by basing assumptions on Research reports , Client forecasts (if available) , Industry trends  percent growth is usually an input; aggregate sales is derived from this input . Estimate the following by percent of sales, Cost of Goods Sold (COGS), Selling, General and Administrative (SG&A) Expenses

Determine Interest Expense- Refer to the debt schedule and calculate the weighted average interest rate. If no debt schedule is available, then compute Interest Expense as a percent of average Long-Term Debt= (Beginning LTD + Ending LTD)/2, Assess tax rate based on the marginal tax rate (federal, state and local) and current tax regulation. Depreciation- Sometimes expressed as % of Property, Plant and Equipment (PP&E). Capital Expenditures (CapEx)- Expenditures necessary to maintain the required capital intensity

Balance Sheet Items – Working Capital excluding cash and cash equivalents and STD. WC = (Current Assets–Cash and Cash Equivalents)–(Current Liabilities–STD). Estimate WC as a percent of sales, Possible to squeeze cash from WC by operating more efficiently, Three major components of working capital are: inventories, receivables and payables, Property, Plant and Equipment (PP&E): , Project by capital intensity/efficiency: sales divided by (PP&E), Beginning PP&E–Depreciation+ CapEx = Ending PP&E

DCF – WACC- Weighted Average Cost of Capital (WACC) Ascertainthe costs of the various sources of capital for the company, with a given capital structure, Debt, Equity. The after-tax costs of the various sources are then averaged to arrive at an appropriate discount rate to value unlevered cash flows. Debt and equity market values used should represent the “target” capital structure (the capital structure that includes planned debt and equity financings, if any)

Cost of debt- Consult with the debt capital markets group for a 10-year maturity all-in new issue rate at the credit rating corresponding to the targeted capital structure. As part of this process, you should look at the yield on new issues of comparable companies since the cost of debt is a function of the risks associated with a given business/industry. If the company has public debt outstanding and you do not intend to change its capital structure, find the debt rating

Cost of equity- Use the Capital Asset Pricing Model (CAPM). The risk-free rate can be taken as the interest rate on a generic 10-year government noteRoughly matches the maturity of projections

= cov(r,rM)/var(rM), usually estimated using a regression. Estimation issues- Betas may change over time- Don’t use data from too long ago- Five years of monthly data is reasonable

DCF – Terminal value Terminal value is the value of all future cash flows after the explicit forecast period of 10 years. Key value drivers, Growth rate of NOPLAT (g), Return on invested capital ROIC, Value is higher if ROIC is higher than WACC, Higher growth rate is good because our projects have a ROIC greater than the cost of capital, Value is lower if ROIC is higher than WACC, Higher growth rate is bad because our projects have a ROIC lower than the cost of capital. Can also estimate terminal value using an exit multiple. (Terminal value = Statistic x Multiple. Forecast 10 explicit years of FCF, EBITDA, Net Income .Use a multiple of any relevant figure: Book Value, Net Income, Cash Flow from Operations, EBIT, EBITDA, Sales, etc.  Terminal Value should be an Enterprise Value; NOT ALL multiples produce an Enterprise Value (e.g., P/Es)

Multiply and estimate Terminal Value- DCF – Terminal value: exit multiple-DCF – Terminal value: perpetuity growth- Validate and test projection assumptions- Carefully consider all variables in the calculation of the discount rate, Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is critical, Thoughtfully consider terminal value methodology, Do sensitivity analysis (base projection variables, synergies, discount  rates, terminal values, etc.) 

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