Discounted Cash Flow (DCF) Analysis
Imagine you have an opportunity to buy your friend’s business. Once you buy it, you are entitled to all the cash that the business makes in the future. What would this business be worth to you?
You wouldn’t want to pay more than what you’ll get in the future. Discounted cash flow analysis it is a tool to help you calculate how much cash you’ll get in the future and how much that future cash is worth today. In other words, DCF helps you calculate the present value of all future cash flows.
Therefore, DCF is considered to be one of the essential valuation methods because it is trying to determine the intrinsic value of the company (irrespective of what other analyses, such as trading comps, might say).
The analysis assumes that the company is worth as much as the present value of all future unlevered free cash flows, discounted at the company’s weighted average cost of capital (WACC). If the last sentence sounds like gibberish to you, don’t worry, we’ll explain what it means below.
One thing to keep in mind about DCF is that it is based on multiple assumptions (e.g. amount of future cash flows, timing of cash flows, cost of capital, growth rate, etc.). Because of this, even a small change in any of the assumptions can result in vastly different company values.
Steps to DCF are following:
1.) Calculate Unlevered Free Cash Flow (FCF) using forecasted financial statements
FCF represent cash that is available to the investor or the owner of the business after accounting for all business expenses.
Unlevered means that the cash flow is looked at before you pay interest on the debt. Why? Because you are trying to value the business based on its operations, unaffected by the amount of debt it has. The example below shows how two equal businesses can have different net income only because one has debt and the other doesn’t. Though large amounts of debt entitles a company to tax benefits, these benefits are taken into account in the WACC calculation. Debt has nothing to do with business operations, and it should be excluded from the FCF analysis.
2.) Discount Unlevered Free Cash Flows using the Weighted Average Cost of Capital (WACC) – the blended cost of capital for debt and equity
WACC is one of those very important concepts that sounds scary and complicated, but in reality, it is very simple.
First of all, what is cost of capital? Cost of capital is the rate your debt and equity investors require for giving you their money. Since debt is less risky than equity, cost of capital for debt is usually lower than cost of capital for equity. Also, because interest payments are tax deductible, the true cost of debt is rdebt (1 – tax rate).
Let’s break the equation down.
Cost of equity is typically calculated through the CAPM formula (Capital Asset Pricing Model). Let’s look at its components.
Therefore, WACC is nothing more than figuring out the company’s cost of debt and equity, and then doing the weighted average of the two, depending on how much debt and equity the company has.
3.) Determine Terminal Value (value of the company at the end of the forecasting period)
There are two ways to determine terminal value – perpetuity growth method and terminal multiple method.
Perpetuity growth method
The goal is to calculate the value of company’s cash flows assuming that they will grow forever at some modest rate (e.g. 3%)
As you might have noticed, this formula looks very similar to the PVperpetuity formula (PMT/r). In this case, your FCF acts as a payment, and the difference between WACC and rgrowth is your rate.
If you look at the perpetuity formula, in order to calculate the value of all future payments at time 0 (today), you need to take the payment from year 1 and divide it by r. So, in this case, if you want to calculate the value of FCF in perpetuity at time n, you need to divide cash flows from n+1.
Once you have the terminal value, you still have to discount from year n to year 0 (today). The formula is:
Terminal multiple method
This method assumes that the terminal value of the company equals to its EBIT or EBITDA multiplied by the terminal multiple. The multiple is usually obtained through the comparable company analysis.
Once you obtained the terminal value, you again have to discount it to the present.
4.) Add the present values of all forecasted Free Cash Flows and Terminal Value together
This shows you the total enterprise value of the company TODAY. Enterprise value is the sum of the present value of free cash flows (5 or 10 years in the future) plus the present value of the terminal value.
5.) Subtract value of net debt (debt – cash) and any preferred stock to calculate equity value
6.) Divide the derived equity value by the number of shares outstanding to get the share price
7.) Compare the price you got to the actual price in the market and determine if the company is being traded at a premium/discount