Discounted Cash Flow (DCF)

A discounted cash flow (or DCF) is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital, and may incorporate judgements of the uncertainty (riskiness) of the future cash flows.

Discounted cash flow analysis is widely used in investment banking.

Discounted Cash Flow (DCF) Valuations

1) Can you walk me through a DCF?

2) What’s the difference between Levered and Unlevered Cash Flows and why does it matter?

3) What exactly is WACC and what is it used for?

4) In the WACC calculation, how do you get the cost of Equity and Debt?

5) What exactly is CAPM and how do you find the Risk Free Rate and Beta?

6) What is Terminal Value and how is it calculated?

7) Which would you rather use, Gordon Growth Method or Exit Multiples?

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(1) Project out the Free Cash Flows (FCF) for a given period of time

• How long should your project out the FCFs?
  • Typically is 5 to 10 years

• Why would you choose 5 years vs. 10 years?
  • 5 years for more volatile companies, such as technology companies
  • 10 years for less volatile companies, such as industrial companies

• How do you derive FCF?
  • FCF =
  • EBIT x (1 – Tax Rate)
  • + Depreciation and Amortization
  • - Capital Expenditures
  • - Net Increase in Working Capital: (Current Assets – Current Liabilities)

(2) Use a Terminal Value (TV) calculation on your final year FCF 5 or 10

• Gordon Growth Model (also known as the Perpetual Growth Model)
  • (FCF,year 5 or 10)(1+g)
  • ----------------------------
  • (Discount rate (WACC) - g)

• Multiples Method
  • (FCF, year 5 or 10) * Multiple
  • Multiple will vary based on each deal, industry, timing, etc...

(3) Discount the FCFs at some required rate of return

• Weighted Average Cost of Capital (WACC)
  • WACC = [E /(D + E)]*CAPM + [D /(D + E)]*DebtInterestRate*(1 - T)
  • + E = Equity Value
  • + D = Debt Value
  • + CAPM = Capital Asset Pricing Model
  • + T = Tax Rate

• Capital Asset Pricing Model (CAPM)
  • CAPM = rf + Beta*(rm - rf)
  • + rf = Risk free interest rate (T-Bill rate)
  • + Beta = stock volatility
  • + rm - rf = excess market return

(4) Sum these discounted FCFs to get the Net Present Value (NPV)

Pros of DCF

• Produces the closest thing to intrinsic stock value
• Relies on FCF, which are trustworthy because FCF cut through reported earning "guesstimates" and tracks the money left over for investors
• Identifies where companies value is coming from and if current stock price is justified

Cons of DCF

• If assumptions are wrong/incorrect then the output will be inaccurate
• Terminal Value calculation projects the FCF into the future at the same rate, which will clearly never happen
• The debt to equity ratio is held constant in the WACC