Valuation: Discounted

Cash Flow (DCF) Analysis

Lecture 5

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Definition
◼ Intrinsic value can be derived from PV of projected
free cash flow
◼ Important alternative to market-based valuation
techniques
◼ Typically, FCF is projected for 5 years. Terminal value
(“going concern” value) captures remaining value
beyond projection period
◼ WACC is the discount rate commensurate with
business and financial risks
◼ Sensitivity analysis is used to test assumptions
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Steps

◼ 1. Study the target and determine key

performance drivers
◼ 2. Project free cash flow
◼ 3. Calculate weighted average cost of capital
(WACC)
◼ 4. Determine terminal value
◼ 5. Calculate present value and determine
valuation
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Step 1
◼ Study the target: business model, financial profile,
customers, end markets, competitors, key risks. Source
of info: SEC filings, earnings call transcripts, investor
presentations, MD&A section, equity research reports
◼ Study key performance drivers (sales growth,
profitability, FCF generation):
◼ Internal: new facilities/stores/products/customer contracts,
improve operational and working capital efficiency
◼ External: acquisitions, end market trends, consumer buying
patterns, macroeconomic factors, legislative/regulatory
changes
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Step 2

◼ FCF: cash generated after paying all cash

operating expenses and taxes and after

funding capex and working capital, but before
paying interest expense
◼ FCF is independent of capital structure
◼ FCF calculation?
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Projecting FCF

◼ Historical performance: prior 3-year period

financial statements with adjustments for
non-recurring items and recent events
◼ Projection period length: 5 years, or when
financial performance reaches steady stage
◼ Alternative cases: Management case, Base
case, and upside and downside cases
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Sales Projections
◼ Using consensus estimates, equity research,
industry reports, consulting studies. Be aware of
cyclical business
◼ Compare projections with target’s historical
growth rates, peer estimates, sector/market
outlook
◼ Growth assumptions need to be justifiable
◼ Sales projections are consistent with other
related assumptions (capex, working capital)
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COGS and SG&A Projections

◼ Historical gross profit margin and SG&A as a
percentage of sales
◼ For private companies, examine research
estimates for peer companies
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EBITDA and EBIT Projections

◼ For future 2 or 3 years: use consensus
estimates
◼ For outer years: hold margins constant at the
last year level provided by consensus
estimates, consider profitability increasing or
decreasing
◼ For private companies: use historical trends
and consensus estimates for peer companies
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Tax Projections
◼ Target’s marginal tax rate, 35% to 40%
◼ Actual tax rate (effective tax rate) in previous
years also serves as reference point
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D&A Projections
◼ Depreciation: projected as percentage of sales or
capex based on historical levels. Or build a detailed
PP&E schedule. Ensure depreciation and capex are in
line by the final year of projection period
◼ Amortization: projected as percentage of sale, or
build detailed schedule based on existing intangible
assets
◼ D&A as one line-item: projected using 2 methods
for depreciation above, or D&A = EBITDA - EBIT
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Capital expenditures Projections

◼ Historical capex is a reliable proxy
◼ Consider company’s strategy, sector, or phase
of operations
◼ Future planned capex can be found in MD&A
section, research reports
◼ Generally driven as percentage of sales in line
with historical levels
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Change in net working capital Projections

◼ An increase in NWC is a use of cash. A

decrease in NWC is a source of cash
◼ NWC is projected as percentage of sales
◼ Recommended approach is to project each
component of current assets and current
liabilities which is projected based on
historical ratios from prior year level or 3-year
average
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Change in net working capital Projections

◼ Accounts receivable: use DSO

◼ Inventory: use DIH or Inventory turns
◼ Prepaid expenses and Other current assets:
projected as percentage of sales in line with
historical levels
◼ Accounts payable: use DPO
◼ Accrued liabilities and Other current liabilities:
projected as percentage of sales in line with
historical levels
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Step 3: WACC
◼ WACC is also called opportunity cost of capital
◼ Steps for calculating WACC:
◼ Determine target capital structure
◼ Estimate cost of debt (rd)
◼ Estimate cost of equity (re)
◼ Calculate WACC
◼ Often use WACC range by sensitizing its key inputs
◼ Target capital structure: is consistent with long-term strategy.
Use company’s current and historical debt-to-total
capitalization ratios, or mean and median of its peers. Target
capital structure is held constant throughout projection period
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Step 3
◼ Cost of debt (rd): if company is currently at its target capital
structure, , cost of debt is derived from blended yield on
outstanding debt instruments (public and private debt).
Otherwise, cost of debt is derived from peer companies
◼ Publicly traded bonds: current yield on all outstanding issues
◼ Private debt (revolving credit facilities and term loans): consults
with debt capital markets specialist for current yield
◼ If no current market data, use at-issuance coupons of current
debt maturities, or estimate company’s credit rating at target
capital structure and use cost of debt for comparable credits
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Step 3
◼ Cost of equity (re): use CAPM
◼ Cost of equity = Risk-free rate + Levered beta x Market risk
premium
◼ Beta for public company: use historical beta
◼ Beta for private company: is derived from a group of publicly
traded peer companies, but need to neutralize the effects of
different capital structures:
◼ Calculate unlevered beta (asset beta) of each peer, then take the
average
◼ Calculate relevered beta using company’s target capital structure
and marginal tax rate
◼ Size premium (SP): added to cost of equity of CAPM
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Step 4: Terminal value

◼ Exit multiple method (EMM):
Terminal value = EBITDAn x Exit Multiple
◼ n: terminal year of projection period. Multiple is the current
LTM trading multiples for comparable companies
◼ Use normalized trading multiple, normalized EBITDA
◼ Sensitivity analysis: range of exit multiple
◼ Perpetuity growth method (PGM):
Terminal value = FCFn x (1+g) / (r-g)
◼ n: terminal year of projection period
◼ FCF: unlevered free cash flow
◼ g: perpetuity growth rate (2% to 4%) r: WACC
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Step 4
◼ Perpetuity growth rate:
◼ Based on company’s expected long-term industry growth
rate (2%-4%)
◼ Is sensitized to produce valuation range
◼ The followings are calculated to check between EMM
and PGM:
◼ Implied perpetuity growth rate (end-of-year discounting and
mid-year discounting)
◼ Implied exit multiple (end-of-year discounting and mid-year
discounting)
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Step 5: Calculate Present

value
◼ Discount factor: year-end and mid-year convention
◼ Terminal value considerations: if using mid-year
convention for FCF of projection period, use mid-
year discounting for terminal value under PGM, but
use year-end discounting under EMM
◼ Enterprise value
◼ Implied equity value
◼ Implied share price
◼ Sensitivity analysis
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Key Pros
◼ Cash flow-based: reflects value of projected FCF, a
more fundamental approach to valuation
◼ Market independent: more insulated from market
bubbles and distressed periods
◼ Self-sufficient: DCF is important when there are
limited or no “pure play” public comparables
◼ Flexibility: can run multiple financial performance
scenarios (growth rates, margins, capex
requirements, working capital efficiency)
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Key Cons
◼ Dependence on financial projections: accurate forecasting of
financial performance is challenging, especially as projection
period lengthens
◼ Sensitivity to assumptions: small changes in key assumptions
(growth rates, margins, WACC, exit multiple) can produce
different valuation ranges
◼ Terminal value: accounts for three-quarters or more of DCF
valuation  decrease the relevance of FCF of projection
period
◼ Assumes constant capital structure: no flexibility to change
capital structure over projection period