1 Discounted Cash Flow Analysis
2 Agenda Main concepts in a DCF Advantages & disadvantages of a DCF valuation Comprehensive DCF analysis example Sample DCF interview questions
3 Main concepts in a DCF valuation
4 What is a DCF valuation? DCF analysis is based on the idea that anything is worth the present value of its future cash flows CF1 CF2 CF3 CF4 CF Projection period & terminal period CF CF2 CF3 CF4 CF Terminal Period Money today is worth more than money tomorrow $1 $1.03 $0 $1 When you receive money matters Year 0 Year 1 Year 0 Year 1
5 Present value (PV) Present value of future cash flows = CF X /(1+Discount rate) x Discount rate = Expected rate of return $100 $100 $100 Year 0 Year 1 Year 2 Discount rate = 10% Year 0 = $100/(1+10%) 0 Year 0 = $100 Year 1 = $100/(1+10%) 1 Year 1 = $90.91 Year 2 = $100/(1+10%) 2 Year 2 = $82.64 Value of Investment = $273.55
6 6 steps in a DCF analysis 1. Project a company s free cash flows (FCF) 2. Calculate the company s discount rate (WACC) 3. Discount and sum the company s FCF 4. Calculate the company s terminal value 5. Discount the terminal value to its present value 6. Add the discounted free cash flows to the discounted terminal value
7 Free cash flow
8 Free cash flow FCF = how much after-tax cash flow the company generates on a recurring basis, after taking into account non-cash charges, changes in operating assets and liabilities, and required CapEx Calculating Free Cash Flow Revenue Less: Cost of Goods Sold Less: Operating Expenses EBIT Less: Taxes NOPAT Plus: D&A Less: Change in NWC Less: CapEx Unlevered Free Cash Flow Unlevered FCF Excludes net interest expense and mandatory debt repayments Levered FCF Includes net interest expense and mandatory debt repayments
9 Free cash flow (example) Revenue = $5,626.3 Depreciation = $146.2 Amortization = $62 COGS = $3,432 Operating Expenses = $1,508 Beginning NWC = $31.3 Ending NWC = $83 Capital Expenditures = $398.1 Tax Rate = 28% Revenue $5,626.3 Less: Cost of Goods Sold 3,432 Less: Operating Expenses 1,508 EBIT Less: Taxes NOPAT Plus: D&A Less: Change in NWC 51.7 Less: CapEx Unlevered Free Cash Flow 252.8
10 Projection period 1. Revenue growth 2. Operating margin 3. Apply the effective tax rate to calculate NOPAT 4. Non-cash charges (as a percentage of revenue, or CapEx) 5. Changes in NWC (as a percentage of sales) 6. CapEx (as a percentage of sales) **This method of projecting free cash flow is purposefully simplified, in the real world you will receive projections from management, creditors, equity research analysts, etc.
11 WACC analysis
12 WACC Why discount FCF and terminal value? Time value of money Expected rate of return from investors in the company The discount rate also reflects the riskiness of the company Risk is correlated with return (Higher risk = higher expected rate of return, and vice versa) WACC = (Cost of debt) * (% of debt) * (1 Tax rate) + (Cost of preferred stock) * (% of preferred stock) + (Cost of Equity) * (% of equity)
13 Steps in a WACC analysis 1. Estimate capital structure and determine the weights of each component: w d, w p, w e 2. Estimate the opportunity cost of each of the sources of financing: k d, k p, k e and adjust for the effect of taxes when appropriate 3. Calculate WACC by computing a weighted average of the estimated after-tax costs of capital sources used by the firm WACC = k d (1 Tax Rate)w d + k p w p + k e w e
14 Analyze the capital structure Liabilities & stockholder's equity Current liabilities Current portion of long-term debt 513 Accounts payable 3,766 Other current liabilities 3,403 Total current liabilities 11,491 Long-term liabilities Long-term debt 18,024 Deferred income taxes 4,508 Other liabilities 3,403 Total long-term liabilities 25,935 Stockholder's equity Common stock 23,611 Retained earnings 14,636 Preferred equity 800 Total stockholder's equity 39,047 Total debt = 18,513 Total preferred stock = 800 Total equity = 23,611 W d = 18,513/(18, ,611) = 43.13% W p = 800/(18, ,611) = 1.87% W e = 23,611/(18, ,611) = 55%
15 The cost of debt K d We use yield to maturity (YTM) on publicly traded bonds Example A company has a bond issue currently outstanding with 25 years left to maturity. The coupon rate is 9% and they are paid semiannually. The bond is currently selling for $ per $1000 bond. What is the pre-tax k d? Use a financial calculator N = 50 PMT = 45 FV = 1000 PV = CPT I/Y = 5% (This is what you solve for) YTM = 5*2 = 10%
16 The cost of preferred stock K p Preferred stock generally pays a constant dividend every period (perpetuity), so we take the perpetuity formula, rearrange and solve for k p P 0 = Div/r K p = Div p /P p Example Alabama Power Company pays a 5.3% annual dividend on a $25 par value, or $1.33 per share. K p = $1.33/$24.96 = 5.33% On February 26, 2014, these preferred shares were selling for $24.96 per share.
17 The cost of equity K e Most common approach: Capital Asset Pricing Model (CAPM) CAPM Used to estimate a company s K e based on the risk-free rate + a premium for equity risk K e = r f + b * (r p ) r f : risk-free rate, 10-year U.S. treasury bond b: beta, captures risk of a security relative to the market r p = risk-premium, expected rate of return required by investors above risk-free rate Example Yield on 10-year U.S. treasury bond = 1.762% Ibbotson market premium (2015) = 5.9% A company with beta = 1.3 K e = * (5.9) = 9.432%
18 Calculate the WACC Example W d = 43.13% W p = 1.87% W e = 55% K d = 10% K p = 5.33% K e = 9.432% WACC = W d * (1 tax rate) * K d + W p * K p + W e * K e WACC d = 43.13% * (1 35%) * 10% = 2.8% WACC p = 1.87% * 5.33% = 0.1% WACC e = 55% * 9.432% = 5.19% WACC = 8.1%
19 Terminal value
20 Exit multiple method Calculates the remaining value of a company s FCF produced after the projection period on the basis of the multiple of its terminal year EBITDA (or EBIT) Multiple is typically based on the current LTM trading multiples for comparable companies Important to use both a normalized trading multiple and EBITDA as current multiples may be affected by sector or economic cycles Needs to be subjected to sensitivity analysis Terminal value = EBITDA n * Exit multiple Example Terminal year EBITDA = $500m; Exit multiple = 9.0x Terminal value = $4.5bn
21 Gordon growth method Calculates terminal value by treating a company s terminal year FCF as a perpetuity growing at an assumed rate Perpetuity growth rate is typically chosen on the basis of the company s expected long-term industry growth rate Tends to be within a range of 2% 4% (i.e. nominal GDP growth rate) Terminal value = FCF n * (1+g) / (r g) Example Terminal year FCF = $18m; g = 3.2%; r = 11% Terminal value = 18 * ( %)/(11% 3.2%) Terminal Value = $238.2m
22 Discount FCF & terminal value
23 PV of FCF Projection period 2017E 2018E 2019E Revenue 45, Less: COGS 28, Less: Operating Expense 12, EBIT 4,618 4,757 4,899 Less: Taxes NOPAT 3,002 3,092 3,185 Add: D&A 1,200 1,200 1,200 Less: Change in NWC Less: CapEx Unlevered FCF 3,602 3,612 3,825 Period Tax-rate = 35% WACC = 9% FCF 1 = 3,602/(1+.09) 1 = $3, FCF 2 = 3,612/(1+.09) 2 = $3, FCF 3 = 3,825/(1.09) 3 = $2, Sum of Discounted FCF = $9,298.34
24 PV of terminal value Terminal Value Exit multiple method Terminal year EBIT 4,899 Exit multiple 12.0x Terminal value 58,788 Gordon growth method Terminal year FCF 3,825 Growth rate 2.00% Terminal value 55,736 PV of terminal value = 58,788/(1+9%) 3 = $45, PV of terminal value = 55,736/(1+9%) 3 = $43,038.42
25 Summary 1. Project a company s free cash flows (FCF) 2. Calculate the company s discount rate (WACC) 3. Discount and sum the company s FCF 4. Calculate the company s terminal value 5. Discount the terminal value to its present value 6. Add the discounted free cash flows to the discounted terminal value
26 Advantages & disadvantages of DCF analysis
27 Advantages & disadvantages Advantages Flexible, adaptable analysis Incremental effects of changes in expected growth rates, margin improvements, synergies, expansion plans, etc. Objective calculation (through present value) Requires scrutiny of key drivers of value Always obtainable Disadvantages Cash flows from forecasts Possible bias Reliability Subjective valuation Based on numerous assumptions Highly sensitive to changes in: FCFs = growth rates & margin assumptions Estimated terminal value Assumed discount rate (beta, market conditions) DCF results should be presented as a range of estimated value, not as a single estimate!
28 Comprehensive example
29 Project FCF Historical Projected E 2010E 2011E 2012E 2013E Sales $4,483 $4,699 $5,384 $5,626 $5,885 $6,162 $6,457 $6,774 EBITDA Less: Depreciation (147) (138) (161) (178) (237) (301) (370) (445) Less: Amortization (33) (35) (35) (30) (30) (30) (30) (30) EBIT Less: Taxes (129) (129) (179) (192) (194) (196) (198) (200) NOPAT Plus: Depreciation & amortization Less: Capital expenditures (398) (414) (431) (449) (469) (Increase)/decrease in NWC (52) (52) (54) (56) (57) Unlevered free cash flow
30 Calculate WACC Assumptions 10-year treasury 3.75% Market risk premium 5.00% Total debt Total equity 208 Beta 0.97 Estimated cost of debt 7.75% Tax-rate 35% Compute weights of capital structure W d = 107.6/( ) = 34% W e = 208/( ) = 66% Compute cost of equity K e = 3.75% * 5.00% = 8.6% Compute WACC WACC =W d * (1 tax rate) * K d + W e * K e 34% * (1 35%) * 7.75% + 66% * 8.6% WACC = 7.39%
31 Calculate terminal value Exit multiple method Gordon growth method Terminal year EBITDA Exit multiple 13.0x Terminal value 15,480 Terminal year FCF 464 Growth rate 3.20% Terminal value 11,440 Terminal value = FCF * (1 + g)/(wacc g) = 464 * ( %)/(7.39% 3.2%) = 11,440
32 Discount FCF & terminal value Discounted FCF = FCF n /(1+WACC) n FCF 1 = 253/(1+7.39%) 1 = $ FCF 2 = 300/(1+7.39%) 2 = $ FCF 3 = 351/(1+7.39%) 3 = $ FCF 4 = 405/(1+7.39%) 4 = $ FCF 5 = 464/(1+7.39%) 5 = $ Sum of FCF = $ Implied enterprise value range is $9,417.6 $12, Exit multiple method Discounted TV = $15,480/(1+7.39%) 5 = $10, Gordon growth method Discounted TV = $11,440/(1+7.39%) 5 = $8, Enterprise value by exit multiple = $1, $10, = $12, Enterprise value by Gordon growth = $ $ = $9,417.6
33 Sample DCF interview questions
34 Explaining a DCF What s the basic concept behind a discounted cash flow analysis? Walk me through a DCF If I m working with a public company in a DCF, how do I move from enterprise value to its implied share price?
35 Calculating free cash flow Why do you add back non-cash charges when calculating free cash flow? How do you calculate free cash flow? As an approximation, do you think it s okay to use EBITDA Changes in NWC CapEx to approximate unlevered free cash flow? If you use levered free cash flow, what do you use as the discount rate?
36 Discount rates and WACC How do you calculate WACC? How do you calculate the cost of equity? How you calculate beta? Why do you have to un-lever and re-lever beta when you calculate it based on the comps? Can beta ever be negative? What would that mean? How do you determine a firm s optimal capital structure? What does it mean?
37 Terminal value How do you calculate the terminal value? What s an appropriate growth rate when calculating the terminal value? How do you select the appropriate exit multiple when calculating terminal value? What s the flaw with basing the terminal multiple on what the public comps are trading at?