Discounted Cash Flow Valuation (DCF)

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Author article: Joris Kersten MSc BSc RAB

Uden/ The Netherlands

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.

Discounted Cash Flow Valuation (DCF)

Discounted Cash Flow Valuation: An Introduction

Discounted cash flow valuation (DCF) is an important alternative to market-based valuation techniques like “multiples”.

So DCF is very valuable when there are limited of no pure play peer companies of comparable acquisitions available.

With DCF valuation I basically look at the free cash flows of a company and we “discount these back” to get to an “enterprise value”. I will discuss all these steps in more detail.

You can image that within DCF valuation we need to make a lot of assumptions, that is why “sensitivity analysis” is a very important component of this type of valuation. Here “Microsoft excel” comes in very handy, because excel is great for sensitivity analysis.

Determine key performance drivers

For DCF valuation you need to understand the target and its sector the best way possible. Think of the business model, financial profile, value proposition, end markets, competitors, key risks etc.

This way you can determine the key drivers of a company’s performance, particularly sales growth, profitability and free cash flow (FCF) generation. This since we need to come up with projections of future free cash flows (FCFs). And here fore we need to have insight on the:

1. Internal value drivers: e.g. opening new facilities, developing new products, securing new customer contracts, improving operational and/ or working capital efficiency etc.

2. External value drivers: e.g. acquisitions, end market trends, consumer buying patterns, macro-economic factors, legislative/ regulatory changes etc.

Unlevered free cash flow

When we take a closer look at unlevered FCF then we mean the cash generated by a company after paying: cash operating expenses, associated taxes, funding of CAPEX, funding of operating working capital (OWC).

But prior to payment of any interest expense!!

This because FCF is independent of capital structure as it represents the cash available to all capital providers, so both debt and equity holders.

In order to estimate FCF we need to make a lot of projections, think of projections on:

1. SALES, EBITDA and EBIT;

2. COGS and SG&A;

3. TAX;

4. D&A (depreciation and amortization);

5. CAPEX;

6. Changes in OWC.

For the projections we study carefully the past growth rates, profit margins and other ratios. These are usually a reliable indicator of future performance, especially for mature companies in non-cyclical sectors.

The projection period is on average 5 years, but this depends on its sector, stage of development, and the predictability of its financial performance.

With DCF valuation is it very common (and wise) to use multiple scenarios. The “management case” is often received directly from the company and alongside different scenarios should be developed.

Sales, COGS, SG&A, EBITDA and EBIT projections

Top line projections in sales often come from “consensus estimates” (consensus among equity analysts around the world).

Equity research often provides projections for a two to three year period. For the time after that industry reports and studies of consultants can be consulted to estimate longer term sector trends and growth rates.

Of course these projections need to be “sanity checked” with historical growth rates as well as peer estimates and sector/ market outlooks.

With COGS and SG&A projections I often rely upon historical COGS and SG&A levels and/ or estimates from research in the projection period.

EBITDA and EBIT projections for the projection period are typically sourced from consensus estimates for public companies. Of course here it is wise to review historical trends as well.

TAX, D&A, CAPEX and OWC

EBIT typically serves as the start for calculating FCFs. To bride from EBIT to FCF, several additional items need to be determined, including “marginal tax rate”, depreciation & amortization (D&A), CAPEX and changes in OWC.

First we need to take tax out of the EBIT in order to arrive at NOPAT (net operating profit after taxes). Here fore we use the “marginal tax rate”, but the company’s actual tax rate (effective tax rate) in previous years can also serve as a reference point.

After that D&A is added because these are “non-cash” items. CAPEX is deducted because this is a real cash out and this also counts for OWC. OWC needs to be carefully studied and largely consists out of the “delta” in two subsequent years between “current assets minus current liabilities”.

When we have carefully made the above steps, this then results in for example 5 free cash flows (ideally in 5 different operating scenarios).

Now it is time to discount these FCFs with a discount factor which we also call the “WACC”.

Weighted average cost of capital (WACC)

The WACC is broadly accepted as a standard for use as the discount rate to calculate the present values of a company its FCFs.

The WACC can be thought of as an opportunity cost of capital of what an investor would expect to earn in an alternative investment with a similar risk profile.

It basically represents the weighted average of the required return on the invested capital in a given company.

For the WACC you need to choose a target capital structure for the company that is consistent for its long term strategy.

In case you target company is not public then consider the capital structure of “public comparable companies”. This since it assumed that their management teams have created right capital structures since they are seeking to maximize shareholder value.

The cost of debt in the WACC represents the company’s credit profile. This is based on multiple factors like size, sector, outlook, cyclicality, credit ratings, credit statistics, cash flow generation, financial policy, acquisition strategy etc.

So for the cost of debt we can for example look at publicly traded bonds and then the cost of debt is determined on the basis of the current yield on outstanding issues. But with private debt we can also look at current yield on outstanding debt.

Cost of equity

To determine the cost of equity is a little more complex. In many cases we will use the Capital Asset Pricing Model (CAPM). With this model we will look at a suitable return for the equity of a company.

This return consists out of the risk free rate (the return that you can make while staying in bed), so for example the return on 10 year government bonds of The Netherlands.

On top of that investors want to be compensated for the “Market Risk Premium”, this is the spread over the expected market return and the risk free rate.

At last this market risk premium is affected by a Beta. A Beta is a measure of the covariance between the rate of return on a company’s stock and the overall market return, with for example the “Amsterdam Exchange Index (AEX)” used as a proxy for the market.

When the valuator has collected all info: Target capital structure, cost of debt and cost of equity the WACC can be constructed.

Terminal value

In DCF valuation we calculate the terminal value of all future cash flows of a company. In many case FCFs are estimated for 5 years and then we assume a company will be in a steady state.

So we can calculate the present value of the estimated 5 FCFs, but then we still have to deal with the value after these 5 years.

We can do this with two methods: the 1) Exit Multiple Method (EMM) or the 2) Perpetuity Growth Method (PGM).

With the EMM we take the EBITDA of for example year 5 and multiple it with an exit multiple. After that we need to discount back this “terminal value” to year 0 (now).

Or we can use the PGM and take the FCF year 5 and we divide it by the WACC to calculate the “perpetuity value” (with or without “growth”). Of course, this terminal value also needs to be discounted back to year 0 (now).

Eventually we discount al the FCFs of the estimation period (let’s say 5 years) and we also add the present value of the terminal value. And the outcome of this calculation is the “Enterprise Value (EV)”.

When we deduct all debt and debt-like items and add all excess cash and cash-like items we have then calculated the market value of equity.

And simply said, when this market value of equity is higher than the book value of equity, there is “goodwill”.

Then we can add the EV from DCF in the “football field” next to EV calculations from for example “comparable companies”, “precedent transactions” and a “Leveraged Buyout Analysis (LBO)”.

Thanks for reading, see you next week, best regards, Joris !!

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.