Discounted Cash Flow (Dcf) Analysis

Topics: Discounted cash flow, Free cash flow, Generally Accepted Accounting Principles Pages: 7 (1400 words) Published: April 15, 2012
DCF Modeling
Copyright 2008 © by Wall Street Prep, Inc.

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Table of contents
SECTION 1: OVERVIEW DCF in theory and in practice Unlevered vs. levered DCF SECTION 2: MODELING THE DCF Modeling unlevered free cash flows Discounting to reflect stub year and mid-year adjustment Terminal value using growth in perpetuity approach Terminal value using exit multiple approach Calculating net debt Shares outstanding using the treasury stock method Modeling the weighted average cost of capital (WACC) Sensitivity analysis using data tables Modeling synergies

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DCF in theory and in practice
DCF in theory • The DCF valuation approach is based upon the theory that the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate. • Discounted cash flow (DCF) analysis is one of the most fundamental, commonly-used valuation methodologies. It is a valuation method developed and supported in academia and also widely used in applied business practices. DCF in practice • There is no consensus on implementation – controversies predominantly over the estimation of the cost of equity. • Extremely sensitive to changes in operating, exit and discount rate assumptions. • That said, there are general rules of thumb that guide implementation. Two-stage DCF model is prevalent form • • • • The prevalent form of the DCF model in practice is the two-stage DCF model. Stage 1 is an explicit projection of free cash flows generally for 5-10 years. Stage 2 is a lump-sum estimate of the cash flows beyond the explicit forecast period. In addition to the two-stage DCF, there are multi-stage manifestations of the DCF model (3-stage, high-low models, etc.) designed to more clearly identify cash flows generated at different phases in a firm’s life cycle. ***************************** • We will focus on the two-stage model FROM TUTORIAL GUIDE SAMPLE PAGES in this course, given its prevalence in practice. For illustrative Purposes Only ***************************** 3

DCF in theory and in practice
Two-stage DCF model Stage 1: Free cash flow projections Stage 2: Terminal value • What is the projected operating and • We cannot reasonably project cash flows financial performance of the business? beyond a certain point. • Typical projection period is 5-10 years • As such, we make simplifying assumptions about cash flows after the explicit projection • How do we calculate free cash flows period to estimate a terminal value that represents the present value of all the free t=n FCFt cash flows generated by the company after Valuet = ∑ the explicit forecast period. (1 + r)t t=1 • Analysts use both the perpetual growth and exit multiple methods to estimate terminal value Discount rate Both stages should be discounted to the present using a rate that appropriately reflects the cost of capital (much more on this later) Valuet = FCFt+1 r–g

Valuet = Exit EBITDA x multiple

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Modeling unlevered free cash flows
Unleveled free cash flows must be projected and then appropriately discounted to determine a present value of the company under analysis. Since firms do not report this figure of free cash flows, analysts must make adjustments to information provided in the reported financial statements.

Start with EBIT The typical starting point for calculating unlevered free cash flows is operating income ***************************** (operating profit before interest and taxes, or EBIT) reported on the SAMPLE PAGES FROM TUTORIAL GUIDE income statement. For illustrative Purposes Only ***************************** 5

Modeling unlevered free cash flows
Arriving at unlevered free cash flows from EBIT: Free cash...
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