DISCOUNTED CASH FLOW

(DCF) MODELLING
01 Overview
05 Weighted Average
Cost of Capital

02 DCF Mechanics
06 Bells and Whistles

03 DCF Modeling Topics

07 Cash in Valuation

04 Diluted Shares Outstanding 08 Value Drivers

 Valuation
Valuation is a quantitative process of
determining the fair value of an asset or a firm.
In general, a company can be valued on its
own on an absolute basis, or else on a relative
basis compared to other similar companies or
assets.
 Valuation Perspectives

You buy a house (investment property)

What do you most care about?

Equity value or total value?
Original price (book value) or current value?
To determine current value, do you look at comps or discount future
cash flows?

The same questions apply to businesses

BOOK VALUE VS MARKET VALUE
Example
DCF Mechanics
 Intrinsic Value vs Relative Value
DCF and comps seem
quite different but they’re
actually very related – in
Intrinsic valuation (DCF) theory a DCF should yield
the same value as comps Relative valuation
is derived from the (but rarely does) (“comps”) is derived by
fundamental analysis of comparing a company to its
the company’s cash flow comparable peers.
generation potential
 DCF Valuation

• DCF values a business as the sum of all the cash flows it

will generate, discounted to the PV at a rate that reflects
the riskiness of the cash flows
• Cash flows = Operating cash flows – cash reinvestment
• Discount rate: The required rate of return for the investors
and is a function of the riskiness of the cash flows
 DCF Advantages in Contrast to Comps

Widely used in practice and DCF implementation challenges

respected academically.
• No real consensus on implementation –
estimating cost of equity is controversial
• Requires detailed company financials
• Very sensitive to changes in operating,
Theoretically, very sound Can value individual terminal value, and cost of capital
method of valuation pieces of business / assumptions
synergies • Garbage in = garbage out

Not influenced by current

market pricing
 Levered vs Unlevered DCF
Levered DCF Unlevered DCF
• Forecast unlevered free cash flows
• Forecast levered free cash flows (UFCF): Cash flows that trickle down to
(LFCF): Cash flows that trickle down to both debt and equity providers of
equity owners after all non-equity capital
related expenses are removed • UFCF = EBIAT + D&A/noncash items
• LFCF = CFO – capex – debt principal +/- WC changes – capex
payment • UFCF takes out operating expenses,
• LFCF takes out operating expenses, capex but not debt related payments
capex and debt related payments • The appropriate discount rate on
(interest expense & principal) unlevered FCFs is the weighted
• The appropriate discount rate is the average cost of capital (WACC), which
cost of equity, which captures risk and captures risks and expected returns to
expected returns to equity only both debt and equity providers
Equity Value to Enterprise Value

01 In a levered DCF, the resulting PV of LFCF is the equity value; you

can easily get to enterprise value by adding net debt

02 Conversely, in an unlevered DCF, the resulting PV of UFCF is

enterprise value but you just subtract net debt to get to equity value

03 For the same company, both approaches should yield exactly the
same equity value and enterprise value
• The prevalent form of the DCF model in practice is the two-stage
unlevered DCF model (our focus)
• Multi-stage DCFs (3-stage, high-low models) are possible but less
used in practice
DCF Implementation
 DCF Implementation
Stage 1 Stage 2
• Terminal value (TV)
• Unlevered free cash flow • Beyond stage 1, assume a constant
projections (5-10 years) growth rate and use the perpetuity
• Annual cash flow freely available formula to estimate a TV that
(but necessarily distributed) to all represents the PV of all the FCFs
providers of capital in the business, generated after stage 1
after accounting for all necessary • Alternatively, analysts use ‘exit
reinvestments multiple’ approach (more on this later)
• Linking from an integrated FSM is • TV is present value at end of stage 1,
optimal so needs to be discounted yet again to
beginning of stage 1 (PV of TV)
DCF Modeling Topics
Terminal Value (TV)
Terminal value (TV) is the value of a business or
project beyond the forecast period when future
cash flows can be estimated. Terminal value
assumes a business will grow at a set growth
rate forever after the forecast period. Terminal
value often comprises a large percentage of the
total assessed value.
 Terminal Value- Growth in Perpetuity

Analysts calculate the PV of all What is the right long term growth rate ‘g’?
the FCFs generated after stage 1
by assuming cash flows will grow • No business can be expected to grow forever at rates
at a perpetual & constant growth above the economy, so ‘g’ should be a sustainable rate
rate • In practice a 2-5% range is most frequently used
• Companies in high growth / early stage with high
growth rates during stage 1 tend to be valued with a
higher LT g than companies with lower growth rates in
stage 1
• ‘Fuzziness’ of this is an often-criticized part of the DCF
• DCF outputs are frequently presented using a range of
growth rate assumptions
 Exit Multiple Method
• Instead of using the growth in
perpetuity equation, TV is often
calculated by simply multiplying an
LTM EBITDA multiplex EBITDA in the
last forecast year

• The LTM EBITDA multiple is usually

derived from a trading comps or
transaction comps analysis, depending
on the purpose of the DCF (standalone
valuation or for acquisition analysis)

• Used because it requires fewer

explicit assumptions about future cash
flows, growth, and more ‘realistic’
TV: Exit Multiple Method Vs. Perpetuity

When using the EBITDA • Today’s company multiple provides a

more ‘realistic’ valuation than the
multiple to calculate the generic growth input in the perpetuity
TV, you can calculate the formula (i.e. “all companies get the
implied growth rate by same g”)
using the following • On the other hand, the multiple itself
incorporates implicitly all the
formula: assumptions about growth, discount
rate, and FCFs the perpetuity formula
incorporates explicitly
• The multiple selected is derived from
market-based comps analysis, which in
turn, is used to determine DCF value.
Implementation
Caveats

• EV/EBITDA is most common multiple but can

use any enterprise value multiplein unlevered
DCF (EV/Rev, EV/EBIT, etc.)
• P/E and P/B is most common in levered DCF
• Just like with perpetuity approach, terminal
value needs to be discounted to present using
the WACC
Diluted Shares
Outstanding
Diluted vs. Basic Shares Outstanding

You should use diluted shares instead of

01 actual (basic) shares when calculating
fair value per share..

This is because the fair value per share

02 should account for not just the actual
shares outstanding, but also potentially
dilutive securities.

Ignoring this in the share count would

mean you’re dividing the model-derived
03 equity value by not enough shares and
thus overstate the value of each share
 Diluted Shares Outstanding
• Calculating shares correctly using source filings is critical
• Used in arriving at equity value per share in the DCF
 Dilutive Securities
Stock Options
Stock options issued to pay and motivate employees.
Gives employees the option to purchase common
stock at a given price over an extended period
Warrants
Warrants are similar to options, except they are
usually issued to lenders, not employees

Restricted stock and restricted stock units

Restricted stock and restricted stock units (RSUs) are shares subject to
vesting and, often, other restrictions. Unlike options, there is no exercise
price and employees receive the stock free and clear after vesting.
Convertible Bonds
Convertible bonds are bonds that the company issues
that can be converted into common shares upon a
certain strike price.
Convertible Preferred Stock
Convertible preferred stock is similar to convertible
debt, except that the provider of capital usually
receives a preferred stock dividends instead of interest
payments
 Restricted Stock Disclosure
Like options, restricted Vested restricted shares Unvested shares: The most common
stock vests over approach is to include in
several years, but the diluted share count,
when they vest, they logic being that since it
automatically get is highly likely that
included in the actual unvested restricted stock
share count, so there will in fact vest over the
is no dilutive impact next several years
(vesting periods average
1-3 years), it is more
conservative to include
all unvested restricted
shares in the dilutive
share count than to
exclude.
 Impact of convertible debt and
preferred stock on shares
When co. has convertible preferred stock or
convertible debt on its balance sheet, determine
whether to assume conversion when calculating
diluted shares using the “if-converted” method
“If-converted” method
1. If convertible is “in-the-$” (current share price >
conversion price)
b. Assume conversion & include converted shares
in dil. share count
c. Exclude the convertible security principal
amount outstanding from the calculation of net
debt
4. If convertible is “out-of-the-$” (current share
price is < conversion price)
a) Do not assume conversion, treat as normal
debt and do not include converted shares in the
share count
 Understanding conversion price for
convertible preferred
Redemption (Liquidation) value:
The value that the firm must pay to eliminate
the preferred stock obligation assuming no
conversion. The $ amount of preferred stock
outstanding can be found in the footnote.
Alternatively, use the value on the balance
sheet as a proxy.
The conversion ratio:
The number of common shares that each
convertible share can receive upon conversion
Preferred shares outstanding:
The number of preferred convertible shares
currently outstanding (do not confuse this with
shares authorized which are typically much
bigger).
DCF Bells & Whistles
Normalizing terminal free cash flow
The final year of stage 1 should
reflect sustainable long term
growth and reinvestment rates Since most real world DCF
(i.e. normalized). models are 2-stage models,
where stage 1 is only 5 years,
the final year of stage 1 is
In practice practitioners simply
sometimes not normalized.
adjust the FCF used for
calculating the TV to a
“normalized” FCF by converging
the capex/ depreciation ratio to
1, and removing any major
working capital and DTL/DTA
inflows/outflows. In addition, for private
. companies, no β is available
Despite various vendor because there are no
algorithms to mitigate the observable share prices.
problem (Bloomberg’s forward /
adjusted β), this limits the
usefulness of historical β as a
predictor
 Delivering and relieving βs of
Industry β industry peers

Industry peers can still have different

For private companies and for capital structures
when public company βs have a
high standard error, one solution We must undo the distorting impact of
is to use an industry β. different capital structures on β as, all
else equal, more highly leveraged
companies will have higher observed
By looking at historical βs of a βs.
company’s peer group with similar Cash flows to equity holders are
sensitivity to market fluctuations, a more volatile due to the higher
private company’s β can be derived, and fixed interest payments
a public company β with high standard
error can be improved as the impact of To eliminate this distortion, we
uncorrelated company-specific events de-lever βs of comparable
that raise the standard error will cancel companies and re-lever them at
each other out the more peers are added the target company’s target
capital structure
 Some Formulas
Delevering βs

Re-levering β
Cash in Valuation
Large cash (negative net debt) weirdness in
valuation
Negative net debt in valuation creates a weird (but not
incorrect) outcome: the equity capital weight is > 1 and the
debt capital weight is < 0.
 Negative net debt quirks in valuation

All else equal, the more cash a This is an underestimation of the true
company the lower the observed β, cost of equity of the unlevered FCFs,
leading to a lower cost of equity. but is resolved by the >1 equity capital
weight and <0 debt capital weight which
bring up the cost of capital

There is an alternative which avoids

the weirdness by using gross debt,
The cost of equity is higher but but then the β needs to be adjusted
cost of capital is almost the same to remove the impact of cash.
(the minor difference arises from
the tax deductibility of debt).
Value Drivers in the DC
 Value drivers

FCF can be thought of as operating

profit – reinvestment

• Reinvestments are made to generate

returns and along with the returns on
those reinvestments, ultimately
determine a company’s growth rate

The perpetuity formula can be re-

expressed as:
 Calculating multiples
intrinsically
What does it mean when the DCF-derived multiple ≠ comps-
derived multiple?
Suggests there are differences between the implicit ROIC, rr
and discount rate assumptions baked into the comps analysis
and those baked into the DCF analysis.

• Had the we used earlier in the course as comps truly been

comparable in growth, ROIC, and discount rate
characteristics, the derived multiple should have been
identical to our stand’s multiple.
 Case & Solution (Practical)

Please refer the excel to have

more practical knowledge about
Discounted Cash Flow (DCF)
Modeling.