Preparing for a DCF Analysis

I am currently stepping into interview season with investment banks. Being able to walk through a DCF analysis could be the difference between achieving my dream job or not. I am jotting down my notes as I prepare for the technical side of interviews.

What is Discounted Cash Flow (DCF)?

Valuation method used by investment bankers that that values a company based on it's future cash flows. Future cash flows are projected by using assumptions on how a business will perform in the future. These assumptions are then translated into how a companies performance will produce cash flows in the future.

After future cash flows are established, we use Net Present Value to determine each projected annual cash flow amount into today's current dollar value.

Why use DCF?

DCF is the most theoretically correct valuation technique available because the value of a company stems its future cash flows to it's stakeholders. A shortfall of using DCF is it's contingency on assumptions. If one key assumption is off, even marginally, the valuation result will be wrong.

Checklist structure of DCF (CVS)

Confirm historical financials for accuracy
Validate key assumptions for projections
Sensitize variables driving projections to build a valuation range.

Important Assumptions and Projections

These are three main factors that determine the valuation result from a DCF analysis:

1) Free cash flow projections - projections of the amount of cash generated by a companies operations after paying out operating expenses and capital expenditure.

2) Discount Rate - The cost of capital (debt & equity) for the company. This rate acts like an interest rate on future cash inflows is used to convert them into current dollars equivalents. (WACC)

3) Terminal Value - A value of the Business at the end of the projection period (usually 5 year projection period or even a 10 year period).

DCF = sum of discounted projected free cash flows + discounted terminal value

Two DCF approaches - Levered and Un-levered

There are two ways of projecting free cash flow.

1) Levered - Projects Free cash Flow after Interest expense (debt) and interest income (cash). Values the equity portion of a company's capital structure directly.

• Project FCF after interest expense (debt) and interest income (cash)
• Discount FCF using the required rate of return on equity (cost of equity)
• Value generated is Equity Value or Market Value

Why use? - The capital structure is taken into account in the calculation of the company's cash flows. Which means the LFCF analysis will need to be re-done if a different capital structure is assumed.

2) Un-levered - projects FCF before the effect of debt and cash. Values the company as a whole.

• Before accounting for debt and cash, project FCF for each year.
• Discount FCF using WACC 
• Value produced is the enterprise value of the company

Why use? - This is the industry norm and standard because it allows for an oranges to oranges comparison of the cash flows between different companies. It also allows the analyst to test out various capital structures in order to see how they effect the company's value. In conclusion, the analyst can separate the cash flows produced by the company from the structure of the ownership and liabilities of the company. The cash flows are projected regardless of the capital structure selected in the analysis. The precise capital structure is not taken into account until the WACC is determined.

5 Steps in DCF analysis: 

1) Project the company's free cash flows - FCF is usually projected out to 5-10 years.

2) Determine the company's terminal value - Terminal value could be calculated 2 ways:

• Terminal Multiple Method - 
• Perpetuity Method - 

3) Determine the business's discount rate - WACC

4) Use net present value - Discount the projected FCF and Terminal Value to year 0. Then sum the figures to find the enterprise value of the business.

5) Make Adjustments - If using the Un-levered free cash flow method, subtract net debt and other factors from Enterprise Value to find the Market Value

Sources of DCF information

To project a company's FCF accurately, the analyst will need to take into account needed information about the business.

1) Historical financial Results - The SEC website (www.sec.gov). Include 10-K, 10-Q.

2) Cost of Debt - Use weighted average of the debts interest rates in the capital structure to find the company's pre-tax cost of debt. Can be found in 10-K debt instrument.

3) Cost of Equity

• Risk free rate - estimated as a function of the current 10 YearTreasury Bond Rate. (www.treasury.gov)
• Beta - Relationship between prices in a company's securities and changes in the value of a market benchmark index such as the S&P 500.  Individual stock's betas can be found on Bloomberg, Google finance, FactSet, Capital IQ. If the beta is not published, you can calculate it by simple linear regression.
• Market Risk Premium - degree to which investors expect to be compensated for holding a risky equity security. Calculated by using the Capital Asset Pricing Model. Estimates are published on Morningstar and be determined by using historical returns on government bonds versus overall equity market investments. 

4) Financial Projections - Management Estimates, Sell-side research estimates, and Internal estimates.