Walk Me Through a DCF

Step 1) Project Free Cash Flow

Remember, the final result is sensitive regarding assumptions. Review this checklist when fishing for data:
Confirm historical financials for accuracy
Validate key assumptions for projections
Sensitize variables driving projections to build a valuation range.

Key Inputs: Free Cash Flow = Operating Income (EBIT) - Taxes + Depreciation & Amortization - Change in operating working capital - capital expenditures for the year.

Projecting free Cash Flow:

1) Revenue - Year over year are the most common method. Look at historical growth rates of the company. In order to increase accuracy look at Management projections, sell side projections and internal estimates. 

2) Cost of Good Sold (COGS) - expressed as a percentage of Revenue. As Revenue grows we shrink the COGS percentage because as a business grows it should experience improved cost efficiency (economies of scale). Include depreciation and subtract it out later. 

3) Selling General and Administrative (SG&A) - expressed as a percentage of Revenue. Can be fixed or variable. 

4) EBITDA - Direct output of revenue and cost assumptions. Add depreciation to operating income (EBIT) to arrive at EBITDA. 

Next we take our business performance projections and find Un-levered free cash flow in each year. 
1) Tax adjusted EBIT - Depreciation and Amortization has to be taken out of EBITDA to find after tax Operating profit (EBIT). D&A is an expense for tax purposes. We must subtract D&A to find tax amount then add it back after taxes. 

2) Tax Rate - Use the last twelve months (LTM) tax rate in order to project future tax rates. 

3) D&A - The D&A was initially taken out in order to find taxes but then we add it back because it is a non cash expense. 

4) Capital Expenditures (CapEx) - This represents cash needed to to fund new and existing assets. Not expensed on income statement because purchases assets will be used to support operations in the future and is gradually expensed year by year via depreciations. We subtract out CapEx.

5) Change in Operating Working Capital (OWC) - Represents investments in the short term net operating assets needed to fund revenue growth. Annual change in current assets minus current liabilities on the balance sheet excluding cash, cash like items and debt. OWC is subtracted out. 

Now we apply the formula: UFCF = Tax Adjusted EBIT + D&A - CapEx - Change in OWC

We have projected the UFCF in each year. 
We now discount the UFCF figures using Net Present Value.

The formula is as follows:

The Un-Levered Free Cash Flow will be inputed into each of it's respected FCF year. Then it is divided by the discount factor which is 1+ the WACC. The exponent n is the number of the year. 

2) Determine the company's terminal value: 

The Terminal Value represents the value of the cash flows after the projection period (5-10 years). 

There are 2 ways to find Terminal value.

1) Terminal Multiple Method - Uses a multiple of a financial metric (EBITDA) to calculate a company's valuation. Multiples can be derived from comparable companies. 

• Choose multiple (EV / EBITDA) range based on historical trading ranges for the businesses as well as comparable companies in the industry. 
• Multiply the (EV / EBITDA) multiple by the end of the EBITDA estimate. The result is equal to the EV of the company at the end of the projection period. 

2) Perpetuity Method - Assumes that the FCF will grow at a constant rate in perpetuity over the given time period. Analysts usually use long term growth rates such as GDP growth. 

• Find reasonable FCF growth rates to use in perpetuity. GDP could work or something that pertains to the industry dynamics. 
• Calculate Terminal value using this formula: 

        Terminal Value = Latest UFCFn × (1 + g) ÷ (r – g)

3) Find the Weighted Average Cost of Capital (WACC)


What is WACC? - WACC is the required rate of return to investors for investing in a risky business. It is a blend of raising debt and equity based on market value, not book value. WACC could be used to discount projected free cash flow in a DCF analysis. 

How to calculate WACC:

(Re * E%) + (Rpfd * P%) + (Rd * (1-Tc) * D%)

Where:

Re (Return on Equity) = Can be found using the CAPM model. 
Risk Free rate + Beta * (market risk premium) or (Div1/Price)+Growth rate

E% = Percentage of the company that makes up it's equity capital structure.
(Equity/(Debt+Equity)) 

Rpfd = Return on preferred stock capital. (Dividend of preferred / Price of Preferred.)

P% = Percentage of the company that makes up preferred stock capital structure. 
(Preferred stock/Debt+Equity)

Rd - (Effective Cost of Debt before interest tax) - interest on Debt or Yield To Maturity on current debt. If business recently issued debt at par, then the coupon rate is equal to the YTM of the debt

Tc = Tax rate

D% = Percentage of the company that makes up it's debt capital structure.
(D/E+D)


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