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Discounted Cash Flow Analysis

Analysis of historical performance


A crucial step in the DCF model is to collect and analyze relevant historical information in order to
evaluate the historical performance. A solid understanding of the past performance will enable
reasonable forecasts of future performance. The historical information should at a minimum include
income statements and balance sheets.
Additional information such as cash flow statements and relevant notes may also add value. The
number of years of historical data included should be sufficient to determine historical performance
and business trends. In order for the historical information to provide an understanding of historical
performance it needs to be analyzed. The analysis is performed through calculating historical financial
ratios such as sales growth, profit margins, capital expenditure etc. Through analyzing these ratios
over a number of years the historical performance will become evident and reasonable assumptions
regarding future performance can be made.
Forecasting future performance
The analysis of the historical performance should provide a clarifying connection to the assumptions
that are made regarding future performance. These assumptions should be able to generate future
expected income statements and balance sheets from which the free cash flow can be derived.
Furthermore, the assumptions should be clearly stated in a separate section. The forecasting of a
firms financial performance is divided into two periods: the explicit forecast period and the posthorizon period.
For each given year in the explicit forecast period the corresponding income statement and the
balance sheet is used to derive the expected annual free cash flow. In some implementations of the
DCF model it is requirement that the explicit forecast period is not shorter than the economic life of the
firms property, plant and equipment (PPE).
The explicit forecast period should consist of at least 10-15 years. Through forecasting entire income
statements and balance sheets an analysis using financial ratios is possible. This analysis can be used
to determine the fairness of the assumptions regarding the future.
Estimating the cost of capital
The discount factor for the free cash flows must represent the risk faced by all investors. The weighted
average cost of capital (WACC) combine the required rates of return for net debt (rnd) and equity (re)
based on their market values. The tax effect on cost of net debt is accounted for in the WACC.
Through using a constant WACC it is implicitly assumed that the capital structure will remain
unchanged. The WACC is defined as follows:
The components of the WACC should be calculated accordingly:

The cost of net debt should be calculated using the companys yield to maturity on its longterm debt
The marginal tax rate should be used as the tax rate in the WACC formula, which is the tax
that the firm would pay if the financing or non-operating items were eliminated
For mature companies, the target capital structure is often approximated by the companys
current debt-to-value ratio, using market values of debt and equity

The Capital Asset Pricing Model (CAPM) is used to determine the required rate of return on equity:
CAPM should be calculated accordingly:
Local government default-free bonds should be sued to estimate the risk-free rate. Ideally,
each cash flow should be discounted using a government bond with a similar maturity

To estimate the beta, first measure a raw beta using regression which should at least contain
five years of monthly returns and then improve the estimate by using industry comparables
No single model for estimating the market risk premium has gained universal acceptance

Based on evidence from the different used models suggests a market risk premium around 5 percent.
One should note that, given the WACC formula, it is possible to use the required return on equity as
the discount factor if it is assumed that the future target capital structure will be 100 percent equity and
0 percent net debt. A net debt of zero requires that the model assume that no interest bearing liabilities
or financial assets will exist in the target in the future, in this case the tax rate become irrelevant in the
WACC.
Estimating the continuing value
As already mentioned the forecasting of a firms financial performance is divided into two periods: the
explicit forecast period and the post-horizon period.
During the explicit forecast period the firm is expected to transform into a steady state. When the firm
has reached the steady state the terminal value is calculated by a continuing value formula. The
continuing value formula is applied to the first year in the post-horizon period, which therefore
becomes representative for all subsequent years in the steady state. The explicit forecast period must
be long enough for the company to reach a steady state. The following characteristics must be fulfilled
in order for a company to truly be in a stead state:

The company should grow at a constant rate and reinvests a constant proportion of its
operating profits into the business each year
The company earns a constant rate of return on new invested capital
The company earns a constant return on its base level of invested capital

If these conditions are fulfilled in steady state the free cash flow will grow at a constant rate consistent
with the assumed terminal growth rate and thereby a continuing value formula can be applied.
DCF model
The DCF model should be constructed in such a way that an extra way in steady state could be added,
this enables to verify if the company truly is in steady state, since the free cash flow during the extra
year is supposed to grow with the terminal growth rate.
The continuing value formula that is commonly recommended is the Gordon growth model. It should
be noted that even though the terminal value is calculated by a simply Gordon growth model it does
not imply that it is unimportant and irrelevant for the value of the firm. Normally a significant part of the
total firm value is in the terminal value. The terminal value calculations are crucial for the overall
accuracy of a valuation model. The terminal growth rate in steady state must be less than or equal to
that of the economy (the GDP growth). A higher growth rate would eventually make the company
unrealistically large compared to the aggregated economy. The growth rate is often assumed to equal
the rate of inflation.
A DCF valuation is a valuation method where future cash flows are discounted to present value. The
valuation approach is widely used within the investment banking and private equity industry.
Step 1 Enter historical financial information in the DCF valuation
Enter historical information
Enter the historical information of the company you wish to value, this information can be found in an
annual report or can be ordered via this link for example. It depends on what company you wish to
estimate value of. The CAGR (Compounded Annual Growth Rate) and the percentage numbers you
have entered all information. Below is a picture of the information you should fill in:

Steps
1.
2.
3.

Enter net sales, total costs, EBITDA, Depreciation & Amortization for each year, which will
sum up to EBIT.
Enter taxes paid, in this example 30% is used, but it varies from country to country.
Enter CapEx (Capital Expenditure) which is the annual investments for the company each
year. This is normally specified in the Annual Report under Cash Flow Statement. If you
cannot find the information in the Annual Report you can also take the difference from two
years in tangible assets. For example, if the company had tangible assets of 100 in year
2006 and 110 in 2007, the company spent 10 on investments (CAPEX) during 2007.

The historical information will be used to make likely forecasts of sales growth and EBITDA margins,
which will be performing in coming steps.
Step 2 Enter historical working capital
In step two we are entering historical information. This is indeed in order to make good prediction of
future working capital needed. The working capital is such an important and difficult input, which needs
some extra attention.
In the picture below we have circled the information you should supply in order to calculate the change
in net working capital. The first circle shows the outcome of the information supplied:

Steps
1.
2.
3.
4.
5.
6.
7.
8.
9.

Account receivables
Inventory
Prepaid Expenses and other
This information will sum up to Total Current Assets
Enter Account payable
Accrued Liabilities and
Other Current Liabilities
This will sump up Total Current Liabilities
The total Net Working Capital will now be calculated automatically in the model

Step 3 Make future projections


The projections in the DCF model have large impact on the valuation; therefore, this step is extremely
important. We will now use the historical information as a base in order to make good and likely
projections of the future.
In the picture below we have circled the information you should supply. However read the instructions
below the picture before you make you assumptions and input.

Steps
1.

2.

3.
4.
5.

Make projections of future sales by looking at historical values In this example the business
has had annual organic growth between 14% and 21% implying a CAGR of 16%. This is
normally a good measure for future estimates. However, we have spoken to the management
of this company and they have a financial target of 6.900 in 2014 and that is why we use an
annual growth of 8% in this example.
EBITDA margins look at historical values. This company has had EBITDA margins in the
range of 13.5 15% in the past few years. In our example we have chosen to use an average
value of the historical information in the projection period, implying 14.3%. This number will
determine EBITDA in the projection period.
Depreciation and Amortization look at historical depreciation in relation to sales and use an
average from these years to use in the projection period. In this case, it was quite simple, we
used 1.8% of sales.
Taxes use either the historical tax level or the business tax applied in your region. We have
used 30% in this example.
CAPEX Determine capital expenditures that you believe the company will have in the future.
This is quite difficult to estimate, therefore, use an average of the last five years in relation to
sales. In our example the CAPEX actually decreased between 2009 and 2010, which might
be inappropriate. However, after a short discussion with the management of the company we
still decided to use 2.3% of sales.

Step 4 Calculate Unlevered Free Cash Flow, DCF model


We shall now calculate the unlevered free cash flow, but first we need to make some assumptions
regarding the working capital and estimate the needs in the projection period.
See comments below picture:

Steps
1.
2.
3.
4.
5.

Estimate total current assets in the projection period. Use the average during the past four
years in relation to sales
Estimate total current Liabilities in the projection period. Use the average during the past four
years in relation to sales
The net working capital will now be calculated automatically based on your above input
The difference (increase or decrease) between 2010 and 2009 will now be subtracted or
added to the cash flow. A growing business will normally take on more working capital for
each year, which will lower the free cash flow.
The Free Cash Flow can now be calculated for every year in the projection period!

Step 5 Target Capital Structure and Beta


This section is for you who have access to a database such as Bloomberg or Reuters. If you do not
have such access, you can type in:
Debt to Total Capitalization: 30%
Equity to Total Capitalization: 70%
This is the most common assumption when determining capital structure in a business valuation
model. However, the below described method is more accurate and preferred if you have all the
needed tools.
The picture describes the input we have made in our example valuation, which is further described
below:

Assumptions and input


1.
2.
3.
4.
5.
6.

Identify a couple of listed companies that are similar to the one that you want to estimate
business value upon
Enter the listed companies beta which can be found via database such as Bloomberg
Enter the Market Value of debt of these companies. The market value of debt is the same as
book value of debt
Enter the market cap for the traded peers
Enter the marginal tax rate
All this information can be found in the database. Now the model will calculate the Beta and
unlevered and levered Beta and put as input in the valuation model

Step 6 Determine WACC


The capital structure is given from the previous step and works as a base for determining WACC in the
calculation below.

Assumptions for WACC


1.
2.
3.
4.
5.

Enter the risk free rate. This is the same rate as the 10-year treasure bond and can most likely
be found on your governments website.
Enter the market risk premium this is used to adjusted for specific company risk and should
be 7.1% according to: Ibbotson
The Levered Beta is given from previous exercise.
Now add a size premium according to Ibbotson as well. We have used 1.7% since our
company is pretty small.
Now enter Cost of Debt, the rate that your company gets to borrow money at. If you are not
sure, you can calculate the rate by dividing interest paid during the last financial year with total
debt.

6.

Enter the tax-rate for the companys current country so that the tax-shield deduction can be
calculated.

Step 7 Present value of free cash flow


Next step is to calculate the present value of the generated cash flows in the projection period.

Steps
1.
2.
3.
4.

Make sure the WACC is correct according to step 6.


The Discount Period is set according to the mid year method and could be leaved as is since
the cash flow is evenly generated through the year.
The Discount Factor is calculated with WACC and the chosen Discount Period.
The present value of the free cash flow is now automatically generated

Step 8 Calculate Terminal Value


The terminal value has the largest impact on the valuation and it is extremely important that this input
is correctly performed.
Most values are already given as can be seen below:

Steps
1.
2.

Perpetuity growth rate is the rate at which the economy is expected to grow; this is normally
2.5% or 3%.
Make sure the implied exit multiple isnt too high, since that probably means your assumptions
are too aggressive in the terminal year. Another way of judging if this value is too high, is if
you put in the relation of the later calculated enterprise value. If the terminal value is more
than 80% of the enterprise value, it is likely that something is wrong with you assumptions.

Step 9 Enterprise Value


The DCF valuation is almost done, you have made all the inputs required and the enterprise value is
already calculated. Now we will try to describe the results and make sensitivity analysis.
Below are the results in our valuation example:

Comments
In the results above you can see the enterprise value of the business and some multiples on the 201
years estimated results. You should enter debt, cash and outstanding shares to get additional
information on your valuation.
Step 10 DCF Sensitivity Analysis

With this sensitivity analysis you can see how the valuation changes with different assumptions and
changes in input.
This is our sensitivity analysis:

Comments
To perform a sensitivity analysis like this, you should copy the exact value of your WACC, EBITDA %,
Perpetuity Growth and annual sales growth in the middle of each row and column. The numbers that
you should replace are dark blue and bold.
Valuation Range
It is now time to decide the valuation range for the company. In this example valuation we decide the
range by changes in WACC with 1% up and one percent down which gives a range of approximately
5,000 6,000!

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