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 firms life cycle. ***************************** We will focus on the two-stage model FROM TUTORIAL GUIDE SAMPLE PAGES in this course, given its prevalence in practice.
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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 rg

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.
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Modeling unlevered free cash flows

Arriving at unlevered free cash flows from EBIT: Free cash flow calculation
EBIT (Operating income) EBIT (1 tax rate) (Tax-effected EBIT, EBIAT or NOPAT) Plus: Depreciation and amortization Less: Increases in working capital assets2 Plus: Increases in working capital liabilities Less: Increases in deferred tax assets Plus: Increases in deferred tax liabilities Less: Capital expenditures Less: Other required investments Equals: Unlevered free cash flows Footnote calculating levered free cash flows When valuing financial institutions, levered FCFs are projected to arrive at equity value directly. Projected income and cash flow streams are after interest expense and net of any interest income: Net income - Increases in working capital +/- Deferred taxes + D&A ***************************** expenditures - Capital +/- Net SAMPLE PAGES FROM TUTORIAL GUIDEborrowing Levered FCF 6 For illustrative Purposes Only

Historical
Income Statement (10-K / 10-Q / PR / Company) Use normalized EBIT Use effective tax rate CFS / IS / Footnotes

Projections
Analyst research Company Internal projections Use marginal tax rate Analyst research Company Internal projections

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Modeling unlevered free cash flows

Always remember to: Footnote assumptions in detail Test your assumptions Use consistent cash flows and costs of capital

Reference from core model

Input WACC of 10% for now. ***************************** We will calculate wacc shortly. SAMPLE PAGES FROM TUTORIAL GUIDE For illustrative Purposes Only *****************************

Calculation = days post-deal date / 365

Discounting to reflect stub year and mid-year adjustment

Discount free cash flows back to the present

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Terminal value using growth in perpetuity approach

Mid-year adjustment The mid-year adjustment also applies to the growth in perpetuity formula, which otherwise assumes all future cash flows are generated at year-end.

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Calculating net debt

From enterprise value to equity value Now that we calculated enterprise value (read the DCF value of operations), our focus shifts to calculating equity value. Add non-operating assets First, all non-operating assets (typically excess cash and other investments) must be added to the enterprise value. Why? Understand that we just calculated expected cash flows generated from the operating assets of the business Short-Term Debt the cash flows related to non-operating assets (i.e. + Current Portion of LT Debt interest income) were not reflected in the FCF calculation. + Long-Term Debt + Minority Interest Instead the book value of these assets (as identified on the most recent 10-K or 10-Q) is typically used as a proxy + Preferred Stock + Leases for the intrinsic value of these assets (the book value of (Cash + Investments) cash is, after all, typically the market value of cash, right?) Net Debt Subtract non-equity claims Next, all non-equity claims (debt and equivalents) must be subtracted to identify what the equity in the business is. Net Debt Include all non-equity claims on the business that have not been accounted for in the calculation of FCF. Common items are debt, preferred stock, minority Equity interests, leases. ***************************** Value Use the book values of thesePAGES FROM TUTORIAL GUIDE SAMPLE items as proxies for the market value unless instructed otherwise.
Net Debt is defined as:

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Calculating net debt

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Shares outstanding using the treasury stock method

Total $ proceeds In-the-$ shares x avg. strike price Calculate option proceeds using the SUMPRODUCT function Total shares repurchased Proceeds / current share price

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Modeling the weighted average cost of capital (WACC)

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Modeling the weighted average cost of capital (WACC)

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Modeling the weighted average cost of capital (WACC)

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Modeling the weighted average cost of capital (WACC)

Now we can relever the weighted average industry beta

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Modeling the weighted average cost of capital (WACC)

and calculate the cost of equity

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Modeling the weighted average cost of capital (WACC)

and the weighted average cost of capital

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Modeling synergies

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