BUILD ME A DCF FOR VALUATION

You said build me a DCF!

A DCF is a Discounted Cash Flow model to calculate the enterprise value of a company used for business valuation. One of the three approaches currently used are (i) cost approach, (ii) market approach, (iii) Intrinsic value (DCF).

Few fun facts 

-> Value depends on the quantity and timing of future cash flows. We convert all future cash flows to present value using a discount rate. So the projected cash flow and the discount rates are important components.

->  Methodologies:

o  Market view: Comparable approach

o  Buyer view: recent transactions

o  Your view: DCF

-> For cash flow, we need to use the unlevered free cash flow (“UFCF”) and the Weighted Average Cost of Capital (“WACC”) to determine an enterprise value or EV, but why?

o  UFCF is cash flow available to all capital providers

o  WACC is also the cost of capital for all capital providers.

The EV is calculated as the quotient of cash flow available to all capital providers by the cost of capital available to all capital providers or UFCF/WACC. The numerator and denominator represent all capital providers.

-> Two parts in a typical DCF model: (i) discrete forecast and (ii) terminal value

o  Discrete forecast: the Company grows faster than the economy, then growth slows down as more competition enters the market, and eventually the Company reaches a steady pace that growths in line with the economy.

o  Terminal value: that is the steady pace of the Company in line with the economy. We use a growing perpetuity formula to value the perpetual growing cash flows.

-> First approach for terminal value is the growing perpetuity approach by taking UFCF on year 6 (assuming discrete cash flow forecast is over 5 years) and applies the formula UFCF (year 6)/ (WACC-perpetual growth rate). The perpetual growth rate is the long-term, constant growth rate of a company’s FCF beyond the explicit forecast period. Most models would use a conservative 2% rate.

-> Enterprise value (“EV”) is the market capitalization (“equity value”) + net debt 

-> Net debt is the interest-bearing debt (current and long-term) minus the cash as the cash remaining is assumed to repay the outstanding debt.

->  Model design is critical as it will help you save time and includes inputs, calculations and outputs. You need to thoroughly understand your business and the business drivers as these will be tested for sensitivity throughout the model.

-> Models are important tool for decision making and should include a dashboard to improve communication of the outputs to your audience.