Discounted cash flow (DCF) analysis is one of the most commonly used valuation methodologies. DCF analysis is just another way like comparable company analysis and comparable transaction analysis to estimate the value. DCF 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 discount rate (i.e. Weighted Average Cost of Capital). In other words, the value of a company is derived by discounting projected free cash flows at the company’s cost of capital (required rate of return) to obtain an economic present value of assets called the Enterprise Value of the Company. Subtract the market value of outstanding debt and preference share capital from the present value of assets/enterprise value to get the present value of equity. (Enterprise Value- Net Debt) = Equity value.
Steps in DCF Analysis
1. Calculate Future Unlevered (Free) Cash Flows
- Project the operating results and free cash flows of a business over the forecast period (5-10 Years). Adjust economic cycle impact (i.e. COVID-19 impact)
- Calculate free cash flows
- Measure of cash available to all providers of capital of a business (Equity & Debt). FCF= EBIT-Taxes-/+ Increases/Decrease in working capital+/- Deferred Taxes+ D &A-Capital Expenditures
- Projected income and cash flow streams are free of debt, net of excess cash
- Present value obtained is the value of the assets, assuming no debt, net of excess cash. (Enterprise Value)
- Debt associated with the business is subtracted and excess cash balances are added to determine the present value of Equity (Equity Value)
- Cash flows are discounted at the Cost of capital /Required rate of return calculated as WACC (Weighted average Cost of Capital) or through Build up method.
Note: ** Unlevered Cash flow is the cash available to the business (Equity). The fundamental difference between Levered and unlevered FCF is: While the present value of Unlevered FCF yield a company’s Enterprise Value, the present value of a levered cash flow yields a company’s Equity Value.
2. Calculate the Terminal Value
- The terminal value represents the value of a business at the end of the projection period.
- There are 2 common ways of calculating terminal value
- Exit multiple method: Estimating the exit multiple (i.e. EBITDA X) at the end of the forecast period Assuming that the business is valued/sold in the terminal year is the rate of return that investor
- Growth in perpetuity method- Assumes the cash flows grow at a perpetual rate(forever) that is; TV= FCF in the last projected year*(1+g)/(WACC-g)
- Once calculated, the terminal value is discounted back to the appropriate date using the relevant discount rate
3. Determine the Discount Rate
- The discount rate is the rate of return that an investor expects. Investment may be in 100% equity or the combination of Debt and Equity and hence it is basically the cost of equity and debt. The expected cost or rate of return includes risk premium.
- Discount rate can be ascertained either based on CAPM (Capital Asset Pricing model) or WACC (Weighted Average Cost of Capital).
- The Cost of Equity or required rate of return in the CAPM model is a function of three inputs: The risk-free rate, the risk premium on the market portfolio, and the beta of the equity investment being assessed. That is: Expected Return= Risk-free Rate+ Bm (Risk Premium on market Portfolio). Bm being the beta,
- Since the firm can rase its money from three sources- Equity, Debt, and Preferred Stock- the Cost of Capital is defined as the weighted average of each of these costs. WACC=WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)].
Whereas:
| E = Market value of the company’s equity | ||
| D = Market value of the company’s debt | ||
| V = Total Market Value of the company (E + D) | ||
| Re = Cost of Equity | ||
| Rd = Cost of Debt | ||
| T= Tax Rate |
Note: Because interest is tax deductible, the true cost of debt is the after-tax rate due to the ability of interest expense to shield taxes. The tax rate used should be the marginal tax rate for each specific company
- The WACC, an important assumption in DCF analysis, represents the required rate of return of an investment given the risk associated with the business as they relate to achieving future projected cash flow and an optimum capital structure.
4. Calculate Present Value of FCF and Terminal Value.
- Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present
- The present value calculation takes into account the cost of capital by placing greater value on those cash flow streams generated earlier in the projection period vs later cash flows. Since most businesses do not generate all of their FCF on the last day of the year, but rather in a generally continuous basis throughout the year, present value calculations of FCF are sometimes made using a “midyear convention”, which takes into account the fact FCF occur throughout the year.
- To derive the present value of Terminal Value, TV is discounted back to the present date using the Discount rate. Assuming WACC is the discount rate, PV of Terminal Value= TV (calculated above)/(1+WACC) ^last projection year
The Calculated Enterprise Value is before the adjustment of DLOM (Discount for Lack of Marketability) and Key Person Discount mainly for Non-Listed companies and privately held companies.
Note:
- The Annual discount rate is also dependent on the stages of development of the company: (IDEA Stage, Development Stage, Start-Up Stage and Expansion Stage)
- Expected VC Returns vary by their financial commitment and the financial condition of the company
- There are Cost of capital database including Cost of capital- NYS, Pitch book and other third-party data source.