Valuation: Discounted Cash Flow Analysis

There are many ways to go about valuing a company and each has its strengths. A
comparable companies analysis or precedent transactions analysis may be a good
determinant of market value that is, what a company will actually sell for. But a
discounted cash flow analysis has its strengths too. Lets look at how to perform one.
If there are simpler valuation methods out there that give accurate estimates for the
value of a company, why do we need to use a discounted cash flow analysis (DCF)?
In short, a DCF analysis can be adjusted to a very specific situation, whereas
comparable companies and other forms of valuation are more generic.
For example, a private equity firm that is looking to purchase a company may place a
lower value on it than would another company within the specific industry. Another
company or strategic acquirer may be able to realize significant cost savings in
a merger and thus be willing to pay more than a PE firm that cannot realize such
savings.
Cost savings such as these can be incorporated into a DCF analysis in a way that other
forms of valuation cannot. Thus, a DCF model can be used to determine the upper end
of a negotiation range for acquiring a company.
The Big Picture
So how do we get started with a DCF analysis? The concept is simple: we forecast the
companys free cash flows and then discount them to the present value using the
companys weighted-average cost of capital (WACC).
Forecasting free cash flows and calculating WACC, however, can be a bit more
complicated. To illustrate a DCF analysis, lets look at a hypothetical private discount
retail company. Well forecast its free cash flow, calculate its WACC and determine its
valuation.
Forecasting Free Cash Flow
Forecasting free cash flows is an art. There are many things that can impact cash
flows and as many as possible should be taken into account when making a forecast:

What is the outlook for the company and its industry?

What is the outlook for the economy as a whole?
Is there any factors that make the company more or less competitive within its
industry?
The answers to these questions will help you to adjust revenue growth rates and EBIT
margins for the company. For our hypothetical company, lets assume a normal
economic outlook for the future, a positive outlook for the industry and an average
outlook for our company.
Given these assumptions, we can simply look at our companys historical
performance and continue this performance out into the future. Looking at our
companys revenues for the past three years, we can calculate the compound annual
growth rate (CAGR) and use it to forecast revenue for the next five years. The
formula for calculating CAGR is:
(Year 3 Revenue/Year 1 Revenue)^(1/2 Years of Growth)-1
Next, lets calculate the companys EBIT margin so that we can forecast earnings
before interest and taxes. The formula for EBIT margin is simply EBIT over
Revenues. To forecast EBIT we simply multiply our forecasted revenues by our EBIT
margin.
The Taxman Cometh
To get to free cash flows, we now need to forecast taxes and make certain
assumptions about the companys needs for working capital and capital expenditures.
We calculate our companys tax rate by dividing the companys historical tax
expenses by its historical earnings before taxes (EBIT less interest expense). We can
then forecast tax expenses by multiplying the tax rate by our forecasted EBIT for each
year.
Once we have after-tax income forecasted (EBIT taxes), we need to add back
depreciation and amortization, subtract capital expenditures and subtract working
capital investments. We can forecast depreciation and amortization expenses by
calculated their percentage of historical revenues and multiplying that percentage by
forecasted revenues.

Capital expenditures are made to upgrade depreciating equipment and invest in new
assets and equipment for growth. Although capital expenditure is typically higher than
depreciation and amortization for growing companies, we will make the simple
assumption that capital expenditure is equal to depreciation and amortization in order
to forecast capital expenditures in the future.
Finally, we need to forecast working capital investments. In order to grow the
business, we would need a growing amount of working capital on the balance sheet in
order to achieve higher revenues. This addition of capital to the balance sheet would
result in a negative cash flow. For our model we will assume that working capital
needs to grow by 1% of revenue, therefore our working capital investment forecast
would simply be 1% multiplied by our forecasted revenues.
We can now get to free cash flow by adding depreciation and amortization to after-tax
income and subtracting capital expenditure and working capital investment.
Terminal Value
If we were to take the net present value of these cash flows, we would be grossly
understating the value of the company. We would be leaving out the value of the
companys cash flows beyond five years. In order to capture this value, we need to
calculate the companys terminal value (the value of the company in year five or the
last year in our DCF analysis).
Terminal value can be calculated a couple of ways with a perpetuity calculation or
an exit multiple calculation. The perpetuity calculation is like a mini DCF analysis of
the companys cash flows off into infinity. The calculation of the perpetuity value is as
follows:
Cash Flow in Terminal Year / (WACC Long-Term Growth)
The exit multiple method is similar to a comparable companies analysis. You pick a
valuation multiple for data point you have forecasted and multiply it by the data point
to get the companys valuation at that point in time.
Since we havent yet calculated our companys WACC, well use the exit multiple
method and simply multiply our EBIT value in year five by a multiple of seven to

calculate our terminal value. We can get an accurate multiple for our company by
pulling a few public comps and seeing where the range of multiples currently falls in
todays marketplace.
Finally, we add this terminal value to our cash flow in year five to get our five years
of free cash flows. Now all we need to do is discount these cash flows by the
companys WACC to determine the enterprise value.
Taking a WACC
The weighted average cost of capital or WACC represents weighted average price a
company must pay for debt or equity capital. The formula for WACC is
straightforward:
WACC = Cost of Debt * Debt / (Debt + Equity) + Cost of Equity * Equity / (Debt +
Equity)
The weightings of capital in this equation are very easy to calculate based on the
companys current balance sheet. The cost of debt is a little more involved, but pretty
straightforward, but the cost of equity calculation can be difficult.
For a company with publicly traded debt, you would need to look up the current yield
to maturity for each piece of debt that it has outstanding. You would also need to look
at the rate paid on each piece private debt on the companys balance sheet. You then
take the weighted average of all these yields and rates to come up with companys
cost of debt.
Since our hypothetical discount retail company only has private debt, we can calculate
its cost of debt by dividing its last year of interest expenses by the average of its debt
balances from the current year and the previous year.
Cost of Equity
The cost of equity in our WACC computation can be represented by the capital asset
pricing model (CAPM):
Ke = Rf + Beta (market risk premium) + (other company-specific premiums)

In this equation, Ke is the cost of equity and Beta is a measure of how the value of a
company moves with respect to the value of the overall market. The market risk
premium is the premium that investors demand to invest in the stock market versus
the U.S. treasury market. Other premiums might include a small cap premium or a
private company premium.
The market risk premium as well as other premiums are often taken from a source
such as Ibbotson. In general the market risk premium is usually somewhere between 7
and 8%. The risk free rate is usually assumed to be a medium-term U.S. treasury yield
(1-10 years).
Calculating Beta is the fun part. Since Beta is a measure of how a stock moves with
the overall market, you would calculate it by doing a regression analysis of the stocks
performance against a broad index such as the S&P 500. Fortunately, many stock
information services such as Bloomberg or Yahoo Finance have already calculated
Beta for stocks.
The problem with these Betas is that they are levered Betas. We need an unlevered
Beta for our cost of equity calculation. The reason we need an unlevered Beta is that
the amount of debt or leverage that a company has can affect its Beta. And since a
potential acquirer of a company could choose to significantly alter its capital
structure, we should take out the effect of leverage to have a better sense of the
companys value.
Unlevering a Beta
Unlevering a Beta can be a tricky process. The formula for an unlevered Beta is as
follows:
Unlevered Beta = Equity Beta / [ 1 + (1 tax rate) * Debt / Equity]
The equity Beta would be the Beta you get from Yahoo Finance on the Key Statistics
page. You can calculate the companys tax rate by dividing tax expenses by before tax
income on the companys income statement. Debt is the companys total debt. Equity
in this case is the market value of the companys equity its market capitalization.
Beta Comps

As if calculating an unlevered Beta were not tricky enough, our hypothetical company
is private, and therefore, we cant calculate a Beta since it is not publicly traded.
Instead, we must analyze industry comparables to find and average or median
unlevered Beta as an approximation for our companys Beta.
What this means is that we need to look up public comps for our company, calculate
each of their unlevered Betas and take an average. Since our company is a discount
retailer, well use Wal-mart, Target, CostCo and BJs as our comps.
Now that we have an approximation for our companys Beta, we can plug all our
variables into capital asset pricing model to calculate our cost of equity. We can now
take the weighted average of our cost of equity and cost of debt using our WACC
formula to calculate our companys weighted average cost of capital.
Net Present Value
Now that we have our free cash flows forecasted and our WACC calculated, we can
calculate the net present value of these cash flows using WACC to get our companys
enterprise value. The net present value is the sum of the present values of each of the
cash flows. The formula for present value is as follows:
Present Value = Future Value / (1 + Discount Rate) ^ Number of periods
For our cash flows, the future value will be the free cash flow that we projected for
each year. The discount rate will be equal to WACC. And the number of periods will
correspond to the year of each cash flow (year five cash flow equals five).
Fortunately, Excel has an NPV function we can use in which we can simply reference
our rate (WACC) and the cells for our free cash flows in order to calculate the net
present value.
Although the net present value of free cash flows will determine a companys
enterprise value, people often want to determine the equity value of a company
because that is the value to which owners can lay claim. The equity value is simply
the enterprise value less total debt (including preferred and minority interests) plus
cash. In other words, the owners would have to pay off any debt owed on the
company and would be able to keep any cash left in the event of the companys sale.

As you may guess, a discounted cash flow analysis can be highly sensitive to the
assumptions that you make. You may want to include a sensitivity table at the end of
your analysis that looks at changes in WACC and perhaps revenue growth or your
terminal value multiple to see how the valuation changes if these values are different.
Again, a DCF analysis is one method of valuing a company that has its advantages
and disadvantages. In most cases you should attempt to perform a variety of valuation
methods comparable companies, precedent transactions or DCF to make an
informed determination of a companys value.