A Primer on Discounted Cash Flow Analysis

Discounted Cash Flow (DCF) Analysis yields the theoretical valuation of a firm. The concept behind a DCF
analysis is that the value of a company is based on the present value of the cash flows that it can generate in
the future. The technical term commonly used is “Intrinsic Value”.
A DCF valuation has three major components:
1) A discount rate, called the weighted average cost of capital (WACC), which we will use to discount the
future cash flows and the terminal value back to their present value;
2) Forecasting cash flows or, more precisely, unlevered free cash flows;
3) A terminal value of the company.
Let’s take each of these in turn:

1) Weighted average cost of capital

In a DCF analysis, a company’s value is determined by estimating its future free cash flows over several
years (i.e. 5 – 10 years), then discounting those cash flows back to the present, using a risk factor called
the weighted average cost of capital (WACC). WACC captures the risk of those future cash flows and
reflects the cost of the company’s equity capital (cost of equity) and of its debt capital (cost of debt). You
can also think of WACC as the blended rate of return that the company’s equity and debt investors require
to compensate them for the risk of investing in the company. The formula for weighted average cost of
capital (WACC) is illustrated below:
Cost of
Debt
Where:
After tax
X
cost of debt • The tax rate is the marginal rate
1 – Tax rate X
Weighted cost • The risk-free rate is typically the yield
of debt
Percentage
on the 10-year U.S. Government Bond
of debt
Weighted Average
• Beta measures the volatility of a
Risk free
rate + Cost of Capital company’s stock price compared to the
(WACC) overall market
Percentage
+ of equity • Market risk premium is the rate of
Weighted cost
Beta X
of equity
return in the market minus the risk-free
Cost of rate. For example, the historical U.S.
X
equity market risk premium is often in the
Market risk
premium
range of 5.0% to 7.0%

2) Unlevered free cash flow

Unlevered free cash flow is cash available to capital holders before debt holders are paid. “Free” implies
that it is the cash flow in excess of what is needed to fund the company’s operations. Loosely translated, it
is the cash flow after taxes are paid, capital expenditure requirements are met, and working capital needs
are satisfied.
Historical Projected
FYE-2 FYE-1 FYE FYE+1 FYE+2 FYE+3 FYE+4 FYE+5
Sales $7,385.0 $7,998.0 $7,586.0 $7,705.5 $7,826.8 $7,950.0 $8,075.2 $8,202.4
Cost of goods sold 4,121.0 4,549.0 4,272.0 4,339.3 4,407.6 4,477.0 4,547.5 4,619.1
Gross Profit 3,264.0 3,449.0 3,314.0 3,366.2 3,419.2 3,473.0 3,527.7 3,583.3
Selling, General and Administrative 1,808.0 1,885.0 1,782.0 1,810.1 1,838.6 1,867.5 1,896.9 1,926.8
EBITDA 1,456.0 1,564.0 1,532.0 1,556.1 1,580.6 1,605.5 1,630.8 1,656.5
Less: Depreciation (263.0) (271.0) (264.0) (297.9) (315.0) (332.6) (350.7) (369.3)
Less: Amortization 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
EBIT 1,193.0 1,293.0 1,268.0 1,258.3 1,265.6 1,272.9 1,280.1 1,287.2
Less: Taxes @ 36.7% (437.9) (474.6) (465.4) (461.9) (464.6) (467.2) (469.9) (472.5)
Tax-effected EBIT 755.1 818.4 802.6 796.4 801.1 805.7 810.2 814.7
Plus: Depreciation and amortization 271.0 264.0 297.9 315.0 332.6 350.7 369.3
Less: Capital expenditures (298.0) (345.0) (350.4) (356.0) (361.6) (367.2) (373.0)
Less: Additions to intangibles 0.0 0.0 0.0 0.0 0.0 0.0 0.0
(Increase)/decrease in w orking capital (119.0) (59.0) (3.9) (4.0) (4.1) (4.1) (4.2)
Unlevered Free Cash Flow $672.4 $662.6 $739.9 $756.1 $772.7 $789.6 $806.8

In practice, finance professionals typically select a forecast period of 5 to 10 years. The length of the
projection period depends on the characteristics of the company and its industry. The main consideration
for determining the length of this period is when the company will reach a “steady state.” One steady-state
indicator is when a company is sustaining its capital investment – that is, all the company’s new spending
goes simply to replacing the fixed assets that they are losing each year from depreciation. This implies that

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 the business is only replacing existing fixed assets in order to sustain its current levels of production, rather
than investing in new or additional property, plants or equipment. Another sign of steady-state operations
is when the company’s working capital or short-term operating cash flows have stabilized.
3) Terminal value of the company
The terminal value of a company represents the present value of the sum of the additional cash flows
beyond the forecasted period. Two methods are widely used to project the terminal value:
a) The Terminal Multiple Method: This assumes that at the end of the forecast period, the company is
worth a lump sum that is calculated as a multiple of an operating metric, e.g., a multiple of EBITDA:

Terminal Value = multiple x EBITDAn

Where
• n equals the final year of the forecast period
There are many important factors to consider when determining the terminal multiple. Most practitioners
begin with the current trading multiple, then examine whether that multiple is sustainable and reasonable. If
it is not, they adjust reflect the estimated multiple in a mature-state and in a normal economic environment.
b) The Perpetuity Growth Rate Method: This assumes that the company’s free cash flows will grow at a
moderate, constant rate indefinitely:
Where
FCFn x (1 + g) • FCF is the normalized free cash flow in period n
Terminal Value =
(r - g) • g is the nominal perpetual growth rate, and
• r is the discount rate or WACC
The nominal perpetual growth rate (g) is the company’s sustainable long-run growth rate. This rate can be
higher than inflation but should not exceed the growth rate of the overall economy. Rates vary by situation
and company, but the typical range is 2% to 5%.
Getting to a per share value:
PV of PV of The present value of unlevered free cash flows
Free Cash Flows Terminal Value plus the present value of the terminal value
gives you the enterprise value of a firm. To
derive equity value from enterprise value,
Enterprise subtract net debt.* For a public company, most
Value professionals will calculate down to equity
value per share, so that they can compare the
Net Debt* calculated intrinsic value to the current share
price.
Diluted Shares
Equity Equity Value
To calculate equity value per share, take the
Value Diluted Shares total equity value calculated above and divide it
by the number of diluted shares outstanding.

Conclusion
There is no single right answer when doing a DCF analysis, but there are simple steps one can take to improve
the quality of the analysis. First, use reasonable and defensible assumptions for your forecasted period. The
starting point for assumptions is usually management, consensus estimates, historical analysis or based on
performance of peers. Second, consider materiality when you are trying to develop your assumptions; what is
the impact on the final output? Third, there is no perfect WACC or terminal multiple to use, but observe
industry averages as a sanity check which can be sourced from equity research reports. Fourth, compare your
final equity value per share to the current stock price and calculate the implied CY+1 P/E multiple and compare
against the peer group to build confidence around your assumptions. If your assumptions reflect general
market consensus, then your implied share price should be within a reasonable range of the current share
price. Finally, because a DCF analysis has so many variables, your final equity value per share should be
shown as a range rather than as one single number in order to account for some variability in those
assumptions.

* In this example, net debt refers to all interest-bearing liabilities, plus the value of preferred stock, plus the value on any non-controlling interest
(often called minority interest), less all cash and cash equivalents.

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