DCF DCF ModelingModeling - Amazon S3 · DCF in theory and in practice • The DCF valuation...

DCF DCF ModelingModelingCopyright 2008 © by Wall Street Prep, Inc.Copyright 2008 © by Wall Street Prep, Inc.

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SAMPLE PAGES FROM TUTORIAL GUIDE

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http://www.wallstreetprep.com

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 methodShares 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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• 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.

• There is no consensus on implementation – controversies predominantly over the estimation of the cost of equity.

DCF in theory

DCF in practice

For illustrative Purposes Only3

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.

• 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 firm’s life cycle.

• We will focus on the two-stage model in this course, given its prevalence in practice.

Two-stage DCF model is prevalent form

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Valuet = FCFt

(1 + r)tt=1

t=n

Stage 2: Terminal value

• We cannot reasonably project cash flows beyond a certain point.

• As such, we make simplifying assumptions about cash flows after the explicit projection period to estimate a terminal value that represents the present value of all the free cash flows generated by the company after the explicit forecast period.

Stage 1: Free cash flow projections

• What is the projected operating and financial performance of the business?

• Typical projection period is 5-10 years

• How do we calculate free cash flows

Two-stage DCF model

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(1 + r)t=1

Valuet = FCFt+1

r – g

• Analysts use both the perpetual growth and exit multiple methods to estimate terminal value

Exit EBITDA x multipleValuet =

Discount rateBoth stages should be discounted to the present using a rate that appropriately reflects the cost of capital (much more on this later)

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� 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 income statement.

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Free cash flow calculation Historical Projections

EBIT(Operating income)

•Income Statement (10-K / 10-Q / PR / Company)•Use normalized EBIT

Analyst researchCompanyInternal projections

EBIT (1 – tax rate)(Tax-effected EBIT, EBIAT or NOPAT)

Use effective tax rate Use marginal tax rate

Plus: Depreciation and amortizationLess: Increases in working capital assets2

Plus: Increases in working capital liabilities

CFS / IS / Footnotes Analyst researchCompanyInternal projections


Arriving at unlevered free cash flows from EBIT:


Plus: Increases in working capital liabilitiesLess: Increases in deferred tax assetsPlus: Increases in deferred tax liabilitiesLess: Capital expendituresLess: Other required investments

Internal projections

Equals: Unlevered free cash flows

Footnote – calculating levered free cash flowsWhen 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 - Capital expenditures+/- Net borrowingLevered FCF

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Reference from core model

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



Calculation= days post-deal date / 365

Input WACC of 10% for now. We will calculate wacc shortly.*****************************


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Discounting to reflect stub year and mid-year adjustment


Discount free cash flows back to the present

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Mid-year adjustment

Terminal value using growth in perpetuity approach


Mid-year adjustmentThe 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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Net Debt is defined as:

Short-Term Debt + Current Portion of LT Debt+ Long-Term Debt

• Why? Understand that we just calculated expected cash flows generated from the operating assets of the business – the cash flows related to non-operating assets (i.e. interest income) were not reflected in the FCF calculation.

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.

For illustrative Purposes Only 10

Equity Value

Net Debt

+ Long-Term Debt+ Minority Interest + Preferred Stock + Leases – (Cash + Investments)Net Debt

interest income) were not reflected in the FCF calculation. • Instead the book value of these assets (as identified on

the most recent 10-K or 10-Q) is typically used as a proxy for the intrinsic value of these assets (the book value of cash is, after all, typically the market value of cash, right?)

Subtract non-equity claims• Next, all non-equity claims (debt and equivalents) must be

subtracted to identify what the equity in the business is. • 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 interests, leases.

• Use the book values of these items as proxies for the market value unless instructed otherwise.

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Total $ proceeds

• In-the-$ shares x avg. strike price

• Calculate option proceeds using the SUMPRODUCT function

Total shares repurchased

Shares outstanding using the treasury stock method


Total shares repurchased

• Proceeds / current share price

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Now we can relever the weighted average industry beta…

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…and calculate the cost of equity…


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…and the weighted average cost of capital


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Modeling synergies


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Copyright2008 Wall StreetPrep, Inc. All rights reserved. "Wall StreetPrep", "Wall Street Prep", "The EDGE Self Study Program", and various marks are trademarks of Wall Street Prep, Inc.


DCF DCF ModelingModeling - Amazon S3 · DCF in theory and in practice • The DCF valuation...

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