3.1a. A Discounted Cash Flow Checklist

Please begin by repeating after me “In the real world, all models are to some extent false”

Types of models

Discounted Equity Cash Flows (DDM or E FCF)R(e) requires beta or some other risk proxy

Discounted Levered Firm Cash Flows (operating cash flow)Interest tax shields remain in the cash flowsValues the entire firmDeduct value of net debt from firm value to get equity valueWACC requires a capital structure assumption, R(e) and R(d)

Discounted Unlevered Firm (Free) Cash FlowsRemove the int. tax shield from operating cash flowsImpute int.tax savings in one of two ways:

1. AT-WACC – the discount rate is adjusted for tax savings2. “Adjusted Present Value”

R(u) estimates discount rate for an unlevered firmPV of interest tax shield is added separatelyHas the virtue of allowing explicit debt modeling but GIGO

Deduct net debt from firm value to get intrinsic equity value

Terminal Value ComputationsConstant growth model at a “terminal,” steady-state, growth rateMultiple of a cash flow proxy (Earnings, EBITDA, Sales etc.)

All models are approximations because the assumptions required for validity are not likely to be met precisely in any application. There are some validity checks. But you should try several models and see if they are close. If not, some of the assumptions are being violated.

Most common errors in application:

1. Applying the wrong discount rate concept (mixing models and discount rates).

2. Assuming a constant capital structure in the discount rate but not modeling this reality in the cash flow process. e.g. the firm’s implicit equity value is growing at a faster rate than the debt value.

3. Failing to account for the impact of a falling debt percentage, if modeled in the cash flow process – if debt percentage falls, R(e) falls and AT-WACC rises.

4. Extrapolating firm level historical growth into future per-share growth. Per-share growth is what drives share value. e.g. a fair value stock acquisition that increases firm earnings but not eps is not meaningful growth. Ignore historical earnings growth and focus on historical eps growth if trying to extrapolate into the future.

5. Relying too heavily on an arbitrary terminal multiple (always provide sensitivity analysis on terminal value)

6. Not modeling maturation carefully to include CapEx and WC stabilization. CapEx should tie back to a reasonable multiple of depreciation.

7. Linking the debt discount rate to historical debt rates although market rates have changed.

8. Not accounting for the beta of debt when determining R(u) from R(e)

9. Using an equity beta estimate that is unrealistic for the long term. Check several sources and account for regression to the mean over time.

10. Failing to countenance market saturation (reconciling revenue growth with market share)