discounted cash flow

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  • 1. Project TrainingDiscounted Cash Flow

2. Learning Objectives DCF Analysis Understand the theoretical basis of a DCF Understand the weighted average cost of capital Understand the different terminal value approaches: Terminal Multiple method Perpetuity Growth method Derive an implied valuation range Application: Construct a DCF & WACC model[2] 3. What is a Company ultimately worth? Cash in the investors pockets[3] 4. Two Key Questions of DCF How much cash? When investors receive it?[4] 5. What is a DCF Analysis? Intrinsic value of the company Theoretical vs. relative value Base on unlevered free cash flows (FCFs) Independent of capital structure Free cash flows available to all capital holders Value equals the sum of the present values (PV) of: (1) Unlevered free cash flows & (2) Projected terminal value Estimated value beyond the forecast period PV calculated by on a discount rate Typically, weighted average cost of capital (WACC)[5] 6. Advantages of a DCF Valuation Intrinsic value based on projected FCFs Flexible, adaptable analysis How do changes in projections impact value? Growth rates Operating margins Synergies, expansion plans, etc. Objective calculation (through PV) Requires scrutiny of key drivers of value Always obtainable[6] 7. Challenges of a DCF Valuation*DCF results should be presented as a RANGE of estimated values not a single estimate! Cash flows from forecasts Possible bias (run sensitivities) Reliability Subjective valuation Based on numerous assumptions Highly sensitive to changes in: FCFs: growth rates & margins assumptions Estimated terminal value Assumed discount rate (beta, market conditions)[7] 8. Methodology Steps for a DCF1. Estimate the Cost of Capital2. Forecast Free Cash Flows (FCFs)3. Calculate the Present Values of FCFs4. Estimate the Terminal Value5. Derive an Implied Valuation Range[8] 9. Sources for Forecasting Free Cash Flow Use standalone model projections for DCF and FCF projections Alternative cases to assess: Upside potential Downside risk Synergies usually treated as separate analysis Consider "steady state" forecast horizon Cash flows can be "sustained forever" (stable growth) Generally viewed NOT to exceed economys growth rate[9] 10. "Multi-Stage" Projections Forecast horizon potentially can be in stages Concept: Slow growth over time to steady-state How long does it take to achieve steady state? Length varies by industry / situation Does the company have a sustainable advantage? Growth from single product with protected position? Generally speaking: As growth nears stable growth, risk and CAPX needs decline Closer to industry average?[ 10 ] 11. Calculating Free Cash Flow EBITDA Less: Depreciation and amortization = EBIT Less: Taxes (at the marginal tax rate) = Tax-Effected EBIT or NOPAT Plus: Depreciation and amortization +/-: Changes in deferred taxes Less: Capital expenditures Watch your Sources & Uses of Cash! +/-: Changes in net working capital +/-: Changes in other non-cash items = Unlevered Free Cash Flow[ 11 ] 12. What is the Terminal Value? Value of the business beyond the projections Used due to the impractical nature of extended forecast period (i.e., 20 or 30years) Projections ?Yr 0Value - Yr N Value - ??? Two methods:1. Exit Multiple Assumes the business is worth (or "sold") a multiple of an operating statistic at the end of the projections2. Perpetuity Growth Assumes growth of FCFs at constant rate in perpetuity[ 12 ] 13. Exit Multiple Method Value the business as a multiple of a relevant operating statistic "Worth/sold for 8.0x EBITDA at the end of year N Choosing the appropriate Exit Multiple: Multiple of EBITDA, EBIT, etc. Reasonable multiple from comparables, usually current Is the current multiple sustainable? Public Comparables: "worth" a multiple at end of Year N Acquisition Comparables: "sold" for a multiple at end of Year N Do not double count synergies for a potential M&A target if using a separate DCFvaluation of synergies Be wary of cyclical industries Examine ranges and rolling average of EBITDA multiples Valued on pre-tax basis (to investors)[ 13 ] 14. Perpetuity Growth Method Assumes the business grows at a constant rate in perpetuity Consider using "normalized" cash flow in final year Sustaining capital investment (i.e., Depreciation ~ CapEx) Steady state working capital needs Consider no deferred taxes Perpetuity growth formula: Where: FCFn x (1 + g) FCF = normalized free cash flow in period NTerminal Value = g= nominal perpetual growth rate (r - g) r= discount rate or WACC[ 14 ] 15. Which Method to Use - When and Why? Perpetuity Growth Rate: Academically proven approach Exit Multiple: more often used in practice Inherent difficulty in estimating when the company achieves "steady state",perpetual growth rate growth Multiples commonly used for valuation Major considerations: How do you choose the appropriate multiple? Introduces relative value with intrinsic value approach Perpetuity Growth Rate is commonly used by practitioners for: Synergies Mature industries[ 15 ] 16. Equivalent Perpetuity Growth Rate Helpful reality check to analyze the results calculated by Exit Multiple Method:[EBITDAN x Multiple x Discount Rate) FCFN] Equivalent Perpetuity Growth Rate 1 = [FCFN x EBITDAN X Multiple)] Resulting equivalent g should be within a reasonable comfort level 1 Quick, less complex short-cut approximation: Estimated Perpetuity Growth Rate Discount Rate [FCFN+1 /(EBITDAN x Multiple)][ 16 ] 17. Equivalent Exit Multiple Helpful reality check to analyze the results calculated by Perpetuity Growth Rate Method:FCFN X (1 + g) Equivalent EBITDA Multiple = EBITDAN (r g) Resulting "equivalent multiple" should be within a reasonable comfort level Compare with the comparables[ 17 ] 18. Calculate the Enterprise Value +PV ofPV of Free Cash Flows Terminal Value (Discounted @ WACC)(Discounted @ WACC)=Enterprise Value (Firm Value)[ 18 ] 19. Calculate the Equity ValueEnterpriseDebt, Preferred StockEquityValue and Min. Interests + Cash=Value1 Which balance sheet do you? (1) Latest available (2) PV date projected balance sheet Equity ValueDiluted Shares= Equity Value Per Share Typically, use latest available share and option information Ideally, consistent timing with balance sheet items Footnote and use reasonable assumptions 1 For certain companies, it may be appropriate to include equity investments, NOLs or non-operating assets. Such assets not reflected in the cash flows would raise the equity value[ 19 ] 20. Terminal Value as % of Enterprise Value Calculate the PV of the Terminal Value as % of Enterprise Value Another reality check How much of the firms DCF value is derived from value generated beyondthe projected FCFs? Comfort level depends on: Company and industry Situation Forecast horizon[ 20 ] 21. The Final DCF Analysis Compare DCF result with current stock price Derive a reasonable, defensible range Range of discount rates Range of exit multiples / perpetuity growth rates Weigh DCF results more heavily when comparables analyses are not as applicable No "pure play" public comps or acquisition comps Common to see various scenarios ("cases")[ 21 ] 22. Basis of Mid-Period Convention Acquisition occurs on December 31, 20X0Key:Periods 1-5 Cash Flows Fiscal year end of December 31 Assumes mid-year cash flows Discount rate of 10%Discount back Discount back Discount back Discount backDiscount back0.5 years 1.5 years 2.5 years 3.5 years4.5 years 12/31/20X0 12/31/20X112/31/20X212/31/20X312/31/20X412/31/20X5 Basis for the mid-period convention: Valuation date: Cash flows are generated more or less continuously DURING the period, not at the end of the period. Mid-period convention moves each cash flow from the END of the period to the MIDDLE of the same period. Q: What is the impact of the valuation?[ 22 ] 23. Terminal Values & Mid-Period Convention Perpetuity growth method: "FCFN" means FCF during period "N" is received at "N - 0.5" with the mid-periodconvention Continuous flow consistent with other forecasted free cash flow periods Discount back "N - 0.5" periods Use MID-PERIOD FCFN X (1 + g) (r g) X (1 + r) Terminal Value forPerpetuity growth method Exit multiple method: Assumption: Business sold or valued at the end of period "N" Discount back "N Common to use end-periodEBITDAN X Multiple (1 + r)N Terminal Value forExit multiple method[ 23 ] 24. Equivalent Multiples and Growth Rates To equate implied multiples and growth rates when using the mid-periodconvention, grow the perpetuity growth rate method by 1/2 a period FCFN X (1+r) 0.5EBITDA X Multiple = (r g)Equivalent Perpetuity Growth Rate ((EBITDAN X Multiple X Discount Rate) FCFN X (1 + r)0.5)(using mid-period convention) =(EBITDAN X + (FCFN X (1 + r)0.5)Equivalent Perpetuity Growth Rate FCFN X (1 + g) X (1 + r)0.5)(using mid-period convention) =EBITDAN X + (r - g)[ 24 ] 25. What are Synergies? Financial benefits arising from a merger 3 main areas to consider: 1. Net incremental revenues (net of costs to achieve) 2. Cost savings 3. Merger outlays (severance, additional CapEx) Sources of synergy projections Management Research Estimates from comparable acquisitions (e.g., "5.0% of Target sales")[ 25 ] 26. How Do You Value Synergies? DCF valuation of the synergies Project the synergy cash flows Terminal value via perpetuity growth rate method Value on an independent basis from the standalone DCF Create a "DCF with synergies" value Standalone DCF value + synergies DCF value Do NOT double count the control premium in the standalone DCF terminal value[ 26 ] 27. Some Synergy DCF Considerations 1. Progression of the phase in Achieving full potential does not happen in one year 2. Percentage realization Common to see 50% & 100% realization cases 3. Tax-effect the operating income impact At the marginal rate 4. Factor in costs to achiev