valuation discounted cash flow analysis

7/23/2019 Valuation Discounted Cash Flow Analysis

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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. Let’s look at how to perform one.

f 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 !"#$%&

n short, a "#$ analysis can be ad'usted to a very specific situation, whereas

comparable companies and other forms of valuation are more generic.

$or e(ample, a private e)uity 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 ac)uirer — may be able to reali*e significant cost savings in

a merger and thus be willing to pay more than a + firm that cannot reali*e such

savings.

#ost savings such as these can be incorporated into a "#$ analysis in a way that other

forms of valuation cannot. Thus, a "#$ model can be used to determine the upper endof a negotiation range for ac)uiring a company.

The Big Picture

-o how do we get started with a "#$ analysis& The concept is simple we forecast the

company’s free cash flows and then discount them to the present value using the

company’s weighted/average cost of capital !0A##%.

$orecasting free cash flows and calculating 0A##, however, can be a bit more

complicated. To illustrate a "#$ analysis, let’s look at a hypothetical private discount

retail company. 0e’ll forecast its free cash flow, calculate its 0A## and determine its

valuation.

Forecasting Free Cash Flow

$orecasting 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



0hat is the outlook for the company and its industry&

0hat is the outlook for the economy as a whole&

s there any factors that make the company more or less competitive within its

industry&

The answers to these )uestions will help you to ad'ust revenue growth rates and BT

margins for the company. $or our hypothetical company, let’s assume a normal

economic outlook for the future, a positive outlook for the industry and an average

outlook for our company.

1iven these assumptions, we can simply look at our company’s historical

performance and continue this performance out into the future. Looking at our

company’s revenues for the past three years, we can calculate the compound annual

growth rate !#A12% and use it to forecast revenue for the ne(t five years. The

formula for calculating #A12 is

!3ear 4 2evenue53ear 6 2evenue%7!658 3ears of 1rowth%/6

9e(t, let’s calculate the company’s BT margin so that we can forecast earnings

before interest and ta(es. The formula for BT margin is simply BT over

2evenues. To forecast BT we simply multiply our forecasted revenues by our BT

margin.

The Taxman Cometh

To get to free cash flows, we now need to forecast ta(es and make certain

assumptions about the company’s needs for working capital and capital e(penditures.

0e calculate our company’s ta( rate by dividing the company’s historical ta(e(penses by its historical earnings before ta(es !BT less interest e(pense%. 0e can

then forecast ta( e(penses by multiplying the ta( rate by our forecasted BT for each

year.

:nce we have after/ta( income forecasted !BT ; ta(es%, we need to add back

depreciation and amorti*ation, subtract capital e(penditures and subtract working

capital investments. 0e can forecast depreciation and amorti*ation e(penses by

calculated their percentage of historical revenues and multiplying that percentage by

forecasted revenues.



#apital e(penditures are made to upgrade depreciating e)uipment and invest in new

assets and e)uipment for growth. Although capital e(penditure is typically higher than

depreciation and amorti*ation for growing companies, we will make the simple

assumption that capital e(penditure is e)ual to depreciation and amorti*ation in order

to forecast capital e(penditures in the future.

$inally, we need to forecast working capital investments. n 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. $or our model we will assume that working capital

needs to grow by 6< of revenue, therefore our working capital investment forecast

would simply be 6< multiplied by our forecasted revenues.

0e can now get to free cash flow by adding depreciation and amorti*ation to after/ta(

income and subtracting capital e(penditure and working capital investment.

Terminal Value

f we were to take the net present value of these cash flows, we would be grossly

understating the value of the company. 0e would be leaving out the value of the

company’s cash flows beyond five years. n order to capture this value, we need to

calculate the company’s terminal value !the value of the company in year five or the

last year in our "#$ analysis%.

Terminal value can be calculated a couple of ways — with a perpetuity calculation or

an e(it multiple calculation. The perpetuity calculation is like a mini "#$ analysis of

the company’s cash flows off into infinity. The calculation of the perpetuity value is as

follows

#ash $low in Terminal 3ear 5 !0A## ; Long/Term 1rowth%

The e(it multiple method is similar to a comparable companies analysis. 3ou pick a

valuation multiple for data point you have forecasted and multiply it by the data point

to get the company’s valuation at that point in time.

-ince we haven’t yet calculated our company’s 0A##, we’ll use the e(it multiple

method and simply multiply our BT value in year five by a multiple of seven to



calculate our terminal value. 0e can get an accurate multiple for our company by

pulling a few public comps and seeing where the range of multiples currently falls in

today’s marketplace.

$inally, we add this terminal value to our cash flow in year five to get our five years

of free cash flows. 9ow all we need to do is discount these cash flows by the

company’s 0A## to determine the enterprise value.

Taking a WACC

The weighted average cost of capital or 0A## represents weighted average price a

company must pay for debt or e)uity capital. The formula for 0A## is

straightforward

0A## = #ost of "ebt > "ebt 5 !"ebt ? )uity% ? #ost of )uity > )uity 5 !"ebt ?

)uity%

The weightings of capital in this e)uation are very easy to calculate based on the

company’s current balance sheet. The cost of debt is a little more involved, but pretty

straightforward, but the cost of e)uity calculation can be difficult.

$or 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. 3ou would also need to look

at the rate paid on each piece private debt on the company’s balance sheet. 3ou then

take the weighted average of all these yields and rates to come up with company’s

cost of debt.

-ince our hypothetical discount retail company only has private debt, we can calculate

it’s cost of debt by dividing its last year of interest e(penses by the average of its debt balances from the current year and the previous year.

Cost of !uity

The cost of e)uity in our 0A## computation can be represented by the capital asset

pricing model !#A+@%

e = 2f ? Beta !market risk premium% ? !other company/specific premiums%



n this e)uation, e is the cost of e)uity 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 .-. treasury market. :ther premiums might include a Csmall cap premiumD or a

Cprivate company premium.D

The market risk premium as well as other premiums are often taken from a source

such as bbotson. n general the market risk premium is usually somewhere between E

and F<. The risk free rate is usually assumed to be a medium/term .-. treasury yield

!6/6G years%.

#alculating Beta is the fun part. -ince 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 inde( such as the -H+ IGG. $ortunately, many stock

information services such as Bloomberg or 3ahoo $inance have already calculated

Beta for stocks.

The problem with these Betas is that they are levered Betas. 0e need an unlevered

Beta for our cost of e)uity 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 ac)uirer 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

company’s value.

"nle#ering a Beta

nlevering a Beta can be a tricky process. The formula for an unlevered Beta is as

follows

nlevered Beta = )uity Beta 5 J 6 ? !6 ; ta( rate% > "ebt 5 )uityK

The e)uity Beta would be the Beta you get from 3ahoo $inance on the ey -tatistics

page. 3ou can calculate the company’s ta( rate by dividing ta( e(penses by before ta(

income on the company’s income statement. "ebt is the company’s total debt. )uity

in this case is the market value of the company’s e)uity — its market capitali*ation.

Beta Com$s



As if calculating an unlevered Beta were not tricky enough, our hypothetical company

is private, and therefore, we can’t calculate a Beta since it is not publicly traded.

nstead, we must analy*e industry comparables to find and average or median

unlevered Beta as an appro(imation for our company’s Beta.

0hat this means is that we need to look up public comps for our company, calculate

each of their unlevered Betas and take an average. -ince our company is a discount

retailer, we’ll use 0al/mart, Target, #ost#o and B’s as our comps.

9ow that we have an appro(imation for our company’s Beta, we can plug all our

variables into capital asset pricing model to calculate our cost of e)uity. 0e can now

take the weighted average of our cost of e)uity and cost of debt using our 0A##

formula to calculate our company’s weighted average cost of capital.

%et Present Value

9ow that we have our free cash flows forecasted and our 0A## calculated, we can

calculate the net present value of these cash flows using 0A## to get our company’s

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

+resent Malue = $uture Malue 5 !6 ? "iscount 2ate% 7 9umber of periods

$or our cash flows, the future value will be the free cash flow that we pro'ected for

each year. The discount rate will be e)ual to 0A##. And the number of periods will

correspond to the year of each cash flow !year five cash flow e)uals five%.

$ortunately, (cel has an 9+M function we can use in which we can simply referenceour rate !0A##% 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 company’s

enterprise value, people often want to determine the e)uity value of a company

because that is the value to which owners can lay claim. The e)uity value is simply

the enterprise value less total debt !including preferred and minority interests% plus

cash. n 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 company’s sale.



As you may guess, a discounted cash flow analysis can be highly sensitive to the

assumptions that you make. 3ou may want to include a sensitivity table at the end of

your analysis that looks at changes in 0A## and perhaps revenue growth or your

terminal value multiple to see how the valuation changes if these values are different.

Again, a "#$ analysis is one method of valuing a company that has its advantages

and disadvantages. n most cases you should attempt to perform a variety of valuation

methods — comparable companies, precedent transactions or "#$ — to make an

informed determination of a company’s value.

valuation discounted cash flow analysis

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