Discounted Cash Flow (DCF) model involves projecting future cash flows and discounting them back to the present using a discount rate that reflects the riskiness of the capital, you then add up all of those discounted cash flows, and the sum is the intrinsic value of the company.
2 Types of cash flows (CF):
Unlevered free cash flow (FCF): before the payment of debts
Levered free cash flow (FCF): after pay down of interest expenses and debt
FCF = Operating profit - Reinvestment (or capital expenditure, CapEx)
Stage 1 of Free Cash Flow Analysis
Period: projected years that company will have stable earnings, usually 5-10 years.
Earnings before interest and taxes (EBIAT) = EBIT x (1 - tax rate)
also called Net operating profit after tax (NOPAT)
Unlevered FCF = EBIAT + D&A + WC adjustments + CapEx
adding back non-cash expenses, subtracting non-cash gains, making accrual adjustments, subtracting CapEx
When you build a CF statement:
an increase in asset = use of cash (-), think of cash/accrual method
AR = Previous year - Forecast year 1
an increase in liabilities or equity = source of cash (+)
AP = Forecast year 1 - Previous year
PV of FCF = Unlevered FCF / (1 + WACC)^period
WACC = see below
Step 2: Terminal Value
Terminal value represents all value beyond the explicit forecast period (i.e. from year 6 onward).
Growth in perpetuity
Exit EBITDA multiple
Terminal value is the value assumed to exist on year 5, hence:
FCF (t+1) = Unlevered FCF on t=5 x (1+ growth rate)
Terminal value = FCF / (WACC - growth rate)
PV of Terminal value = Terminal value / (1 + WACC on t=5)^(t=5)
WACC = see below
Step 3: Weighted average cost of capital (WACC)
Diluted share count: dilution counts for all the different ownership claims, so those claims arising from options, warrants, convertible debt or convertible preferred.
After-tax Cost of debt = Cost of debt x (1 - tax rate)
Interest tax shields: Interest expense is tax deductible for companies and it can reduce taxable income, hence tax rate needs to be recalculated.
Cost of debt - 2 calculation methods:
Company debt: Yield to worst
Comparable company debt: Yield to maturity
Cost of equity - 2 calculation models:
Dividend discount model
Capital asset pricing model (CAPM) = risk free rate (rf) + beta x market risk premium
highly debatable when choosing which model to calculate with because cost of debt is fixed whereas cost of equity is uncertain - it is a combination of potential dividend payments and price appreciation.
Debt holders request 3.1% after tax.
Equity holders demand 15% required rate of return.
Important things to note:
Target capital structure = existing capital structure for mature company
Use market values for debt and equity: for debt use latest year (ex. t=2012) balance sheet numbers available before that valuation date, as book value is an acceptable proxy.
Equity = share price x diluted share count
Debt weighting = debt / total capital
Equity weighting = equity / total capital
Weighted average cost of capital (WACC) = (equity weighting x cost of equity) + (debt weighting x after-tax cost of debt)
blended rate of return for all the capital providers of a company (can include preferred stock if you want to be more accurate).
Step 4: Enterprise value to Equity value
Enterprise value = Sum of Stage 1 + Sum of Stage 2
Net debt = Debt - Cash and cash equivalents (assumption: if you have excess liquidity you can pay off some of that debt)
Equity value = Enterprise value - Net debt
Equity value per share = Equity value / Diluted shares outstanding
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