If you are a budding investment banker or financial services professional, it is very likely you will be asked what a Discounted Cash Flow Analysis is during an interview or Assessment Centre. Do not be caught off guard. Know your stuff!
A DCF Valuation is a method used to calculate the value of a company at any given time. It does this by projecting out future Cash Flows and converting them to their present value (because, due to inflation, £100 in 5 years is worth less than £100 today).
In this article we will go over the theoretical process for doing a DCF. I have intentionally used the word theoretical to emphasise that in practice, DCFs can be tricky. It can be hard to get numbers, make certain assumptions or understand what extra pieces of a business should go into the valuation.
An important concept to know before you conduct a DCF analysis – or any analysis for that matter – is that you should not get too focussed on the specifics; look at the broader picture. If you can’t, for instance, calculate the optimal Debt-to-Equity ratio for your company, just use the current Debt-to-Equity ratio – it’s not a huge deal. This article condenses DCF Valuation into 12 steps.
So, without further ado, here we go.
Step 1: Read, read, read!
Most people think that a DCF analysis is just taking numbers from financial statements and crunching them. Before you even open Excel, you must have a solid understanding of the business, industry, economy and future expectations of the company. The reason for this is that it helps you create a narrative. You want to be able to understand what the key drivers are for the business and what kind of things will affect it going forward. In your DCF analysis you will have to make numerous assumptions. For instance, you have to assume the growth rate of the company over the following 5-10 years. How can you know this without understanding the firm’s business model, market structure, culture, etc? Reading about the company will allow you to build up your knowledge for these assumptions.
So, what kind of things can you read? Look at the company’s Form-10K first. This is a regulated document companies are required to submit containing information on the last financial year. Read the sections explaining the business itself and its industry. Then look at its financial results: Balance Sheet, Income Statement and Cash Flow Statement. Look over these for any anomalous results, comparing them to the previous year’s results. Make sure to read over the notes (as you read each line item on the statements), which tell you how they arrived at those figures. Then look for legal issues for anything that could result in material loss for the company. Another important aspect is the Board of Directors. If it is filled with acquaintances of the CEO then there will be little resistance to poor decisions made by him or her.
You can find the 10Ks on the SEC (American companies) or Companies House (UK companies) website.
Other resources in your arsenal include 10-Qs, news articles and annual reports, among other things. Understand their culture and the general market sentiment. Look at how management are talking to shareholders. Do they present information as it is or do they spin and doctor the information? It says a lot about the corporate governance of the company.
This is the one part of DCF analysis which will be most effective in putting you ahead of the crowd. Creating an adequate narrative for your DCF is critical in building an accurate DCF model.
Once you have created your narrative, go back to the financial statements. Does your narrative fit what they say? You may have to adjust your narrative slightly. An easy way to analyse the statements is just ask why each line item is the way it is and why it changed the way it did.
Step 2: Calculate the current financial year’s FCFF and reinvestment rate
Free Cash Flow to the Firm is the cash available to the company’s debt and equity holders after all necessary payments are made. This will give us a picture of the real cash the company has in its hands and whether it can afford to pay its investors.
The formula for FCFF is:
FCFF = EBIT(1-t) – CAPEX + D&A – ∆Working Capital
FCFF = Free Cash Flow to the Firm
EBIT = Earnings Before Interest and Taxation
t = Effective Tax rate
CAPEX = Capital Expenditure
D&A = Depreciation and Amortisation
Working Capital = Current Assets – Current Liabilities
Once you have done this, calculate the reinvestment rate for the year. This is just how much of its earnings the company has put back into itself this year, calculated as:
Reinvestment Rate = (CAPEX – D&A + ∆Working Capital) / EBIT(1-t)
This way, rather than projecting each individual component of reinvestment separately, we can combine them and project them together over the growth period.
Step 3: Calculate the expected growth rate over the growth period
The growth period is the period of 5 or 10 years of high growth the company will experience before it matures. The large majority of companies reach maturity within 5 years, so it’s safe to use 5 years. For very young companies that are just starting out in an industry with high barriers to entry, maybe 10 years is a better bet.
The expected growth rate is the first real assumption you have to make. Remember your narrative? This is where we bring it in. How competitive is the industry? Highly competitive will offer lower future earnings growth as competitors will enter the market and steal profits. Does the industry have any barriers to entry like patents or copyrights? Is the product something that can last a long time (for example, compare Google to a fidget spinner)?
A company’s earnings growth is based on how much they invest and how well they invest it, giving us the equation:
Expected Growth = Reinvestment Rate (%) x Return on Capital (%)
Return on Capital = (Net Income – Dividends) / Capital
This will give the expected growth year-on-year over the growth period.
Step 4: Predict FCFF over the growth period
Over the 5 or 10 years, grow EBIT and EBIT(1-t) by the expected growth rate and remove the expected reinvestment (estimated as EBIT(1-t)*reinvestment rate) from it.
Step 5: Calculate your Company’s Cost of Equity
So now we want to discount these cash flows, for which we need a discount rate. This discount rate will be our Cost of Capital.
Cost of Capital = Cost of Equity * Equity/ (Debt+Equity) + Cost of Debt (1-t)* Debt/(Debt+Equity)
This formula will be explained in Step 7, but let’s focus on Cost of Equity right now.
The CoE is essentially the return that equity investors expect you to make on the money they give you. It is calculated using the following formula:
Cost of Equity = Rf + ß*(Rm-Rf)
This is the Capital Asset Pricing Model equation for CoE. There are other equations but this is the most commonly used one. Let’s go through the components.
The bond used for the risk-free rate, Rf, should match the company’s FCFF in itme horizon and currency. This is very important. What’s the point of using a 20-year T-bond if you are only projecting 5 years of FCFF? Further, what is the point of using a dollar-denominated bond if you are valuing a Croatian consumer goods company that deals in Croatian Kuna. So, for instance, if we value Amazon and project its cash flows for 5 years, we should use a 5-year US T-bill. Rf would then be the interest rate on the bond we decide to use.
Beta is the sensitivity of the company’s stock to a change in the market. The Betas you see on financial sites are largely regression Betas. They compare the market price change to the stock price change over a given number of years, regress them and calculate the gradient to give you Beta. This can be skewed by decisions on the time length used and the market index used (S&P500? Nasdaq?). Another option is the Bottom-Up Beta. In this you look at the company’s operations and you compare each operation with comparable companies.
Finally, we have Rm – Rf. This is the difference between the market return (Rm) and the risk-free return (Rf). It is known as the Equity Risk Premium – the premium that the market returns for investors inheriting the additional risk of the equity market as opposed to other asset markets. You may choose to either use historical ERPs or the implied ERP.
Step 6: Cost of Debt
Next on our road to calculating Cost of Capital is the calculation of Cost of Debt.
One method is to calculate the Yield-to-Maturity of the company bonds and take the median. Alternatively, you can deduce the average rate for each bond based on its ratings. Higher rated bonds will have lower rates and vice versa. Take the median of these as the CoD.
Step 7: And finally, Cost of Capital…
Now that we have CoE and CoD, it’s just a matter of plugging in the correct numbers in the formula given above.
The (1-t) used in the equation with the Cost of Debt represents the tax shield that debt-raising gives a company since no tax needs to be paid on its interest payments which are the same as Cost of Debt.
Use the marginal tax rate for this value of t as the tax shield takes effect on the final unit of debt for the company.
Step 8: Discount the projected FCFF with Cost of Capital to gain their Present Values
We have dealt with the Cash Flow part of the DCF but now we move to the Discounted part of it.
To gain a thorough understanding of the concept of Present Value, look at “How do Financial Managers make Investment Decisions? Time Value of Money & Net Present Value” by Nasiful Islam in the Fundamentals Team.
The formula used for discounting our FCFF is:
Present Value = FCFF/ (1+ Cost of Capital)^Time Period
The discount rate used, r, is none other than the Cost of Capital itself.
Once discounted, you should now have a series of future cash flows, in terms of their respective present values.
Step 9: Calculating Terminal Value
We are almost done now. So, we have projected the cash flows for the next 5 or 10 years, but what about after that? Predicting anything in that time frame is a fool’s errand.
The Terminal Value is what we use at this stage. Once the initial high-growth stage of the company is complete, we assume that it will grow constantly at a lower rate as a going concern.
There are 5 key calculations/assumptions for the stable growth period:
- Growth rate
Once again, based on your narrative, make this assumption. The only restriction is that it is capped by the risk-free rate. In some respect, rf can be seen as the rate at which the economy grows. In the long-run, mature companies’ expected growth cannot be higher than this.
As a company matures and becomes a larger part of the overall market, its Beta tends to 1 in the long run, suggesting that it moves with the market. You may think it won’t be exactly 1 so this, again, will be a judgement call.
- Optimal D/E ratio
Every company has an optimal financing mix which minimises Cost of Capital. It takes a few tries to understand the calculations, but I would definitely recommend that readers research it if possible. Assume that in the long run, the D/E ratio will tend towards the optimal and hence the CoC will tend to the minimum. Hence the Terminal Value CoC will be the minimum CoC at the optimal D/E ratio.
- Return on Capital
Another assumption to make is how Return on Capital compares to the Cost of Capital in the long run. Generally speaking, I tend to set the two equal to each other however if you believe the company has structural competitive advantages then you may wish to increase RoC accordingly.
- Reinvestment Rate
Now comes this step’s most important point. The cardinal sin of DCF analyses. 19th century philanthropist John Ruskin said, “There is no such thing as a free lunch.” When we talk about a company growing its earnings in the long run, we forget the other side of the coin. To achieve said growth the company must reinvest some of its earnings back into itself. How can it grow if it doesn’t actually inject money back into itself? Many people will set the expected growth rate but will fail to project the corresponding reinvestment rate over the stable growth period. Rearrange the formula previously used and input the new expected growth and RoC for the stable growth period.
Now that we have our expected growth and reinvestment rate, we can calculate FCFF in the Terminal Year. Grow EBIT by the initial growth rate and subtract the marginal tax rate for one extra year. We assume in the long run the tax rate tends to the marginal rate as you can’t defer tax indefinitely. Use the reinvestment rate you just calculated to deduce the reinvestment amount and subtract this to give your FCFF in the Terminal Year. Plug this FCFF into the Terminal Value formula, with the new growth rate and minimised CoC, and discount to its present value.
Note we have used a Perpetuity Model based on the Gordon’s Growth model to calculate our Terminal Value. There are other methods too, such as Exit Multiples which are worth looking into if you are interested.
Step 10: Enterprise Value to Equity Value
If we take the sum of all the present values now, we get the enterprise value. But we don’t want this. We want Equity Value as we are interested in the company’s equity. To convert to Equity Value, we use the following formula:
Equity Value = Enterprise Value – Debt – Preferred Stock – Non-Controlling Interests + Cash
Step 11: Equity Value to Value per Share
Finally, divide Equity Value by the Weighted Average Number of Diluted Shares to give you the value per share of the company.
Now your DCF is complete.
A little conclusion….
Now that you are aware of the process, you may be able to see how subjective DCF analyses can get – especially when it comes to the Terminal Value. There are a host of variations of this model as well as the components within it. For instance, Warren Buffett only considers cash flows that are certain to come in the future and then discounts them at the risk-free rate. Some investors may use option pricing models to calculate the value of stock options and incorporate these. Valuing private companies requires adjustments as well. This model is good for public companies growing in 2 stages – a growth phase and a stable growth phase.
You may have noticed a lot of specifics were left out from this article. For instance, what do we include in debt? What is the CAPM? How do we calculate the optimal D/E ratio? This was intentional. This article aimed to give you a deeper-than-normal explanation of the DCF process so that in an interview, if you were ever asked, you would be able to give a detailed theoretical explanation of the process yourself. Hopefully, this 11-step guide has achieved that objective.
If you would like an idea of what all this looks like in Excel, I have attached a link to the DCF model I created for the Boston Beer Company during August 2020. There may be some assumptions that may be disagreeable, and I would love to encourage anyone with questions to reach out in the comments section below!