DCF Valuation

Step by Step Guide

 Why discount future cash flows?
The investor perspective
Let’s consider that an investor wants invest in a company

Cash flow Their primary goal? Return on Investment

Dividends

Investment Divestment

Investment
Future cash flows of the investment

Every Investor buys the shares of a company based on their expectations for
future Cash Flows

Dividends are a function of Divestment price is a function

future cash flows of future cash flows
 What drives company value?
The two key parameters determining a firm’s value
Given that a company’s value is a function of its future cash flows, we need to
determine what drives future cash flows

Two functions drive a firm’s

value in the future:
Growth
Cash conversion
ratio %

Revenues Expenditures Investments Operating cash Profitability

flow

1 2
Why growth? Why profitability?

• Larger size • Same size

• Same conversion ratio • Stronger conversion ratio

Higher future cash flows, higher valuation

Calculating Free Cash Flow
 Calculating Cash Flow: Working Capital & Capex
The cash impact of Balance Sheet items
2 Working Capital
$ in million Year 1 Year 2 Year 3 DeltaY1-Y2 Calculate cash effect
Account receivables 3,621 4,174 3,492 (553) -(Receivables Y2-Receivables Y1)
Inventories 2,311 1,813 2,104 (498) -(InventoriesY2-InventoriesY1)
Trade payables* (3,383) (4,207) (3,212) 824 PayablesY2-PayablesY1

Working Capital 2 2,549 1,780 2,384 (227)

*Please note that Trade Payables are with a negative sign because they are a liability

3 Capital Expenditures
Capital expenditure is the cost which the company sustains to replace old PP&E or
Acquire new PP&E.
A reasonable assumption is that a growing business will need additional PP&E investments.

4 Other assets and liabilities

Used for the generation of Operating cash flows;

Operating
Could be modeled as a % of revenues
vs.
Not used for the generation of Operating cash flows; Their value (positive
Non-operating or negative) should be added/(subtracted) to Enterprise Value
 Calculating Cash Flow
Discounting Unlevered Free Cash Flows

$ in million
PAT Net Operating Profit After Taxes is a measure of operating profitability
PAT
Add-back D&A
Add-back D&A D&A is added back as it is not a Cash expense
Working capital
Net other assets, liabilities Change in Growing a business requires investments in Receivables and Inventory
Working Capital and generates more Payables
Capex
Change in Other Similar to Working Capital. As a business grows it needs more other
Unlevered Free Cash Flow
Operating assets operating assets

!Free cash flows are available Expenditure for PP&E used to replace old PP&E or acquire new PP&E in
to both debt and equity Capex
order to support the growth of the business
investors!

3
(1+Discount factor)
n
(1+Discount factor)
(1+Discount factor) 2
1
(1+Discount factor)

UFCF 2 UFCF 3 UFCF “n”

UFCF 1

T0 T1 T T3 Tn
2
 Finding a proper discount factor: WACC
WACC = Weighted Average Cost of Capital

Debt investors WACC

Two types of Free cash flow is (Weighted average cost of capital)

financial investors available to both

debt and equity Takes into consideration
in a firm Equity investors investors both debt and equity
capital

WACC (Weighted Average Cost of Capital) represents the opportunity cost that
investors sustain for investing their funds in the firm

𝐷 𝐸
WA𝐶𝐶 = ∗ 𝑘 𝑑 ∗ (1− 𝑡) + ∗ 𝑘𝑒
𝐷+𝐸 𝐷+𝐸
D = Amount of debt financing E = Amount of equity financing

𝑘𝑑 = Cost of debt 𝑘𝑒 = Cost of equity

t = Tax rate
 Finding cost of equity and cost of debt
The practical way to calculate cost of equity and debt

Practical
Methodology Needed data implementation

§ Market value § Bond current Use the bond’s Yield to Maturity

of debt pricing
Cost of
debt § Book value § Book value of Financial Divide Interest expense to the
of debt debt in BS amount of Financial debt
§ Interest expense in P&L

§ CAPM § Risk-free rate Use a 10-year government bond

(Capital Asset
Pricing Model)
𝑘 𝑒 = 𝑟𝑓 + 𝖰 ∗ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟 𝒓 𝒓 𝑠 𝑘 § Market Risk Premium Studies show it is between
𝑃𝑟𝑒𝑚𝒓𝒓𝑢𝑚 4.5% and 5.5%
Cost of
equity
§ Company beta A measure of a stock’s volatility in
relation to the market. Available in
financial platforms such as
Bloomberg, Thomson Reuters etc.
 Two stages of DCF
Explicit forecast period + Continuing value

Stage 1 Stage 2

Present value of Cash flows in the

free cash flows Forecast period + Continuing value
5-10 years After forecast

Description Needed data Math formula

𝐹𝐶𝐹1 𝐹𝐶𝐹2
The explicit forecast period § Free cash flow 1
+ +
(1+𝖶𝐴𝐶𝐶) (1+𝖶𝐴𝐶𝐶) 2
Forecast should be long enough to allow Forecast (5 or 10 years
𝐹𝐶𝐹3 𝐹𝐶𝐹4
period the business to reach maturity + +
(1+𝖶𝐴𝐶𝐶) 3 (1+𝖶𝐴𝐶𝐶) 4
(Stage 1) § WACC
𝐹𝐶𝐹5
(1+𝖶𝐴𝐶𝐶) 5

Continuing value (Termina § Free cash flow 𝐹𝐶𝐹5 ∗ (1 + 𝑔)

value) is the period after the Forecast for 5th year
Continuing
explicit forecast period. Often a
(W𝐴𝐶𝐶 − 𝑔)1
Value (1 + W𝐴𝐶𝐶)5
large portion (>50%) of a § WACC
(Stage 2)
company’s valuation lies in its
Continuing value § Perpetuity growth rate (g)
 From Enterprise Value to Equity Value
Understanding the difference between Enterprise Value and Equity Value

1
Non-operating Assets: Assets that are not
used for the core business of the company

Present Value of free cash flows Non-operating real estate, personal cars,
+
Present Value of Terminal value financial subsidiaries etc.

Non-operating Assets 1 2
Financial debt: Interest-bearing financial
Enterprise Value debt

- Financial debt 2 Debt to banks, Bond issues, Leases etc.

+ Cash
- Debt-like items 3 3
Debt-like items: Non-interest bearing
Equity Value liabilities that are not considered within
Free cash flow
Provisions, Unfunded Pension liabilities,
Liabilities from litigation, etc.
 Conclusion
In summary, Discounted Cash Flow (DCF) Analysis is
crucial for investment evaluation due to its ability to
accurately value assets, inform decision-making,
assess risks, aid in strategic planning, and create
value. By considering the time value of money, DCF
analysis provides a clear understanding of an
investment's worth, empowering investors to
optimize their portfolios and navigate financial
markets with confidence.

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