DCF Overview and Key Rules of Thumb

The process of DCF analysis

"In DCF analysis you value a company with the Present Value of its Free Cash Flows plus the Present Value of its Terminal Value. You can divide the process into 6 steps: 1. Project a company's Free Cash Flows over a 5-10 year period. 2. Calculate the company's Discount Rate, usually using WACC (Weighted Average Cost of Capital) 3. Discount and sum up the company's Free Cash Flows. 4. Calculate and sum up the company's Terminal Value. 5. Discount the Terminal Value to its Present Value. 6. Add the discounted Free Cash Flows to the discounted Terminal Value.

What to know about DCF

1. What it is, how you use it, how to walk through a DCF analysis 2. How to calculate FCF and how levered FCF differs from unlevered FCF. 3. How to calculate the discount rate in a DCF and how to apply concepts like WACC and cost of equity. 4. How to calculate terminal value, what it means and how it contributes to DCF 5. How different factors impact the output of a DCF and what changes have the biggest effect.

DCF Basic Concept

A company is worth the present value of its future cash flows. What the market thinks the company is worth is irrelevant - all that matters is how much in real cash flow it generates in the future. Methodology: Divide a company's cash flows into a "near future" period and then a "distant future" period, determine the values for each period, and then discount them back to their present values since money today is worth more than money tomorrow.

Operating Assets and Liabilities

Change in Operating Assets and Liabilities is also known as Change in Working Capital or Change in Operating Working Capital. (This is not the same as only current assets and current liabilities because other things are included) This section comes directly form a company's cash flow from operations section and all you are doing here is the following: -If assets goes up, cash flow goes down. -If assets goes down, cash flow goes up. -If Liability goes up, cash flow goes up -If liability goes down, cash flow goes down. Then you just add all this up to get one number for all operating assets and liabilities. (All pulled from accounting section) Cash is excluded because you're calculating the change in cash.

Free Cash Flow

How much after-tax cash flow the company generates on a recurring basis after you've taken into account non-cash charges, changes in operating assets and liabilities, and required Capital Expenditures. We calculate FCF in a DCF because that closely corresponds to the actual cash flow that you, as the investor, would receive each year if you bought the entire company. It is far more accurate than Net Income and EBITDA because those leave out big uses of cash like CAPEX and because those don't take into account changes in cash due to items like accounts receivable, accounts payable, inventory, and more.

Levered FCF

Includes net interest expense and mandatory debt repayments. Hence LEVERED because you're including the debt obligations that have you levered up.

Calculating Unlevered FCF

Step 1: Project the company's revenue growth (ie; the percentage it grows revenue by each year over the 5-10 year "near future" period). From that you can project the company's projected annual revenue based on the most recent historical numbers. Step 2: Assume an operating margin (related to net income) for the company so that you can calculate its EBIT, or operating income each year. Usually base this on historical margins. So if they have $1billion in revenue and 30% EBIT margin, that's 300Million in EBIT. Step 3. Apply the company's effective tax rate to calculate its net operating profit after taxes (NOPAT). ie; 300Million *(1-40%) = $180Million. Step 4: Move to the cash flow statement and project the 3 key items that impact FCF there: Non-cash charges, changes in operating assets and liabilities, and capital expenditures. Step 5: The main Non-cash charges you project are Depreciation, Amortization, and Stock-Based Compensation. You add them back here because you want to reflect how the company saves on taxes, but does not actually pay any cash for them. (Add back as a percentage of revenue, ie: 5% of revenue here, we add back 50 Million here). Step 6: Estimate the change in operating assets and liabilities. This really means "If the company's operating assets increase more than its operating liabilities, in needs extra cash to fund that, so it reduces cash flow. If its liabilities increase more, that adds cash flow. You can make this a percentage of cash flow as well, so if its 3% of revenue and assets increase more than liabilities, then we subtract 30 million here. 7. Estimate Capital Expenditures each year, which always reduces cash flow. You might average previous years' numbers, assume a constant change or make it a percentage of revenue. If Capex is $50million, that reduces cash flow by $50 million. Final FCF: Take NOPAT, $180million, add back the $50 million of non-cash charges, subtract the $30 million change in operating assets and liabilities, and subtract the $50 million of CapEx, so that FCF equals $150 million. We are basically replicating the cash flow statement but excluding interest, debt repayments, and everything in cash flow from financing. We are also eliminating everything under Cash Flow from Investing except for CapEx because that's generally the only recurring item there from year to year. We eliminate the entire Cash Flow from Financing section because items there are either related to debt (not applicable since this is unlevered FCF) or to one-time events such equity issuances and share repurchases.

Terminal Value

The distant future in a DCF. We assume we can't estimate cash flows as precisely, so you don't even bother, but we can come up with an approximation of how much the company might be worth into the distant future.

Levered Cash Flow

The main difference to the calculation is that you need to subtract interest expense and add interest income right after you calculate EBIT, so that you effectively use something closer to Net Income rather than NOPAT. You also need to subtract mandatory debt repayments after you subtract CAPEX - so if the company must repay $20 million in debt per year, that would be subtracted in the Levered FCF calculation. Overall, definition wise, the differences lie in interest and mandatory debt principal repayments.

Projection Period

The near future in a DCF. We assume we can project a company's cash flows more precisely over the next 5-10 year period, so we project and discount them and add everything up for that period. Beyond that, we look to terminal value.

Unlevered FCF

This is what we care about 99% of the time. This excludes net interest expense and mandatory debt repayments (Obviously this is to investors/bond holders etc)

Discounted cash flow example

You have to discount all of the future cash flows back to their present value to account for the "cost" of money today being worth more than money tomorrow. This cost is the time value of money. ie: You estimate a company's future cash flows are $100 in Y1, $120 in Y2 and $140 in Y3. You're going to discount the cash flows at 10% per year because you believe you could earn 10% per year by investing your money elsewhere. Formula for discounting each sector are as follows: $100 / (1 + 10%), Y2 is $120 / ((1 + 10%)^2) Y3 is $140 / ((1 + 10%)^3) Add them up and you have your net present value of $295. Then it gets more complicated because companies don't just stop operating after a few years. They continue generating cash flows. This problem is tackled by dividing a DCF into two parts: Projection period and Terminal Value