Discounted cash flow (DCF) is a fundamental valuation methodology broadly used by analysts; it forecasts a company’s unlevered free cash flow discounted back to today’s value. The model uses assumptions to simplify the financial complicity of a company. It is typically projected for 5 years and hence is sufficient for spanning at least one business or economic cycle and allows for the successful implementation of in-process or planned initiatives. There are five steps for building a DCF model: study the target and determine key performance drivers, project Free Cash Flow, calculate Weighted Average Cost of Capital, determine terminal value, and calculate present value and determine valuation. This article will focus on the first two steps of the DCF calculations.
The first step is to study the target and determine key performance drivers. To create accurate models, financial analysts must learn and study the target and its sector. It is invariably easier when valuing a public company as opposed to a private company due to the availability of information from sources. For a public company, relevant information can be gathered from the balance sheet, past M&A deals, investor presentations, and equity search, etc. For a private company, the recourses are much more limited on news articles and company websites. Analysts also need to determine the key drivers of financial performance (such as sales growth, profitability, leverage, and cash flow generation).
The second step is to project Free Cash Flow. The projection of UFCF (Unlevered Free Cash Flow) is the cash generated by a company after paying all cash operating expenses and taxes (including any assets and liabilities, capex and other investments) but without interest expense. The targets projected UFCF is driven by P&L (Profit and Loss) and BS (Balance Sheet) assumptions, underlying its future financial performance. These three assumptions are explained below in Figure 1.
Figure 1: Table showing how to calculate free cash flow. Valuation, Leverage Buyouts and Mergers & Acquisitions
P&L assumptions require the use of historical ratios for the financial items (such as gross margin, tax, net income, depreciation and amortisation) and model their future development, typically at least 3 cases would be modelled (optimistic, base, and worst cases). Revenues are extrapolated based on historical performance, cogs (cost of goods sold), operating expenses, and D&A (Depreciation & Amortisation) expenditure are calculated based on a percentage of the revenues. That is, they are in line with the development of revenue or they are functions of revenues. Extradentary items, interest expenses, and taxes are calculated as percentages of EBT (Earnings Before Taxes). The values of total revenues, gross margin, EBITDA (Earnings before Interest, Taxes, Depreciation & Amortisation), EBT, and net income can then be derived from the above P&L assumptions.
Balance Sheet assumptions are in line with the business, this includes the calculations on inventory, trade receivables and trade payables (using days technic). PP&E (property, plant and equipment), other assets, and liabilities are calculated as a percentage of future revenues (which is imported from the P&L sheet). Balance Sheet shows the forecasts on total assets, total liabilities and equities.
Project Free Cash Flow can be further divided into two types of cash flow: levered cash flow (considering the financial structure of the firm) and unlevered cash flow (independent of the financial structure of the firm, calculate the enterprise value). Calculating UFCF requires input from the P&L and BS sheets, where NOPAT (Net Operation Profit after Taxes) can be calculated using EBIT and operation tax (can be calculated as a percentage of EBIT). Then, adding back depreciation and amortisation to get gross cash flow. UFCF is then obtained by summing the gross cash flow and all the items (including any assets and liabilities, capex and other investments) that have changed.
This article (Part I) covered the first two steps of how to build a DCF model, the next article (Part II) will cover the remaining three steps: how to calculate Weighted Average Cost of Capital (WACC), how to determine terminal value and how to calculate present value and determine valuation.
By Jing Xu
Sector Head: Aaron Hobb