Discounted Cash Flow Analysis – Part II

This report details the final three steps for building a DCF model, following on from ‘Discounted Cash Flow Analysis – Part I’

The third step is to Calculate Weighted Average Cost of Capital (WACC). WACC is the average rate at which a company is expected to pay its equity and debt holders. It is dependent on capital structure (i.e., considers the financial structure and use of tax shields). WACC is used to discount the targets projected FCF (Free Cash Flow) and terminal value to the present. It is calculated as shown in Figure 1 below.

Figure 1: Graphic showing the formula to calculate WACC. Investment Banking: Valuation, Leverage Buyouts and Mergers & Acquisitions

The fourth step is to determine the terminal value. It is important that the target’s financial data in the final year of the projection period represents a steady-state or normalized level of financial performance, instead of periodic highs or lows. There are two commonly accepted methods for calculating a company’s terminal value. The exit multiple method calculates the remaining value of the target after the explicitly forecast period based on a multiple of the target’s terminal year EBITDA or EBIT. The perpetual growth method calculates the pace at which the company’s revenues will grow after the explicitly forecast period, normally between 1% and 4%.

The final step is to calculate present value and determine valuation. The projected FCF and terminal value are discounted to the current price and aggregated to calculate the enterprise value. The implied equity value and share price can be derived from the calculated enterprise value. The present value calculation can be performed by multiplying the FCF for each year in the forecast period by its respective discount factor (how much one dollar is worth today assuming a given discount rate).

As a DCF incorporates numerous assumptions about key performance drivers, WACC, and terminal value, it is used to produce a valuation range rather than a single value.  A sensitivity check is therefore necessary to provide an overview of the implication from different rates used. The valuation results should be compared to those derived from other methodologies such as comparable companies, precedent transactions, and LBO analysis as a sanity check.

By Jing Xu

Sector Head: Aaron Hobb

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