Introduction to DCFs

DCF (discounted cash flow) models are one of the most important financial models in determining the true value of a company. DCFs use a combination of quantitative and qualitative information to create an informed projection of future cash flows within a business. By calculating cash flows all the way through a stable, terminal value, a DCF provides bankers an estimate of what a company’s market cap, and current share price, should be.

DCFs can be used for various purposes. Whether it be selling shares of a company, buying shares of a company, or determining if a company is currently overvalued/undervalued, DCF models are useful in providing a detailed analysis of a company and its operations. However, poorly made DCFs can be very inaccurate and misrepresent the true nature of a company. In cases such as these, bankers may make expensive mistakes and cost stakeholders significant losses.

What is a DCF?

A DCF model projects a company’s future cash flows, discounts them to today’s present value, and provides an estimate of what a company’s share price should be, given a terminal value of the company’s cash flows.

This may seem like a lot of confusing terminology at first, but understanding each concept is critical before absorbing the DCF entirely. First, one must understand the time value of money. Essentially, if given the chance to either take $100 today or $100 in a year from now, you want to take the $100 now. This is not just because of inflation. If you have $100 right now, you can buy something right away and have it immediately, invest it and have an even higher return, or do whatever you want with it, making it more valuable to you immediately. Because of this, future cash flows must be discounted to take into account that receiving $100 five years from now does not have the same value as receiving the $100 today.

Creating a DCF

In a DCF, a single year’s unlevered cash flows, or “gross” cash flows before interest payments, are calculated using the following:

Operating profit + Depreciation & amortization — Taxes — Changes in net working capital = Unlevered free cash flow

In order to project future cash flows, individuals will first project future income statements to first retrieve the information we need for cash flows projection (though not all of net income is used in cash flows projections, we generally project all the way down through the bottom line).

Projections are heavily dependent on prior years. Generally, all expenses, except for depreciation & amortization (PP&E), interest (debt), and taxes, are all calculated as a percentage of sales. For the upcoming 2–3 years, bankers typically use expert predictions from those that work closely within the business itself. However, looking past these years, bankers tend to use historical data, or their own research and analysis, to create a prediction on expenses and revenue growth.

After projecting the income statement, the only thing missing from calculations of unlevered free cash flow are changes in net working capital. Net working capital is defined as non-cash current assets minus non-interest-bearing current liabilities. Similarly to expenses, growth/decreases in components within net working capital (ex. A/R, inventory, A/P, etc.) are measured as a percentage of sales.

The Discount Factor

Adding up the different parts of unlevered cash flows provides unlevered free cash flows for a single year. For future years, however, bankers must derive a discount factor into these cash flow projections. Discount factors are calculated using the weighted average cost of capital, calculated from a company’s capital structure and the proportional costs associated to either debt or equity. This means that bankers must look at the proportion of debt to equity in a company, interest paid by a company in relation to its debt, and cost of the company’s equity in relation to the rest of the market’s. The discount factor increases as years progress, as cash you receive farther in time is worth less and less.

After discounting each year’s unlevered cash flow to what it would be worth today, there are two methods used to determine the terminal value of a company, one of the final steps in determining a company’s expected market equity value.

Finding the Terminal Value

The Multiples Method multiplies a given multiple (ex. EV/EBITDA) the EBITDA in the terminal year (generally the last year decided by a banker from above in the DCF, in which the banker believes the business is now stable and there are no changes in working capital). The product of these two numbers is the terminal value of the company.

The Perpetuity Method uses an assumed perpetuity growth rate (usually around 2–4%, or nominal GDP growth rate) to calculate the terminal value of the company. A banker divides the terminal year’s un-discounted unlevered free cash flow (the last year from the DCF) by the difference between WACC and the perpetuity growth rate. This quotient is the terminal value of the company.

Both methods only differ in terms of the terminal values found. After deriving the terminal values, both methods are identical in terms of finding the company’s expected equity value.

Final Valuation

A banker now must discount the terminal value by multiplying the previously found discount factor with the found terminal value. The product is the discounted terminal value. This must then be added to the sum of the previously calculated discounted cash flows. This sum produces the enterprise value of the company.

Afterwards, equity value is calculated by subtracting out debt, preferred stock, noncontrolling interests, and adding back cash. This, in a sense, is the “expected market capitalization” a banker would value the company at. Dividing this value by the current number of diluted shares outstanding gives the banker his or her expected share price.

Conclusion

Though the DCF may seem intimidating to learn at first for many aspiring bankers, it a critical part of banking and must be understood at a basic level before going into interviews. A sound foundation in accounting helps tremendously in understanding the different aspects of the DCF. By studying and practicing the basics of accounting and finance before creating financial models, aspiring bankers will be able to form more accurate and justifiable assumptions and analyses.