Discounted Cash Flow valuation is one of the three primary techniques of financial valuation used by investment banks

Public Trading Comparables:

• Public trading analysis

• No premium included

• Static analysis/ snapshot in time

Precedent

Acquisition Transactions:

• Representative acquisition transactions

• Another static analysis

… Still need a valuation technique to assess the long-term prospects of the target, taking into account the risk profile of the company

Discounted Cash Flow:

• Net present value of free cash flows (over period of model) and an outer year Terminal Value, meant to value the remaining free cash flow not modeled, out into perpetuity.

• Free cash flow = (i) net income plus (ii) non-cash charges (e.g. depreciation, amortization, deferred taxes) less (iii) net change in working capital less (iv) capital expenditures

Benefits of a DCF

• DCF concept is theoretically rigorous, as opposed to simplified “me to” valuation metrics such as price/earnings, price to book value

• Utilizes concepts of time value of money

• Incorporates concept of cost of capital for a company, and can be structured to evaluate projects regardless of differing capital structures

• Shows how differences in growth and timing of a company’s projections can impact value

• Incorporates a concept of risk — important as similar sized cash flows may be generated based on different risk profiles, therefore having different valuations

• Is useful to incorporate with sensitivity analysis, assessing how different drivers impact results and valuation over time

Faults to a DCF Analysis

Be careful to avoid a “garbage in, garbage out” analysis

• As inputs to the DCF are crucial, careful consideration must be taken with each of them, as they have the ability to greatly change valuation depending upon the variable choice, etc.

• Usually more dependent on determination of terminal value rather then interim cash flows

• Terminal multiples

• Growth in perpetuity

• Dividend discount model

• Calculation of the discount rate

• Beta

• Risk free rate

• Equity market premium

• Lack of consistency for inputs

• Improper equity market premium

• High growth projections with a low discount rate

• Terminal multiples not consistent with company

• Remember the sanity checks

• “Hurdle rates”

• Valuation multiples today vs. in the future (terminal multiple)

• Underlying financial projections

Discount Rates

• The discount rate is a critical ingredient in a DCF valuation

• The discount rate used should reflect the risk and the type of cash flow being discounted

• Higher risk cash flows should be discounted as a higher discount rate

THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)

• WACC is defined as the weighted average of the costs of the different components of financing used by a company

• WACC = Re(market value of equity / market value of equity plus debt) + Rd(debt / market value of equity + debt)

THE COST OF EQUITY

• The cost of equity is the rate of return that investors require to make an equity investment in a company

• We calculate the cost of equity using the Capital Asset Pricing Model (CAPM)

• CAPM measures the risk associated with any asset by the covariance of its returns with returns on a market index, which is defined to be the asset’s beta

• The cost of equity = Rf + Bl (Rm – Rf)

• Our standard assumptions for the risk free rate (Rf) and the market risk premium (Rm) are:

• Rf = the current 10-year Treasury Bond rate

• Rm = [ ], which is the difference between average returns on stocks and average returns on risk free securities over a period of time

THE COST OF DEBT

• The cost of debt is a company’s current after-tax borrowing rate