DCF analysis can also be used to estimate a company’s enterprise value. It can assess the intrinsic value of a company, based solely upon its financial information. The figure is ‘discounted’ or ‘adjusted’ to take into account the changing value of money over time. The sum of all future cash flows (in and out) is known as the net present value (NPV) and this can help to determine whether a proposed investment is financially viable. Calculating DCF can be incredibly complicated and as such, we recommend that you study textbooks to gain a strong understanding of how this method of valuation works. For IBD internships in particular, strong knowledge of this calculation method is frequently expected. Note that if the company is not listed on a stock exchange, there are other calculations that must be made (however this is beyond the scope of this handbook). To calculate DCF, you can use the following steps:
1. Calculate the free cash flow to the firm (FCFF) for X number of years
FCFF must be estimated for each separate year into the future (typically 5-7 years into the future) based upon various assumptions (e.g. industry trends and assumptions of growth).
2. Calculate the weighted average cost of capital (WACC)
The WACC is the amount of money the company must pay on average to raise and sustain capital.
- Cost Of Debt: the cost of debt will be calculated using the average interest rate paid by the company (per year) on its outstanding debt (e.g. bonds or loans).
- Cost Of Equity: the cost of equity is calculated using the Capital Asset Pricing Model (CAPM), illustrated below:
- Risk Free Rate: the figure often used is the 10 or 30-year US Treasury Bill (government bond) yield.
- Equity Risk Premium: the average return of the stock market (on which the company is traded) in excess of the risk free rate, over a significant period of history (e.g. the last 10 years, but usually much longer than this).
- Company’s Beta: a measurement of how closely movements in a company’s share price tend to correlate with movements in the overall stock market. A beta of 1 would mean that if the stock market as a whole fluctuates (e.g. its total value increases by 10%), the company’s share price should fluctuate in exactly the same way (e.g. rising by 10%). Assuming the stock market increases by 10%, if a company has a beta of 0.5 this would imply that the share price would likely rise by 5% (0.5 x the change in the overall value of the stock market). A beta of 1.5 would imply an increase of 15% (1.5 x the change in the overall value of the market). Low betas are typically associated with utility companies (e.g. energy companies) whilst high betas usually apply to more risky companies. Conversely, a beta of -1 would mean that if the stock market as a whole fluctuates (e.g. its total value increases by 10%), the company’s share would move in the opposite direction by the same amount (e.g. decreasing by 10%). A beta of -1.5 would imply a decrease of 15% and so on
3. Discount the expected FCFF for future years
Once each separate FCFF has been calculated, they must each be discounted, using the WACC.
As X increases, so does the number by which the estimated FCFF is divided, which in turn reduces its (present) value. As such, the further into the future that we project each FFCF, the lower the value of each projected FFCF present value becomes. These estimations are discounted in this way to take into account the time-value of money, inflation (which reduces the purchasing power of each unit of currency) and the likelihood of receiving the cash flows.
- Time Value Of Money: the ‘time value of money’ is based upon the premise that a set amount of money in the present is worth more than the same amount of money will be in the future due to its earning capacity in the interim period. Take the following example as an illustration of this concept. A set amount of money today, for instance £100, is worth more than that £100 would be in the future. This is partially due to the fact that the £100 could be invested (for instance in return for interest payments or capital gains) in a manner that leaves the investor with, for example, £150 further down the line.
4. Calculate the terminal value
The terminal value of the company must next be calculated. This aims to account for the cash flows that will be received in the years beyond those already forecasted (i.e. the first 5-7 years into the future), which are too far into the future to accurately estimate. The terminal value is calculated as follows:
5. Discount the terminal value
This terminal value must be discounted similarly to the other forecasted cash flows to arrive at its present value.
6. Add together all the discounted FFCFs and the terminal value
The sum of all the discounted FFCFs must then be added to the discounted terminal value of the company to give the intrinsic enterprise value of the firm. This example illustrates the required calculation where FCFFs have been estimated for 7 years into the future (the ‘…’ signifies that the values for years 3-6 would also have to be projected, discounted and added together).
It must be noted that assumptions such as the perpetuity growth rate strongly impact the overall valuation and therefore this method is still fairly subjective.
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By Jake Schogger - City Career Series