Discounted Cash Flow valuation is one of the three primary techniques of financial valuation used by investment banks Public Trading Comparables: o Public trading analysis o No premium included o Static analysis/ snapshot in time Precedent Acquisition Transactions: o Representative acquisition transactions o 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: o 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. o 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 o DCF concept is theoretically rigorous, as opposed to simplified "me to" valuation metrics such as price / earnings , price to book value o Utilizes concepts of time value of money o Incorporates concept of cost of capital for a company, and can be structured to evaluate projects regardless of differing capital structures o Shows how differences in growth and timing of a company's projections can impact value o Incorporates a concept of risk -- important as similar sized cash flows may be generated based on different risk profiles, therefore having different valuations o 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 o 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. o Usually more dependent on determination of terminal value rather then interim cash flows o Terminal multiples o Growth in perpetuity o Dividend discount model o Calculation of the discount rate o Beta o Risk free rate o Equity market premium o Lack of consistency for inputs o Improper equity market premium o High growth projections with a low discount rate o Terminal multiples not consistent with company o Remember the sanity checks o "Hurdle rates" o Valuation multiples today vs.
in the future (terminal multiple) o Underlying financial projections Discount Rates o The discount rate is a critical ingredient in a DCF valuation o The discount rate used should reflect the risk and the type of cash flow being discounted o Higher risk cash flows should be discounted as a higher discount rate THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) o WACC is defined as the weighted average of the costs of the different components of financing used by a company o WACC = Re (market value of equity / market value of equity plus debt) + Rd (debt / market value of equity + debt) THE COST OF EQUITY o The cost of equity is the rate of return that investors require to make an equity investment in a company o We calculate the cost of equity using the Capital Asset Pricing Model (CAPM) o 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 o The cost of equity = Rf + Bl (Rm - Rf) o Our standard assumptions for the risk free rate (Rf) and the market risk premium (Rm) are: o Rf = the current 10-year Treasury Bond rate o 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 o The cost of debt is a company's current after-tax borrowing rate.