The simple guide to Discounted Cash Flow Modeling DCF The simple guide to Discounted Cash Flow Modeling Warning: This guide is simplified. That’s why it’s called the “simple” guide.

What does a DCF do? It literally models all cash that a company has and will produce in the future and determines how much of that can be paid out to shareholders and specifically how much could be paid out per share. This per share potential payout is one measure of the “intrinsic value” of a share. Steps: Model all cash flows from now into eternity Discount those to the present Subtract out cash that needs to be paid to bond holders Divide by the number of shares outstanding

What’s a stock worth? There are many ways to answer this question. 4 that are used frequently are: Public Comparables (Ratios) Precedent Market Transactions Discounted Cash Flow Models Leveraged Buyout Models

The DCF is nice because it’s relatively simple: 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒= 𝐶𝐹 1 (1+𝑟) 1 + 𝐶𝐹 2 (1+𝑟) 2 + 𝐶𝐹 3 (1+𝑟) 3 +…+𝑇𝑉 CF = Cash Flow r = WACC All you need to do is project Cash Flows, then discount them back to the present.

Why “discount” future cashflows? There is a “Time Value” to money. Money now is worth more than money later. Would you rather have $100 right now or $101 in a year? Does your answer change if you can have $110 in a year? What about $150? Your answer says something about your discount rate. How much you “discount” future money vs. now money.

Start with the Income Statement Get a copy of a company’s Income Statement from a 10-Q or 10-K. We need all lines down to “Operating Income” aka “EBIT” aka “Earnings before interest and taxes” Then we’re going to go from Operating Income to Free Cash Flow

Getting to Free Cash Flow (FCF) from Operating Income Free Cash Flow =Operating Income −Taxes+Noncash Expenses −∆ Net Working Capital −Capital Expenditure Examples of non-cash expenses: Depreciation Amortization Prepaid taxes Stock Based Compensation

Now you need to repeat this process for your entire modeling period Now you need to repeat this process for your entire modeling period. Perhaps 5-10 years. There is no “source” for this information several years out. This is where modeling goes from science to art. Remember, garbage in, garbage out. You are running on assumptions and historical precedent here. It’s not an exact science, but it still needs to be based in reason and logic. Do yourself and others a favor by explaining somewhere what assumptions you’re making and why.

What’s next? Terminal Value. Calculate the value of all cashflows beyond your reporting period into infinity. (Some models use “exit multiples.” If you want to learn how to use those, go to Investopedia or something). 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒= 𝐶𝐹 𝑓𝑖𝑛𝑎𝑙 × (1+𝑙𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒) (𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 −𝑙𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒)

Putting it all together Now you have a series of Cash Flows, one for each modeled year, plus a terminal value. Set the terminal value aside for a moment and look at your other cash flows. Notice an issue? We have not yet addressed the time value of money We need a “Discount Factor”

𝐸 = market value of equity WACC (Weighted Average Cost of Capital) is usually the preferred discount factor You can calculate it yourself like this: Or just get it off Bloomberg… 𝑊𝐴𝐶𝐶= 𝐸 𝑉 𝑟𝐸 + 𝐷 𝑉 𝑟𝐷 1−𝑡𝑐 𝑟𝐸 = cost of equity 𝑟𝐸 = cost of debt 𝐸 = market value of equity 𝐷 = market value of debt 𝑉=𝐸+𝐷

Now we need to discount all of those cashflows with WACC and add in our Terminal Value 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒= 𝐶𝐹 1 (1+𝑟) 1 + 𝐶𝐹 2 (1+𝑟) 2 + 𝐶𝐹 3 (1+𝑟) 3 +…+𝑇𝑉 r = WACC

Ok so we have an Enterprise Value which is the value of Equity and Debt, but we want cash that can go to equity holders (we don’t care about bond holders!) So we: Add in the Cash and Cash Equivalents from the company’s Balance Sheet Subtract out debt (b/c debt holders are paid before shareholders can be paid) This gives us the “Equity Value!”

Now all we have to do is divide by the number of shares outstanding to get share value 𝑆ℎ𝑎𝑟𝑒 𝑉𝑎𝑙𝑢𝑒= 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Summary Model Income Statement up to Operating Income (EBIT) for 5ish-10ish years. Make necessary adjustments to get to Free Cash Flow (FCF) Calculate a terminal value Discount Cash Flows from every modeled year and add the Terminal Value to the discounted cashflows from the other years Add in the cash that the company already has lying around and subtract out the cash they owe to others (i.e. debt) Divide by the number of shares outstanding Boom, it’s a coconut. You have your “intrinsic” share price Questions?