Investment Banking Bootcamp: Week 3 – DCF Valuation Pt 1 Fall 2018

Agenda I. Main Concepts in a DCF Valuation II. Steps in a DCF Valuation III. Advantages & Disadvantages of a DCF Valuation Please take notes and ask questions throughout. Decks will be available on our website.

I. Main Concepts in a DCF Valuation

What is a DCF Valuation? Money today is worth more than money tomorrow Would you rather have $100 today or $100 one year from now? DCF analysis is based on the idea that anything is worth the present value of its future cash flows Projection period & Terminal period

Weighted Average Cost of Capital (WACC) How do we discount the cash flows in the future? Weighted Average Cost of Capital is typically the industry norm to calculate the discount rate Companies are typically financed in two ways – debt & equity WACC basically calculates the cost of these components by their respective weights and adds them together Preferred stock is basically in-between debt/equity Try to understand the concepts right now! We will delve deeper into WACC later I’m thinking of going deeper into the components (CAPM model etc in Pt 2). Eg. How to calculate Ke & Kd and talking more in-depth about preferred stock

Present Value (PV) Present Value = Cash Flowt/(1+Discount Rate)^t Year 0 = $100/(1+10%)0 = $100 Year 1 = $100/(1+10%)1 = $90.91 Year 2 = $100/(1+10%)2 = $82.64 Value of Investment = $273.55 Note: In this case, cash flows started at Yr 0, while typically in DCFs it starts at Yr 1 I’m thinking of going deeper into the components (CAPM model etc in Pt 2). Eg. How to calculate Ke & Kd and introducing preferreds etc

II. Steps in a DCF Analysis

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

Calculating Free Cash Flow Free Cash Flow (FCF) = How much after-tax cash flow the company generates on a recurring basis, after taking into account non-cash charges, changes in operating assets & liabilities, and required Capital Expenditures EBIT = Operating Income/Profit FCF = Unlevered Free Cash Flow (So no interest expense)

Calculating Free Cash Flow (Example)

Projecting Free Cash Flow Revenue – Revenue growth EBIT – Operating Margin CapEx - % of Revenue D&A - % of CapEx Changes in NWC - % change in Revenue Note: This method of projecting FCF is purposefully simplified. In the real world, you will receive projections from management, creditors, equity research analysts etc

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

Calculating WACC Cost of Debt = Essentially the Yield-to-Maturity (Can just take the coupon rate for simplicity) Cost of Equity = Calculated using the CAPM Model Cost of Preferred Stock = Fixed Dividend/Price of Preferred Stock For this example, let’s say we calculated WACC to be 9%

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

PV of FCF

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

Terminal Value – Exit Multiple Method First method to calculate the Terminal Value Essentially calculates the terminal value using a multiple of EBITDA (Similar to comps!) EBIT = 4899 D&A = 1200 Exit Multiple = 9x EBITDA = 4899 + 1200 = 6099 Terminal Value = 6099 * 9 Terminal Value = $54,891

Terminal Value – Gordon Growth Method Calculates terminal value by treating a company’s terminal year FCF as a perpetuity growing at an assumed rate Tends to be between 1-3% (nominal GDP growth rate) r = discount rate g = terminal growth rate Example: WACC (r) = 9% ; g = 2% Terminal Value = 3825 * (1 + .02)/(0.09 – 0.02) Terminal Value = $55,736

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

PV of Terminal Value Present Value = Cash Flowt/(1+Discount Rate)^t Remember this formula? Exit Multiple Method (EMM) TV = $54,891 PV of EMM TV = 54891/(1 + 0.09)^3 PV of EMM TV = $42386 Gordon Growth Method (GGM) TV = $55736 PV of GGM TV = 55736/(1 + 0.09)^3 PV of GGM TV = $43048

6 Steps in a DCF Valuation Project a company’s free cash flows (FCF) Calculate the company’s discount rate (WACC) Discount and sum the company’s FCF Calculate the company’s terminal value Discount the terminal value to its present value (PV) Add discounted FCF and the discounted Terminal Value Fall 2019 April May - June The bar is to help them visualize what happens!

Equity Value Calculation PV of FCF = $9298 PV of EMM TV = $42386 Enterprise Value = 9298 + 42386 = $51684 Equity Value = EV – debt + cash – NCI – preferred stock Debt = $10000; Cash = $2000 EqV = 51684 – 10000 + 2000 EqV = $43684

IV. Advantages & Disadvantages of a DCF

Advantages of a DCF Valuation True intrinsic valuation of a company – captures elements that may cause it to be relatively undervalued/overvalued versus its peers Not affected by market irrationality like public and M&A comps Requires scrutiny of key drivers of value Can value niche companies that may not have “true” comparables Sanity Check (Can work backwards from the current companies share price into the operating model)

Disadvantages of a DCF Valuation Based heavily on assumptions – Small changes in WACC & TV calculations can significantly change final valuation Terminal Value often makes up 50-60% of the valuation Widespread disagreements on how to calculate Cost of Equity (Risk Free Rate & Market Risk Premium) Difficult to value early stage startups/FCF negative companies Moving target – DCF Valuation demands constant vigilance and modifications depending on how company expectations change

Agenda for next week Delving deeper into WACC and CAPM Model Free Cash Flow Projection Methodologies Sensitivity Analysis Mid-Year Convention Looking at a completed Discounted Cash Flow Valuation Basic & Intermediate Interview Questions Fall 2019 April May - June The bar is to help them visualize what happens!

Thanks so much for coming, and see you next week!