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

2. 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.

3. I. Main Concepts in a DCF Valuation

4. 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

5. 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

6. 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

7. II. Steps in a DCF Analysis

8. 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!

9. 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)

10. Calculating Free Cash Flow (Example)

11. 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

12. 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!

13. 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%

14. 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!

15. PV of FCF

16. 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!

17. 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 = D&A = 1200 Exit Multiple = 9x
EBITDA = = 6099
Terminal Value = 6099 * 9
Terminal Value = $54,891

18. 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 * ( )/(0.09 – 0.02)
Terminal Value = $55,736

19. 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!

20. 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/( )^3
PV of EMM TV = $42386
Gordon Growth Method (GGM) TV = $55736
PV of GGM TV = 55736/( )^3
PV of GGM TV = $43048

21. 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!

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

23. IV. Advantages & Disadvantages of a DCF

24. 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)

25. 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

26. 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!

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