Walk Me Through A DCF – 5 Steps
September 10, 2024
Discounted Cash Flow (DCF) analysis is a powerful valuation tool used to estimate the value of an investment based on its expected future cash flows. Projecting the future cash flows of a company (based on the business’s potential growth) and then discounting back to today’s value enables investors to determine whether there may be opportunities for potential upside if investing in the company.
Download a DCF template fully set up with FCF and discounting methods to derive a valuation. Here’s a simplified five-step approach to performing a DCF for a company.
Step 1: Forecast the Free Cash Flows
First, we need to forecast the free cash flows (FCFs) up until the steady state period. Typically, this forecast period ranges from five to ten years. For our example, let’s assume a 5-year forecast period. The cash flow is built from post-tax EBIT plus depreciation and amortization and adjusted for movements in operating working capital and capex. Free cash flow is the cash a company generates after accounting for these cash outflows to support operations and maintain its capital assets. It is a key indicator of a company’s financial health and its ability to generate cash.
If the DCF valuation is being completed in the middle of the financial year, its possible to amend the year count to adjust from 1 year to 0.5 year to account for this.
Step 2: Calculate the Weighted Average Cost of Capital (WACC)
Next, we calculate the Weighted Average Cost of Capital (WACC). WACC is the discount rate that will be applied to the future free cash flows. It represents the average rate of return required by all of the company’s investors, including both debt holders and equity shareholders. Essentially, it reflects the cost of the company’s capital. Let’s assume our WACC is 8% in the template. In many professional settings, the WACC might be governed by a team view on the geography and sector. This should be checked with a senior team member as you may not be required to calculate it yourself.
Step 3: Calculate the Terminal Value
In the third step, we calculate the terminal value. The terminal value represents the value of the company’s cash flows beyond the forecast period, extending into perpetuity. Although we only forecast cash flows for a finite number of years, the company is expected to continue generating cash flows indefinitely beyond the 5-year DCF period. The terminal value captures these future cash flows that occur beyond the forecast period. It is calculated using the final year (year 5) FCF from the DCF along with the WACC and long-term growth rate.
Step 4: Discount the Cash Flows to Today
Now, we need to discount all the future cash flows to their present value. This includes the individual free cash flows for each of the 5 forecasted years, as well as the terminal value. Using the WACC, we discount these cash flows to today’s value. The sum of these discounted cash flows gives us the Enterprise Value (EV) of the company.
Step 5: Calculate the Equity Value
Finally, we use the Enterprise Value (EV) to calculate the equity value of the company. The equity value is found by subtracting any net debt (short term + long term debt – cash and cash equivalents) from the EV.
If we know the total number of shares outstanding, we can determine the implied share price by dividing the equity value by the number of shares. This calculation should be based on fully diluted shares and should account for all share options and warrants.
Conclusion
By following these five steps, we can derive a comprehensive valuation for a company using the DCF method. This approach provides a detailed and intrinsic value based on the company’s future cash flow potential, adjusted for the cost of capital. This method is widely used in finance due to its focus on cash flow generation and the time value of money, offering a thorough analysis for investment decisions.
Sample Follow Up Interview Questions on DCF
Interviewer: “So, tell me about the advantages and disadvantages of the DCF approach.”
Applicant: Well, the DCF is great because it really focuses on the future cash flows a company can generate. It’s all about the time value of money, you know? But it’s not perfect. The biggest issue is that it’s super sensitive to the assumptions. Change the growth rate by half a percent, and suddenly the valuation looks totally different.
Interviewer: “Interesting. What about the discount rate? What does that represent conceptually?”
Applicant: The discount rate, or WACC, is basically the company’s cost of capital. It’s like the hurdle rate the company needs to clear to create value. It takes into account both what equity investors expect and what the company pays for its debt.
Interviewer: “Can you explain the difference between FCFF and FCFE?”
Applicant: FCFF (free cash flow to the firm) is the cash available to everyone who’s provided capital – so both shareholders and debtholders. FCFE (free cash flow to equity), on the other hand, is just what’s left for the shareholders after the company’s paid its debts. It’s the money that could theoretically be paid out as dividends.
Interviewer: “What about levered versus unlevered DCF? What’s the difference there?”
Applicant: An unlevered DCF values the whole firm using FCFF and WACC. A levered DCF just looks at the equity value using FCFE and the cost of equity. The unlevered approach is often simpler because you don’t have to forecast the capital structure.
Interviewer: “Let’s talk about WACC. How do you calculate it?”
Applicant: The WACC formula is pretty straightforward. It’s a weighted average of the cost of equity and the after-tax cost of debt. You weight each by their proportion in the capital structure so it could be an 80:20 split of equity to debt. The tricky part is actually estimating the components, especially the cost of equity.
Interviewer: “Speaking of which, how do you determine the risk-free rate?”
Applicant: For the risk-free rate, I usually look at government bonds. In the U.S., that means Treasury bonds. You want to match the maturity to your forecast period. So, if you’re doing a 10-year DCF, you would use the 10-year Treasury yield.
Interviewer: “What about the equity risk premium? What does that represent?”
Applicant: The equity risk premium is essentially the extra return investors demand for taking on the risk of stocks instead of just holding risk-free assets. It’s a key component in the CAPM model for estimating the cost of equity.
Interviewer: “Alright, last question. When might a DCF be inappropriate?”
Applicant: DCF is best for mature companies with steady cash generation, but it can be tricky for early-stage companies or those with really unpredictable cash flows. It’s also not great for companies in financial distress. In those cases, you might be better off using comparable company analysis or looking at precedent transactions. It’s always good to use multiple methods anyway, to cross-check your valuation.
Common Mistakes Applicants make when Answering Questions on DCF
- Overcomplicating things: Some candidates try to show off by diving into complex mathematical formulas right away. Interviewers are often more interested in your conceptual understanding.
- Forgetting the big picture: It’s easy to get lost in the details of WACC calculations or terminal value formulas. But remember, DCF is fundamentally about valuing future cash flows. Don’t lose sight of that.
- Not acknowledging limitations: Many candidates present DCF as a perfect valuation method. It’s not. Being aware of its limitations shows critical thinking.
- Ignoring sensitivity analysis: DCF models are highly sensitive to input assumptions. Good candidates mention the importance of running sensitivity analyses on key variables.
- Misunderstanding terminal value: The terminal value often makes up a large portion of the total valuation. Some candidates underestimate its importance or don’t understand the different methods to calculate it.
- Confusing FCFF and FCFE: These are different cash flow measures used in different contexts. Mixing them up is a red flag.
- Not considering industry specifics: DCF application can vary by industry. For example, using DCF analysis for a cyclical company without adjusting for cycle timing could lead to misleading results.
- Overlooking the mid-year convention: This adjustment can make a material difference in valuation, but many candidates forget about it entirely.
- Failing to link DCF to other valuation methods: Strong candidates understand that DCF should be used alongside other valuation techniques for a comprehensive analysis.
- Not being practical: Some candidates can recite formulas but struggle to explain how they’d actually build a DCF model in real life. Practical knowledge is key.
- Glossing over growth assumptions: Long-term growth assumptions are crucial. Many candidates don’t give enough thought to justifying their growth rates.
- Neglecting working capital: Changes in working capital impact free cash flow, but this is often overlooked in discussions about DCF.