Valuation Methods- DCF Review
Questions and Correct Answers
Discounted Cash Flow analysis ✅intrinsic method of valuation
Based on the present value of the company's future cash flows
Concept is based on the going concern principle in accounting that firms are expected
to operate into perpetuity
Firm total enterprise value = PV of FCFS + PV of terminal value, both discounted using
WACC
PV of fcfs, discounted using WACC + PV of Terminal Value, discounted using WACC =
Implied Total Enterprise Value today
FOUR major steps in performing a DCF analysis: ✅1. Forecast free cash flows 5-10
years
2. Calculate a terminal value using either- gordon growth of exit multiple
3. Discount FCFS and Terminal Value to the Present Value- using using the WACC
4. Sum the two together and get implied enterprise value
Forecasting Free Cash Flows ✅project out cash flows 5-10 years -- long enough to be
useful but short enough to be able to predict cash flows with some accuracy and
confidence
Project out until cash flows become steady
3-5 years for large companies with stable predictable cash flows
Ex: amazon and Microsoft
8-10 years for start ups, riskier companies, or companies with unpredittable cash flows
EBIT*(1-tax rate)
+depreciation
-capital expenditures
+/- changes in NWC
= Unlevered Free Cash Flow
Forecasting Free Cash Flows (cont.) ✅the cash flows are considered unlevered
because they ignore the effects of debt in the firms capital structure by excluding
interest expense
The cash flows are available to pay all investors- both debt and equity
, To obtain levered free cash flows subtract after-tax interest expense (interest expense *
(1-tax rate))
When discounting levered free cash flows- use the cost of equity instead of WACC
Terminal value ✅the value of the firms cash flows beyond the intitial 5-10 year
projection period and extending into perpetuity
What new the two terminal value methods? ✅Gordon growth and exit multiple
Gordon growth model ✅TV= (Final Projected Year FCF X (1+longterm Growth Rate) /
(Discount Rate - longterm Growth Rate)
** think about what were doing in finance
-r = discount rate
FCFT ✅Final projected FCF
Exit multiple method ✅basic calculation to approximate company value at the end of
the projection period
Steps of exit multiple method ✅1.Apply a forward looking multiple (ie. 5x EBITDA,
EBIT, sales etc) at the of the projected FCF
- usually based on a median of comparable
Companies (not the avg. Bcs it would count
Outliers)
-often show a range of exit multiples
2. Take the corresponding metric from the final year of projection period and multiply
3. Discount using WACC and add to PV of fcfs
When to use Gordon Growth Model ✅-useful for stable companies expected to grow
slowly into perpetuity and companies unlikely to be acquired (ex: no one is able to
acquire Apple)
-can be hard to predict a long-term growth rate
-compare final projected year growth rate to perpetuity growth rate
-watch out for "hockey sticks"
When to use exit multiple method ✅-useful for companies expected to be acquired at
the end of a projection period
-can be problematic for cyclical industries due to varied multiples
Cost of capital ✅the quantification of a company's risk profile can be seen in their cost
of capital
Higher cost of reflects more risk (investors demand a higher return for increased risk)
Questions and Correct Answers
Discounted Cash Flow analysis ✅intrinsic method of valuation
Based on the present value of the company's future cash flows
Concept is based on the going concern principle in accounting that firms are expected
to operate into perpetuity
Firm total enterprise value = PV of FCFS + PV of terminal value, both discounted using
WACC
PV of fcfs, discounted using WACC + PV of Terminal Value, discounted using WACC =
Implied Total Enterprise Value today
FOUR major steps in performing a DCF analysis: ✅1. Forecast free cash flows 5-10
years
2. Calculate a terminal value using either- gordon growth of exit multiple
3. Discount FCFS and Terminal Value to the Present Value- using using the WACC
4. Sum the two together and get implied enterprise value
Forecasting Free Cash Flows ✅project out cash flows 5-10 years -- long enough to be
useful but short enough to be able to predict cash flows with some accuracy and
confidence
Project out until cash flows become steady
3-5 years for large companies with stable predictable cash flows
Ex: amazon and Microsoft
8-10 years for start ups, riskier companies, or companies with unpredittable cash flows
EBIT*(1-tax rate)
+depreciation
-capital expenditures
+/- changes in NWC
= Unlevered Free Cash Flow
Forecasting Free Cash Flows (cont.) ✅the cash flows are considered unlevered
because they ignore the effects of debt in the firms capital structure by excluding
interest expense
The cash flows are available to pay all investors- both debt and equity
, To obtain levered free cash flows subtract after-tax interest expense (interest expense *
(1-tax rate))
When discounting levered free cash flows- use the cost of equity instead of WACC
Terminal value ✅the value of the firms cash flows beyond the intitial 5-10 year
projection period and extending into perpetuity
What new the two terminal value methods? ✅Gordon growth and exit multiple
Gordon growth model ✅TV= (Final Projected Year FCF X (1+longterm Growth Rate) /
(Discount Rate - longterm Growth Rate)
** think about what were doing in finance
-r = discount rate
FCFT ✅Final projected FCF
Exit multiple method ✅basic calculation to approximate company value at the end of
the projection period
Steps of exit multiple method ✅1.Apply a forward looking multiple (ie. 5x EBITDA,
EBIT, sales etc) at the of the projected FCF
- usually based on a median of comparable
Companies (not the avg. Bcs it would count
Outliers)
-often show a range of exit multiples
2. Take the corresponding metric from the final year of projection period and multiply
3. Discount using WACC and add to PV of fcfs
When to use Gordon Growth Model ✅-useful for stable companies expected to grow
slowly into perpetuity and companies unlikely to be acquired (ex: no one is able to
acquire Apple)
-can be hard to predict a long-term growth rate
-compare final projected year growth rate to perpetuity growth rate
-watch out for "hockey sticks"
When to use exit multiple method ✅-useful for companies expected to be acquired at
the end of a projection period
-can be problematic for cyclical industries due to varied multiples
Cost of capital ✅the quantification of a company's risk profile can be seen in their cost
of capital
Higher cost of reflects more risk (investors demand a higher return for increased risk)
