DCF

Question 1

1. Why do you build a DCF analysis to value a company?

Answer 1

In theory, a company is worth the Present Value of its expected future cash flows:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate
But you can’t just use this single formula because a company’s Cash Flow Growth Rate and
Discount Rate change over time.
So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where those assumptions may change (the explicit forecast period) and one where they stay the same (the Terminal Period).
You then project the company’s cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s).
You compare this sum – the company’s Implied Value – to its Current Value or “Asking Price” to see if it’s valued appropriately.

Question 2

2. Walk me through a DCF analysis.

Answer 2

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value.
You start by projecting the company’s Free Cash Flows over the next 5 – 10 years by making assumptions for the revenue growth, margins, Working Capital, and CapEx.
Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything.
Next, you estimate the Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5 – 10 years into perpetuity.
You then discount the Terminal Value to Present Value using the Discount Rate and add it to the sum of the company’s discounted cash flows to get its Implied Enterprise Value.
Finally, you add Cash and subtract Debt (and add/subtract all other relevant line items) to get the Implied Equity Value, divide by the share count to get the Implied Share Price, and compare this to the company’s Current Share Price.