Okay, I'm trying to figure something out. I thought that DCFs use free cash flow (EBIT(1-tax rate) +d&a - capex - change in net working capital) for the projections, as well as for calculating the TV. On the WSO site, though, when calculating TV, it states that Gordon Growth uses EBITDA, specifically EBITDA x ((1 + terminal growth Rate) / (WACC - Terminal Growth Rate)). Am I missing something? Shouldn't it be Free cash instead of EBITDA?
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And also, the discount rate is not necessarily WACC either right? It depnds on whether or not the FCF was levered or unlevered, correct?
Okay, couple things.
1.) You are correct, it should be UFCF if you're using the Gordon Growth Method. EBITDA is for the multiples method. Where'd you see this? You said "the WSO site", which could mean basically anywhere.
2.) It would be WACC, because the formula you described above is unlevered FCF. But yes, if you were calculating levered FCF, the discount rate would be the cost of equity. Indicentally, if you do that, the resulting NPV is equity value, not Enterprise Value.
Did that answer your questions?
Apologies, should have specified it was on here: https://www.wallstreetoasis.com/finance-dictionary/what-is-the-gordon-g…
And that is perfect, thank you - but just to clarify, if you use UFCF you must use GGM, and if you use FCF you must use the multiples method?
Howard Hughes let me re-clarify my clarification.
There are two basic types of Free Cash Flow (FCF) we are talking about here:
Unlevered FCF (UFCF or Free Cash Flow to the Firm (FCFF)) UFCF is the formula you had above. Discounted UFCFs result in an NPV that is the Enterprise Value of the company. The discount rate takes into account all types of capital, i.e. WACC. When people say "FCF", they're usually talking about UFCF - unless you're working in an LBO, in which case see below.
Levered FCF (LFCF or Free Cash Flow to Equity (FCFE)) LFCF is a different formula. Discounted LFCFs result in an NPV that is the equity value of the company. The discount rate is the cost of equity.
Moving on to Terminal Value calculations. There are two, as you said. GGM and multiples.
GGM: Regardless of which FCF we're using for our DCF, the Terminal Value (TV) for GGM is calculated using FCF, where:
TV = (FCF*(1+g))/(discount rate - g)
Multiples Method: The multiples method Terminal Value is completely different. It uses the terminal year's EBITDA to simulate a "sale" in that year. Therefore, you apply your terminal year's EBITDA to a multiple to get your TV.
Okay. So. Regardless of the method - GGM or multiples - you discount that TV to the present at the discount rate. Remember, that could be WACC OR the cost of equity.
To recap, FCF is used for GGM, EBITDA is used for multiples. Either type of FCF can be used for GGM, but it will result in a different NPV for your DCF.
Cool?
You the man. Thank you!
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