DCF Analysis **Urgent Help**
I am currently an Investment Analyst for a REIT. Everyday I underwrite properties by performing DCF analysis that consists of the acquisition cost, NOI over a 5 year period and disposition price. I have an investment banking interview tomorrow and was wondering if a DCF analysis in investment banking requires an acquisition cost in the beginning? I am signed up for courses by breaking into Wall Street and he does not include the cost of the acquisition. He only includes the unlevered free cash flow over a 10 year period and the terminal value. Do you need an acquisition cost in an investment banking DCF? What do you analyze at the end - the sum of the discounted unlevered free cash flow over a 10 year period and the terminal value?
The purpose of the DCF is to obtain either the enterprise value (when using unlevered free cash flow) or equity value (lwhen using levered free cash flow). The present values of the cash flows + the present value of the terminal value = either the enterprise value or equity value (depending on the type of cash flow used as shown above). so essentially, your DCF's purpose is to find how much that business is worth, which is what I think you mean by acquisition cost.
so ultimately no, you aren't using an acquisition cost in the DCF, rather, you're finding the value of the company, which I guess is basically the acquisition cost to a potential buyer of the company
Thank you for the help. So is the terminal value in investment banking the price you would sell the company for?
Thank you for the help. So is the terminal value in investment banking the price you would sell the company for?
No no, let me explain.
Let's say you project out 5 years of Unlevered Free Cash Flows (UFCF). Using your discount rate, you'll discount those values to the present, so we have our PV of UFCF. Then we need to find our terminal value, which is basically a simulated sale at the end of the projections.
In order to do this, we'll either use the Gordon Growth Method or the Multiples Method. If using GGM, we will apply a (normally 3%) growth rate to the final year's cash flow. The formula looks like this: (FCF * (1+Growth rate)/WACC - Growth Rate). That will be your Terminal Value there.
Now, you will discount this Terminal Value using your discount rate back to the present. Now you have your PV of UFCF, and PV of TV. You then add your UFCF and TV, which brings you to the Enterprise Value. So to answer your question, you need both the PV of projected free cash flows added with the PV of the terminal value to derive an enterprise value for the company.
If using the multiples method, then you will apply either the industry average EV/EBITDA multiple that its peer companies are trading at; or if the company is public, you will apply its own EV/EBITDA multiple to the final year EBITDA, NOT UFCF. Then you will discount that terminal value back to the present as well using WACC, and will have your PV of the terminal value. Similarly, you will again here add together your PV of UFCF + PV of TV and that will obtain your Enterprise Value.
If you were to use Levered Free Cash Flow instead of UFCF, the only difference is that the value you derive is the equity value, and NOT the enterprise value.
Make sense?
Howard is completely correct, but just to make it even simpler.
Let's say you have a building which only operates for 2 years and has cash flows of $200 each year before it closes down (gets confiscated by the govt or sth). In that case, it's pretty simple. With a discount rate of 10%, the building is worth
$200 + $200*(100%-10%) = $380
But what if the building never closes down? With no discount rate, the building would be worth an infinite amount of money. With a discount rate, cash flows now are worth less in each successive year. So the building is worth
$200 + $200(100%- 10%) + $200(100% - 10%)(100% - 10%) + ...
Clearly the cash flows are converging towards something. In this no growth, constant discount rate scenario, the answer is also pretty simple, it's:
$200/10% = $2000
And that is what is meant by terminal value
Why does the Terminal value not include the 5 years of UFCF?
Also, would projecting a company out for 6 years instead of 5 then increase the enterprise value?
Yes, it can be thought of that way. You don't necessarily have to sell the company after 10 years of course, you can just keep the company and keep earning cash flows. The point of the terminal multiple is to simply estimate the company's value after 10 years. Whether that value is captured in a sale or by continuing to hold, is moot. But sure, think of it as a sale.
The end value in a DCF is the Enterprise Value (from which you can subtract net debt to get the equity value).
Usually the disconnect between the Target Enterprise Value from a DCF and the Acquisition Cost is a control premium i.e. a multiple on top of the Target Enterprise Value.
One way to do this is to add synergies (revenue or cost) to your projections e.g. if you think by acquiring this company you can achieve 5% cost savings per year, then you can build this into your projections, reducing cost and increasing future unlevered free cash flows. Often you might see two projections in a valuation analysis: a DCF and a DCF with synergies.
Depends on what you are valuing. I'll give you examples:
(1) Valuing company x that makes 5 acquisitions - yes, you need to take into account cost of acquisitions
(2) Valuing a fibre project where you have huge negative capex in the beginning - yes
(3) Valuing a real estate building where you spend money to acquire it in year 1 and start making income in subsequent years - yes
On the flip side....what are some "no" examples?
It depends on the context and what are you trying to achieve.
Let's say you are on a buy-side and your client tells you: "We want to acquire Intralinks. Our goal is to grow EBITDA from $115m to $200m in five years. We do not want to engage in acquisitions but we believe that we can cut costs and introduce this new initiative which lets bankers translate documents from any language to English extremely well".
No acquisition costs in this example. You wills imply run a DCF and come up with an estimate of a price.
Let's say then the client changes its mind and says: "Hey, actually having talked to consultants, this new initiative is quite cool but it's not unique so won't attract as many clients as we would have hoped. So we will acquire a smaller player to consolidate and become an unreachable #1 datasite provider for bankers".
Here you will need to include acquisition cost of paying for the acquisition of a smaller player in your DCF.
Let's consider another example:
Verizon calls your MD and says that it wants to start building a FttP network on west coast in areas where FttP penetration is low. They are not willing to proceed with the project alone so they want a partner because they want this project off balance sheet. MD comes to you on a Friday evening before you leave and asks to do a quick DCF because he has a call with Verizon on a Sat morning.
The project will have a huge upfront capex for building the network which you will need to include in your DCF.
Let's then say that you did the DCF, sent it to your MD and went on a date. Next morning, he calls you at 10am so instead of staying in bed with a chick from yesterday's night, he asks you to come in to the office and do another DCF. The client decided not to build the network itself but heard that an existing FttP network operator on the west coast is seeking a partner to accelerate expansion.
In this case, there is no upfront capex and you are just doing a standard DCF to determine purchase price range which then you will need to refine as the project advances.
Hope this clarifies things somewhat
The point of the DCF is to get you a price. That is your acquisition cost, or actually it's the highest acquisition cost you would pay (hopefully you can acquire it for a lot less).
I don't understand your last question "what do you analyze?". What do you mean what do you analyze?
DCF = NPV
For acquisitions, you should normalize expenses related to acquisitions over a number of years (you will have to extrapolate if it is a new firm) and proportion it out into a annual (or quarterly if that's what you're going for) amount that can be added to CAPEX.
This should raise your reinvestment rate to give a more honest look at how much FCF is being generated.
If you're including the cost, you're doing an NPV analysis. If you exclude the up-front cost, you're doing a DCF, or valuation analysis.
Back to the first part of the original question (which has been answered from a technical standpoint); having been in RE, the disconnect in your thinking in terms of acquisition cost vs no acquisition cost in the corporate DCF vs the property level DCF is that the end-goal of a property DCF is to back into an IRR. As such, you need an initial cash outflow. The goal of the corporate DCF is to get a PV of future cash flows, which doesn't require an initial cash outflow.
The technical walk-through and rationale behind the terminal value at the end of the projection that Howard Hughes gave are correct.
You don't include transaction costs in a DCF model for real estate or corporate finance. Your DCF model ascertains the NPV of a building or company. Transaction costs are factored in when you are backing into what you can pay, via a target IRR, but transaction costs have nothing to do with the intrinsic value of a company/building. If you're building an excel model and trying to figure where your purchase price maxes out at, you may factor transaction costs into your model and a next buyer analysis, but your payments to a broker/bank don't have any bearing on the underlying asset's valuation. There's a huge difference between solving for value versus solving for your maximum purchase price. If someone asks you to walk them through a DCF, don't include acquisitions costs. If someone asks you to back into your maximum purchase price, all things included, then you need to factor in acquisitions costs. For interview purposes, unless you're taking a modeling test (in which they will generally provide you with a value for the acquisitions cost input) you shouldn't include acquisitions costs in your DCF valuation.
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