What is a Discounted Cash Flow Analysis? Why do we do a?
Ais a discounted cash flow analysis which is an intrinsic valuation method. This method of valuation is focused on finding the " " which is the cash flow that is available to investors. Then you discount these cash flows to find how much they are worth today. This is in line with the idea that a dollar today is worth more than a dollar tomorrow.
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High LevelWalk Through
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- Project out cash flows for 5 - 10 years depending on the stability of the company
- Discount these cash flows to account for the time value of money
- Determine the terminal value of the company - assuming that the company does not stop operating after the projection window
- Discount the terminal value to account for the time value of money
- Sum the discounted values to find an enterprise value
- Subtract Net Debt and divide by diluted shares outstanding to find an intrinsic share price
Common Interview Follow Up Questions
What do you use as a discount rate?
Assuming that you are calcuating an unlevered , you would use the weighted average cost of capital ( ). This is calcuated as the:
Cost of debt * % of debt in the capital structure * (1- tax rate) + cost of equity * % of equity in the capital structure + cost of preferred equity * % of preferred equity in the capital structure.
Why do you multiply by (1-tax rate)?
You do this because interest expense (the cost of debt) is tax deductible so you need to account for this "debt tax shield."
What is the cost of equity?
The cost of equity is calcuated through the Capital Asset Pricing Model ().
= Risk free rate + Beta * (expected market return - risk free rate)
What should I use as my risk free rate?
You should use the US treasury yield in line with your projection window (i.e. if you are using a 10 year- use the 10 year US treasury yield).
What is theModel?
The gordon growth model is: The final year of free cash flow * (1+ therate) / ( - terminal growth rate)
What is the exit multiple method for determining the terminal value?
Find an industry average multiple and multiply it by final year revenue (if using/Revenue) or final year (if using / ).
Detailed Discounted Cash Flow Concepts to Review
Levered vs. Unlevered Free Cash Flow
Unlevered Free Cash Flows find the cash flow that is available to all investors (both debt and equity). Unlevered free cash flows should be discounted using.
Levered Free Cash Flow represents the cash flow that is available to just equity investors (after debt investors have been paid). This adjusts for mandatory debt repayments and interest expense. Levered Free Cash Flows should be discounted usingor the cost of equity.
Diluted Shares Outstanding
Diluted Shares Outstanding take into account basic shares outstanding and all options that are in the money. It is the worst case scenario for the number of shares outstanding.
What is the problem with the Discounted Cash Flow Analysis?
The is based on projections of the analyst performing the analysis and therefore if you put garbage in for your projections, your intrinsic share price will be meaningless.
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