Is this a proper way to explain DCF?
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First you build a 5yr forecast of a company's FCF based on assumptions for revenue growth using the financial statements. The formal for FCF = (EBIT)(1- Tax rate) + dip + amort - cap expenditures - changes in working capital.
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Then you discount the FCF's using WACC in order to get the net present value. The formula for WACC = (% of equity)(cost of equity) + (% of debt)(cost of debt)(1- tax rate).
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After figuring out the net present value determine the terminal value using either the multiples method or the gordon growth method.
Growth method= FCF5(1 + Growth rate) / (WACC - growth rate) * choose a growth rate a little bit higher than the GDP rate
Multiples method= choose an exit multiple (EV/EBITDA) from comparable companies and assign it to the last years FCF
- Finally you discount the cash flows back to the present value to get the enterprise value.
EV = CF1/ (1+WACC) + CF2/ (1+WACC) + CF3/ (1+WACC) + CF4/ (1+WACC) + CF5/ (1+WACC)
Yes.
Just remember that for the final equation, its CF1 / (1+WACC) + CF2 / (1+WACC)^2 + .. etc, not just each years cash flow divided by (1+WACC)
Please remember that this explanation refers just to the FCF-to-firm model and while working with financial intitutions for example, the proper valuation method should be based on FCF-to-equity (and discounting with cost of equity, instead of WACC). In this case, the present value of the cash flows reflect the Equity Value of the firm.
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