Use of debt and cash in DCF calculations and the use of levered vs unlevered FCF
Hi,
I have been looking recently at how to calculate DCF to find the intrinsic value of a stock. However it is inconsistent whether or not to use total cash minus total current debt + long term debt and adding it to the sum of free cash flows. Also I am wondering whether for me, who is investing just for myself, whether I should use levered or unlevered free cash flow and what kind of discount rate to use. Furthermore when calculating levered free cash flow is it accurate to use Operating Cash flow - CapEX or should you really use Net Income + Depreciation + Amortization - change in net working capital - capital expenditures - mandatory debt payments. Thanks!
If you are investing in the equity of the company, you would use levered free cash flow because this is the cash flow available to you as an equity holder. To discount these cash flows, you would use CAPM. You won’t need to add cash or subtract debt because you already arrived at the equity value. Also, the last formula you have, which includes mandatory debt repayments and interest expense (by virtue of starting at net income) looks about right.
Thank you so much, this helps so much. Just one question, I'm not entirely sure what the discount rate means, my current understanding, which I believe to be false, Is that it is your required rate of return, and if the current share price is at the calculated intrinsic value when using DCF, the share price, by your calculations should increase by the discount rate year on year?
Did not fully understand the last bit of your comment but the discount rate is basically the required rate of return when you invest in the asset which is the return you can get when investing in similar assets.
Remember, returns are a function of risk. Risky asset -> high required rate of return Less risky asset -> lower required rate of return. Also, when investing in the equity side you use cost of equity (CAPM). WACC if you value FCF to the firm.
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