1. Discounted Cash Flow Analysis
Primary way to value a company
Present value of the company’s free cash flow
Known as the company’s intrinsic value vs. market value
Free cash flow is equal to Revenues less expenses less capital investment less net working capital requirements
Provides a check on market based valuation approaches

2. Discounted Cash Flow Analysis
Discount rate used is the weighted average cost of capital (WACC)
Given the fact that slight changes in the WACC and the terminal value have tremendous impact in the valuation a sensitivity analysis is performed based on various WACCs and terminal values

3. Steps Determine the company’s key performance drivers
Project cash flow – 5 years
Calculate the WACC
Determine terminal value
Calculate PV and Determine valuation

4. Determine Key Performance Drivers
Know your industry
Know the company
Drivers
a) Sales growth
1) New products
2) Opening of stores
3) New markets
4) Market trends
5) Government influences
6) M&A

5. Determine Key Performance Drivers
b) Expense growth
1) Sales growth
2) M&A
3) Start-up costs
c) Cap Expenditures
d) Working capital requirements
Want to make sure that year 5 of the projections is at a normal rate representative of the company’s normalized operations.

6. Determine Key Performance Drivers
Make sure that there is a logic to the projection
a) Higher sales mean greater expenses, higher cap exp. And higher working capital requirements.
Operating expenses are usually based on historical operating margins.
S,G &A is usually based on historical % of sales
Expense margins are usually held constant unless there is something specific going on with the company

7. Free Cash Flow EBIT Less: Taxes at the Marginal Rate Equal EBIAT
What we are trying to avoid is earnings that are benefitting from extraordinary low rates for that year. Want projections to be built based on taxes that are at a normalized rate.
What is the marginal tax rate or the normalized rate? - Look at the historical tax rate

8. Free Cash Flow EBIAT Plus: Depreciation and amortization Less: Capex
Less: (Increase or decrease in net working capital)
Depreciation is usually estimated going forward as the existing level of depreciation plus a % of capex or of sales.
Amortization usually lumped in with depreciation or estimated as a % of sales

9. Free Cash Flow
Capital expenditures are shown on the cash flow statement
a) Usually use the historical number and the historical growth rate
b) May be adjusted if there are anticipated changes in the company’s strategy, etc.
c) You usually revert back to the historical rates

10. Free Cash Flow Net working capital
Current assets (accounts receivable, inventory, prepaid expenses and other)
Less
Current liabilities (accounts payable, accrued liabilities and other)

11. Free Cash Flow
Growing company usually has working capital requirements – Sales growth causes increase in inventory and accounts receivable
Can estimate net working capital as a whole but if possible the components of current assets and current liabilities are estimated and then put together

12. Free Cash Flow DSO (Days sales outstanding) = A/R / Sales x 365
Inventory Turns = COGS / Average Inventory
Prepaid and other current assets projected as a % of sales
DPO = Average A/P / COGS x 365
Other current liabilities and accrued liabilities projected as a % of sales

13. Weighted Average Cost of Capital
Rd x (1- t) x (total debt / total capitalization)
Re x (total equity / total capitalization)
Cost of debt is equal the weighted average cost of each outstanding debt issuance. Where there are bond issues it the current yield to maturity of the bonds.
t is the current tax rate

14. Cost of Equity Capital Asset Pricing Model
Rf + Beta x (market risk premium) = Cost of Equity
Market risk premium = 7.1%
Beta found on financial web sites. It is dependent on the capital structure of the company.
Rf is the yield to maturity of the 10 year US Treasury

15. Free Cash Flow
Need to look at the debt to total capital of comparable companies. If it is similar then you can use the beta for the company. If it is not then you need to go through the calculation of the average unlevered beta.

16. Terminal Value
Usually derived based on the comparable company approach. Most often EBITDA x (EBITDA multiple)

17. Determine the Value Calculate the PV of each projected cash flow
Remember to add terminal value to the last period. The terminal multiple is multiplied times the last 12 months results.
Add the PVs to get the value
Divide by the fully diluted number of shares to get the value per share

18. Sensitivity Analysis
Usually you create a chart of values with a number of different terminal values and WACCs
Then you need to pick the value that makes the most sense.

19. Pros and Cons
Pros
Cash flow based. The value of a company is the PV of the future cash flows of the company.
Independent of market and market conditions
Flexibility – Ability to tailor projections to different scenarios

20. Pros and Cons Cons Dependence on financial projections
Value significantly depends on the WACC and the terminal value
Terminal value is based on market conditions
Assumes a constant capital structure

21. Info for Projections Analyst reports
Annual investor day presentations provided by the company
Industry reports
Historical trends and relationships
a) Growth – step down rates for outer years
b) Profit margins
Usually look at the prior 3 years