Wall Street Prep Training Manual

Discounted
Cash Flow (DCF)
Modeling

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v WWW.WALLSTREETPREP.COM
Valuation

Valuation is central to many areas of finance

Investment Banking (“The Sell Side”)

• When the client is the buyer: What is the best (usually lowest) price we can
negotiate?

• When the client is the seller: What’s the best (usually highest) price we can negotiate?

• When the client is a company going public: What’s the right pricing for our IPO?

“The Buy Side” Corporations

• Should we buy, sell or hold positions in • How do we enhance the value of our
a given security? company?

• Will this investment yield the desired • How will operating, financial, and
return? investment decisions affect the
company’s value?

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Valuation

Time value of money

• $1 today is worth more than $1 a year from now
• Why?

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Valuation

Time value of money

• We can express this formulaically as (we denote the discount rate as r):

• So, let’s say you’re promised $1,000 next year and decide you’re willing
to pay $800. We can express this (and solve for r) as:

• If I make the same proposition but instead of only promising $1,000

next year, let’s say I promise $1,000 for the next 5 years. The math gets
only slightly more complicated:

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Valuation

Present value exercise

Calculate the present value of this stream of cash flows:

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Valuation

Present value exercise - answer

Calculate the present value of this stream of cash flows:

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Discounted Cash Flow Basics

Perpetual growth
• In the last example, we assumed cash flows ended after 5 periods
• What if you instead wanted to value cash flows in perpetuity?
• We use a well-established perpetuity formula in mathematics:

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Discounted Cash Flow Basics

Perpetual growth

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Valuation

Net present value / Internal rate of return

• Net Present Value (NPV): The difference between the PV of cash
inflows and the PV of cash outflows. Often used in capital budgeting.
• Internal Rate of Return (IRR): Reflects the discount rate at which the
NPV of a cash flow stream equals zero
Exercise: Calculate the NPV and IRR of this stream of cash flows:

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Valuation

Net present value / Internal rate of return - answer

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Valuation

Enterprise value vs equity value

• In the prior NPV exercise, we never actually defined what “value” we are
talking about. When valuing a company, we have to be clear about “value of
what?” or said differently, “whose value?”
• Let’s think about buying a house as an example:
This is the value of the house (the
◽ The house costs $500k to buy enterprise value) How you decide to finance
(pay for) the home – this
◽ You pay for the $500k house with $100k from your bank account plus is your capital structure,
which summarizes the
a $400k mortgage various stakeholders and
how much their claims in
the home are worth
This is how much your equity
value is worth: how much you
This is the debt value of the house would get if you sold the house
tomorrow

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Valuation

Enterprise value vs equity value

• Finance professionals often explicitly want to value two (very related) things:

Enterprise value Equity value

• Enterprise value is the value of a • Equity value is the value of a

company’s core business company’s… well…equity

• This value is the same, regardless of the • Equity value is the amount you – as the
business is financed (debt or equity) equity owner - would get to put in your
pocket if you sold the company

• All else equal, the more debt, the less

residual value exists for the owners

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Valuation

Enterprise value = net debt + equity value

• What role does cash play in enterprise
value?
• Let’s say we find out that the house –
which we valued at $500k for its
foundation, walls, finishings, etc. – has Cash $50k

$50k sitting inside on the kitchen table

Net
debt
◽ We’re now willing to pay $550k for it, $400k Debt $450k
Enterprise
since we’ll also inherit the $50k, but the value
$500k
house itself is still worth $500k for its
foundation, walls, finishings, etc. Equity $100k

◽ We’ll have to take a mortgage out for

$450k now, and will still put in $100k of
equity

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Valuation

Let’s dig a little deeper: Enterprise vs equity value

• Enterprise value is the value of a company’s core business, which means that
in addition to not accounting for any financial obligations (debt, etc.), it also
doesn’t account for any non-core financial assets.
• As such, we can re-arrange the balance sheet equation to define enterprise
value directly:
Operating assets: All Operating liabilities: Includes cash & nonoperating assets Includes debt (loans, revolver, bonds)
assets except for cash All liabilities except like marketable securities, short term & “debt-like” instruments like leases,
& other investment for debt & debt-like investments, equity investments non-controlling interests, preferred
assets. liabilities. stock

(Operating assets – operating liabilities) + cash – debt = Equity value

This is a formula you’ll see everywhere. Finance

Enterprise value – net debt = Equity value professionals often just net cash against the debt in
this formula to arrive at a “net debt” figure.

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Valuation

Valuation
• Suppose you have a Income Statement
For the year ending 12/31/2019
Balance Sheet
For the period ending 12/31/2019
business and seek Revenues 102,000 Cash 167,900
to sell it and are Cost of goods sold (COGS)
Gross profit
(20,000)
82,000
Marketable securities
Accounts Receivable (AR)
100,000
20,000
offered 10x last SG&A (29,000)
Inventories
Prepaid expenses
30,000
2,500
twelve months EBITDA 53,000 PP&E
Total Assets
60,000
380,400
(“LTM”) EBITDA D&A
Operating Income (aka EBIT)
(10,000)
43,000 Accounts Payable (AP) 10,000
Accrued expenses 4,000
Interest expense (5,000) Deferred revenue 3,000
Interest income 1,000 Debt 250,000
Enterprise value? Pretax profit (EBT) 39,000 Total Liabilities 267,000
________________
Taxes (15,600) Common Equity 100,000
Net Income 23,400 Retained Earnings 13,400
Dividends 10,000 Total Shareholders' Equity 113,400
Equity value?
Earnings per share $2.05 Total Liabilities + Equity 380,400
_______________ Shares outstanding 11,415

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Valuation

Valuation
• Challenge: Instead, you are offered 20x LTM P/E.
• Recalculate the following:

Enterprise value? Equity value?

________________ _______________

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Discounted
Cash Flow Basics

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Discounted Cash Flow Basics

Two-Stage DCF Process

• With the basic present value mechanics under our belts we can use
them to value a business using the The 2-stage DCF discounted cash
flow (DCF) approach:
◽Stage 1: The DCF approach forecasts annual cash flows for 5-7 years
(presumably during this period the forecaster has some confidence
about what they think might happen to the business
◽Stage 2: After 5-7 years, the DCF approach involves assuming a
perpetuity growth rate on the final cash flow forecast and calculating
the present value of all the cash beyond the first stage 1.
• Let’s demonstrate this with a simple hot dog stand example

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Discounted Cash Flow Basics

Hot Dog Stand Exercise

• You own and operate a hot dog stand with expected cash flows and
EBITDA as shown:
• Based on the forecasts on the right Free
and assuming all cash flows are cash
Year flows EBITDA
generated at the end of the period,
2021 10,500 15,500
what is the present value of the hot
2022 13,000 18,000
dog stand?
2023 15,000 20,000
• Although you don’t need EBITDA to 2024 17,500 22,500
calculate this, we’ll use EBITDA later. 2025 20,500 25,500
Growth
2026 and
beyond 5% 5%
Discount
rate 10%
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Discounted Cash Flow Basics

Hot Dog Stand Exercise (Continued)

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Discounted Cash Flow Basics

Hot Dog Stand Exercise (Continued)

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Discounted Cash Flow Basics

DCF in contrast to comps

• We valued our business at $323,547 based on a DCF valuation
approach. We could have valued the hot dog stand by looking at the
value of comparable businesses:
• In comps, values are typically compared relative to a measure of the
firm’s profitability (EV/EBITDA, P/E, P/B):
• These ratios are called multiples; which facilitate comparisons for
companies of different size, leverage and other characteristics

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Discounted Cash Flow Basics

DCF in contrast to comps

• Three nearly identical hot dog stands were recently sold:

Comp 1 Comp 2 Comp 3

• Price: $260,000 • Price: $380,000 • Price: $150,000

• 2021 EBITDA: $9,000 • 2021 EBITDA: $18,000 • 2021 EBITDA: $8,000

Value your hot dog stand using a comps approach

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Discounted Cash Flow Basics

DCF in contrast to comps

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Discounted Cash Flow Basics

DCF as compared to other valuation methods

Comparable Comparable
Discounted Cash
Company Transactions Other
Flow Analysis
Analysis Analysis

Value a company Value a company Value a company by Leveraged buyout (LBO) analysis:
by finding similar by looking at the looking at the future A specific type of valuation approach that
public companies amount buyers cash flows it can looks at the value of a company to new
with readily have paid for generate and discount acquirers under a highly leveraged
observable market acquiring similar them to the present to scenario with specific return
prices. companies in the arrive at a present requirements. We’ll talk about this
recent past. value of your approach later, but it’s basically a hybrid
business. of DCF and comps valuation.
Because these approaches arrive at a company’s Liquidation analysis: Value a company
value by looking at the value of similar
under a worst-case liquidation scenario.
companies, these approaches fall under the
umbrella of “relative valuation.” Because the DCF arrives at
a company value by
looking at the company’s
While the DCF and comps are the most
specific cash flow
common valuation approaches, there are
forecasts and risks, the
often other, specific valuation approaches
DCF approach is a type of
that are included in analyses when it makes
“intrinsic valuation”, as
sense to do so.
opposed to “relative
valuation.”

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Discounted Cash Flow Basics

DCF in contrast to comps

• What are the pros and cons of DCF vs Comps
• When would the DCF be a better approach?
• When would comps be a better approach?

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Discounted Cash Flow Basics

DCF in contrast to comps

• What are the pros and cons of DCF vs Comps?
◽ The DCF looks at the intrinsic value of a business – tells you how much a business is worth based on the company’s
ability to generate cash flows. It is not driven by the market’s supply and demand for the business.

◽ While this is the DCF’s biggest advantage, the challenge with the DCF is that unlike the market derived values of
comps which can be plainly observed, the DCF value is based on the analyst’s assumptions – and key assumptions
like discount rate, growth rates and margin assumptions really impact the valuation

◽ Because of the relative strengths and weaknesses, both are often used together.

• When would the DCF be a better approach?

◽ There are no great comps

◽ The market valuation is unreliable (not traded)

◽ An investor wants to contextualize market valuation to see if the business is overvalued / undervalued

• When would comps be a better approach?

◽ When your goal is to understand the actual price you would need to pay to acquire a business or what you
can expect to achieve when trying to sell a business (i.e. “the market determines the price, not a DCF”)

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Discounted
Cash Flow Model
Basics

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Discounted Cash Flow Model Basics

Roadmap of where we’re headed: how a DCF works

Stage #1: Projecting UFCFs Stage #2: Calculating

Forecast period is typically the TV
5-10 years Estimate the value of the
company at the end of
stage 1 then discount to
present =
Enterprise value
Value of the operations

Discount using WACC

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Discounted Cash Flow Model Basics

6 steps to building a DCF

1. Forecast unlevered free cash flows (UFCFs): Step 1 is to forecast the cash flows a
company generates from its core operations after accounting for all operating
expenses and investments. These cash flows are called “unlevered free cash flows.”
2. Calculate terminal value: You can’t keep forecasting cash flows forever. At some
point, you must make some high-level assumptions about cash flows beyond the
final explicit forecast year by estimating a lump-sum value of the business past its
explicit forecast period. That lump sum is called the “terminal value.”
3. Discount cash flows to the present at the weighted average cost of capital: The
discount rate that reflects the riskiness of the UFCFs is called the weighted average
cost of capital (WACC). Because unlevered free cash flows represent all operating
cash flows, these cash flows “belong” to both the company’s lenders and owners.
▸ The risks of both providers of capital need to be accounted for using the right
debt and equity weights (hence the term “weighted average” cost of capital).
▸ Once discounted, the present value of all UFCFs is the enterprise value.

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Discounted Cash Flow Model Basics

6 steps to building a DCF

4. Add the value of non-operating: So far, the DCF has estimated the enterprise value – the
value of the firm’s operations. To get at what belongs to the equity owners (equity value),
we must consider any non operating assets. Therefore, if a company has cash or non-
operating assets, we must add them to the present value of UFCFs.

5. Subtract debt and other non-equity claims: Similarly, if a company has any loan
obligations (or any other non-equity claims against the business), we need to subtract
this from the present value. What’s left over belongs to equity owners.

Say we calculate that Apple’s enterprise value (value of operations) to be $1.2 trillion. How much value is
there for equity owners if Apple also has $200 billion in cash just sitting around, and $100 billion in debt?
Enterprise value – debt + cash = Equity value
$1.2 trillion $100b $200b $1.3 trillion

6. Divide equity value by shares outstanding: The equity value tells us what the total
value to owners is. But what is the value of each share? For that, we divide the equity
value by the shares outstanding. For public companies, the equity value per share that the
DCF spits out can now be compared to the market share price.

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Discounted Cash Flow Model Basics

1 Forecasting unlevered free cash flows (UFCF)

The Unlevered Free Cash Flow Formula:
EBIT x (1- Tax rate) + D&A + Δ in Net working capital – Capital expenditures
NOPAT

EBIT • Earnings before interest and taxes (GAAP operating profit)

• Represents unlevered accrual-based pre-tax profits
Tax rate When forecasting taxes, we usually use a company’s historical effective tax rate
Also called NOPAT (net operating profit after taxes)
NOPAT NOPAT (net operating profit after taxes) represents unlevered accrual based after tax profits
Think of NOPAT as the accrual-based starting point for the UFCF calculation
D&A Add back depreciation & amortization to NOPAT because it is noncash

Δ in net working Increases in NWC are cash outflows while decreases are cash inflows.
capital (NWC)
Capital Expenditures necessary to sustain the forecast growth of the business. If you don’t factor in the cost
expenditure of required reinvestment into the business, you will overstate the value of the company by giving it
credit for EBIT growth without accounting for the investments required to achieve it.

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Discounted Cash Flow Model Basics

1 Forecasting free cash flows (UFCF)

Unlevered free cash flows

forecast for 5 years

We also must discount these UFCFs to ‘present value’ – we’ll discuss that shortly

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Discounted Cash Flow Model Basics

2 Calculate the Terminal Value

• To figure out the value of a business today, theoretically you have to find the present
value of ALL future unlevered free cash flows.

• Finance professionals usually only explicitly forecast unlevered free cash flows for 5-10
years and then make a very simplified assumption about the value of all unlevered free
cash flows thereafter, called the terminal value (TV). TV is the value the company will
generate from all future unlevered FCFs after the explicit forecast period (stage 1).

• Breaking up the value of a company into two stages is the prevailing practice and is called
a 2-stage DCF

• Formula for a 2-stage DCF with a 5-year explicit forecast period:

Notice that the terminal value itself needs to be discounted back to the present
because it reflects the value of the future cash flows at the final explicit forecast year!

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Discounted Cash Flow Model Basics

2 Terminal value – 2 approaches

1. The growth in perpetuity approach: The growth in perpetuity approach requires that we make
an explicit assumption for a perpetual annual growth % of UFCFs after the last year of stage 1 at a
constant WACC (denoted as ‘r’ in the formula below).

1. Exit EBITDA multiple method: The big problem with the perpetuity approach above is that it
forces finance professionals to explicitly guess the perpetual growth rate of a company.

▸ In practice, it’s usually a range between 3-5% because it’s in-line with macroeconomic
growth expectations and anything higher is considered unjustifiable.

▸ A way around having to guess a company’s long-term growth rate is to guess the EBITDA
multiple the company will be valued at the last year of the Stage 1 forecast.

▸ A common way to do this is to look at the current enterprise value (EV) /EBITDA multiple the
company is trading at (or the average EV/EBITDA multiple of the company’s peer group) and
assume the company will be valued at that same multiple in the future.

▸ For example, if Apple is currently valued at 9.0x its last twelve months (LTM) EBITDA,
assume that in 2022 it will be valued at 9.0x its 2022 EBITDA.
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Discounted Cash Flow Model Basics

2 Terminal value – 2 approaches

Once we calculate
cash flows for
forecast years 1-5
(Stage 1), we turn to
estimating the
present value of cash
flows generated after
period 5 (called the
terminal value) -
there are 2
approaches.

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Discounted Cash Flow Model Basics

3 Discount cash flows to at the WACC

Cash forecasts are just

that – forecasts. They
may not come true!

There are risks.

To figure out how much

a business is worth
today, we need to
discount those cash
flow forecasts to
reflects their inherent
risks to the debt and
equity investors – this
blended risk is called
the weighted average
cost of capital

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Discounted Cash Flow Model Basics

PV of Stage 1 CFs + PV of TV = Enterprise value

Adding the present

value of stage 1 and
the terminal value

Because you use two

approaches to get
terminal value, you’ll
get two enterprise
values (we usually
present both as a
range of possible
enterprise values)

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Discounted Cash Flow Model Basics

4-5 From enterprise value to equity value

• To get from enterprise value to equity value, we must subtract net debt

Net debt

Non-operating Non-equity
assets (cash) financial claims
(Debt)

Enterprise
value
Value of the Equity
Debt is usually greater than
operations value
cash, but as we’ll see with
Apple, that’s not always the case

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Discounted Cash Flow Model Basics

4-5 Getting to equity value: Net debt

Here is Apple’s balance sheet. The non-operating

assets are its cash and equivalents, short-term
marketable securities and long-term marketable
securities. As you can see, they represent a
significant portion of the company’s balance sheet.

Unlike operating assets such as PP&E, inventory

and intangible assets, the book value of non-
operating assets is usually close to the market
value. That’s because they are mostly comprised of
cash and liquid investments that companies
generally can mark up to fair value.

Commercial paper, long-term debt (including

current portion) make up Apple’s non-equity
claims.

As with the non-operating assets, finance

professionals usually just use the latest balance
sheet values of these items as a proxy for the actual
values. The market value of debt doesn’t usually
deviate too much from the book value.

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Discounted Cash Flow Model Basics

6 Equity value to Equity value per share

• Once a company’s equity value has been calculated, the next step is to
determine the number of shares that are currently outstanding to get to
value per share.
• To do this, take the current actual share count from the front cover of
the company’s latest annual (10K) or interim (10Q) filing. For Apple:

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Discounted Cash Flow Model Basics

6 Basic shares + dilutive shares

• Shares must include impact of potentially dilutive securities

These are shares that aren’t quite common stock

yet, but that can become common stock and thus
be potentially dilutive to the common shareholders
(i.e. stock options, warrants, restricted stock and
convertible debt and convertible preferred stock).

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Discounted Cash Flow Model Basics

6 Final valuation

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Discounted Cash Flow Model Basics

DCF Pros & Cons

DCF Advantages
__________________________________________________________ With the DCF,
__________________________________________________________ you always
have the issue
__________________________________________________________ of “Garbage in
= Garbage out”
__________________________________________________________
__________________________________________________________
DCF Disadvantages
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________

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Discounted Cash Flow Model Basics

DCF Pros & Cons

DCF Advantages
◽ Intrinsic – not distorted by supply & demand With the DCF,
you always
◽ Explains market valuation and shows the impact of have the issue
different assumptions on a company’s value of “Garbage in
= Garbage out”

DCF Disadvantages
◽ Heavily based on assumptions
◽ Highly sensitive to impossible-to-accurately-predict terminal values
◽ When exit multiples are used to calculate the terminal value it introduces
significant noise from market into an intrinsic valuation
◽ Doesn’t provide insight into how the market is actually valuing a company

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Discounted
Cash Flow Modeling
Step-by-Step

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Discounted Cash Flow Modeling Step-by-Step

Our case study…

Throughout the case study, assume
date of analysis is February 28, 2020

Open the following files to begin: Apple

(AAPL:NASDAQ)
• DCF Model (Excel)
• Estimates (JPEG)
• Apple 2019 10K (PDF)
• Apple Q1 2020 (PDF)

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Discounted Cash Flow Modeling Step-by-Step

Our DCF modeling roadmap

Part 1 - Building a DCF model

Forecasting Terminal
Discounting Net Debt Presentation
Cash Flows Value

Part 2 - Adding complexity to the DCF

Connect to
Advanced
Midyear 3- Additional
WACC Shares
Convention Statement DCF Issues
Topics
Model

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Discounted Cash Flow Modeling Step-by-Step

Did you get this error when opening the file?

• Click OK and then enable iterative calculations

• Excel 2013, 2010 & 2007: Excel Options | Formulas | Enable Iterative Calculation
• Excel 2003: Tools |Options | Calculation | Select Iteration
• Mac Excel: Excel | Preferences (⌘ + ,) | Calculation | Select Iteration

Why did I get this message?

• Because the DCF model file includes a full financial statement model (FSM) that
we built for Apple which has an intentional circularity. Excel detected the
circularity in the file and wants you to tell it how to deal with it.

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Discounted Cash Flow Modeling Step-by-Step

There are two ways to build a DCF

1) Linked to a fully integrated 3 statement model - Requires a full 3
statement model to be built. Usually used in a live deal or when
complete financials are available (public companies). Has the benefit
of ensuring consistent relationships across the 3 financial statements
but can be overkill in some circumstances.
2) As a standalone (1-pager) DCF - Unlike a full financial statement
model, only a few explicit forecasts are required to forecast unlevered
free cash flows in a 1-pager as you see here. A 1 pager is used for
pitchbooks, back of the envelope analysis, or for private companies
when only key financial data is available.
We will start with a standalone 1 pager model, then show you how
easy it is to link to a fully integrated 3 statement model

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Discounted Cash Flow Modeling Step-by-Step

Getting started
• Historicals: From management (private cos) or filings (public cos).
• Forecasts: will usually come from management (“management case”)
with upside/downside scenarios. For public cos, consensus equity
research may instead anchor the scenarios as a “street case.”
We will use street consensus for key forecasts

Note: See how consensus estimates are presented as absolute values. However, best practice for modeling is to
hardcode the implied growth rates and implied margins and back into the absolute values as a calculation
We do this next…

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Excel worksheet:
Inputs & UFCF

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Discounted Cash Flow Modeling Step-by-Step

General and Date Assumptions

Use EOMONTH

Calculate how much of the Review date

first forecast year has YET WACC is
headers
to happen (use YEARFRAC) sometimes
hardcoded like
this, sometimes,
there’s a full
Ignore Midyear adjustment buildup (we’ll
toggle for now (we’ll get to show you how
this shortly) later)

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Discounted Cash Flow Modeling Step-by-Step

Forecasting
Forecast unlevered free cash flows Forecast the financials based on the research consensus for AAPL

Historicals
(Apple 10K)

When done, check your forecasts against the provided Estimates (“Financials” tab). While
numbers wont exactly match consensus due to rounding and the fact that we’re backing into the
absolute figures by using implied growth rates and margins but should come close.

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Discounted Cash Flow Modeling Step-by-Step

Let’s Discuss…
• Why don’t we just use cash from operations
(instead of unlevered free cash flows?)
• Why don’t we add back stock-based
compensation?
• Why don’t we include debt related
inflows/outflows or dividends (i.e. cash from
financing?)

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Discounted Cash Flow Modeling Step-by-Step

Let’s Discuss…
• Why don’t we just use cash from operations (instead of unlevered free cash flows?)
◽ “free” in free cash flows refers to what can be taken out of the business (via dividends, interest,
etc.) without altering the operating prospects of the business. If you distributed all the operating
cash flows you wouldn’t have enough money to reinvest back into the business (capex, working
capital)
◽ Read more: https://www.wallstreetprep.com/knowledge/ebitda-vs-cash-flows-from-operations-
vs-free-cash-flows/
• Why don’t we add back stock-based compensation?
◽ Even though SBC is non-cash, it leads to future dilution to current shareholders which they
wouldn’t have otherwise. Ignoring it means you will state the equity value to current owners
(because it ignores that part of this value will go to future owners.
◽ So to properly arrive at equity value to current owners, the easiest thing to do is simply not add
back SBC.
◽ Read more: https://www.wallstreetprep.com/knowledge/stock-based-compensation-treatment-
dcf-almost-always-wrong/
• Why don’t we include debt related inflows/outflows or dividends (i.e. cash from financing?)
◽ Because we are directly valuing the enterprise value – which is the value of the operations of the
business and belongs to all providers of capital. To get to the value of equity, we subtract net debt.

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Excel worksheet:
PV UFCF

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Discounted Cash Flow Modeling Step-by-Step

Discounting cash flows - Stub

We’re now ready to turn to discounting unlevered FCF back to the valuation date at the WACC
The first period needs to be stub adjusted to reflect that 40% of the first year’s cash flows are in the
past and we should only count the ~60% that haven’t occurred yet.

No adjustments need to be made

after year one, simply reference
cash flows from row 30

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Discounted Cash Flow Modeling Step-by-Step

Discounting cash flows - Discounting

We’re now ready to discount the cash flows back to the valuation date at the WACC
Note how we can use the date headers to determine the forecast period

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Terminal Value

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Terminal Value

Terminal value (TV) - growth in perpetuity approach

• Assumes cash flows will grow at a perpetual & constant growth
rate after stage 1. This yields value at end of stage 1:

• We need to discount it back further to get the present value as

of the valuation date:

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Terminal Value

Calculating FCF in the terminal year

• Perpetuity formula requires using a FCF that is one year beyond
the projection period

• The most common way to deal with this is to take FCF in the last
year of the projection period (t) and grow it one more year (t+1)
at the long-term growth rate.

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Terminal Value

What is the right long-term growth rate ‘g’?

• No business can be expected to grow forever at rates above the
economy, so ‘g’ should be a sustainable rate
◽In practice a 2-5% range is most frequently used
◽High growth / early stage with high growth rates during stage 1 tend
to be valued with a higher long-term growth rate than companies
with lower stage 1 growth rates
◽‘Fuzziness’ of this is an often-criticized part of the DCF
◽DCF outputs are frequently presented using a range of growth rate
assumptions

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Terminal Value

Exit multiple method

• Instead of using the growth in perpetuity equation, TV is
often calculated simply as:
EBITDA multiple x EBITDA Last Forecast Year

Usually derived from a trading comps or transaction

comps analysis, depending on the purpose of the DCF
(standalone valuation or for acquisition analysis)

The exit multiple approach is popular b/c it requires

fewer explicit assumptions about future cash flows,
growth, and more ‘realistic’ than perpetuity growth

64
Terminal Value

Locate the comps-derived average EBITDA multiple for Apple (Data provided by CIQ)
By using this multiple as the exit multiple, we’re saying that this is the multiple we expect for Apple in 2023

65
Terminal Value

Exit multiple method implementation caveats

• Multiple should reflect a steady-state multiple so check that the
multiple hasn’t changed markedly in last 12 months. If it has,
estimate the average multiple over the last year
• If comps-derived multiple today is inappropriate for 2024 then
multiple should be adjusted.
• For example, assuming multiple expansion (higher future
multiple than current multiple) is aggressive and implicitly
assumes higher returns on capital, growth and lower risk -
usually unjustifiable!

66
Terminal Value

Exit multiple method implementation caveats

• Use median because when peer group is large / mean when
peer group is small
• Both Factset and Capital IQ are widely used data services by
analysts to calculate comps.
◽In practice, you are often required to spread your own comps
rather than relying on a data provider.
◽This process is an important part of the analyst skill set and is
the subject of our comps training program.

67
Terminal Value

Implementation caveats
• EV/EBITDA is most common multiple but can use any enterprise
value multiple in unlevered DCF (EV/Rev, EV/EBIT, etc.)
• P/E and P/B is most common in levered DCF
• Just like with perpetuity approach, terminal value derived from
exit EBITDA needs to be discounted to present using the WACC

68
Excel worksheet:
Terminal Val

69
Terminal Value

Now that we’ve discounted stage 1 cash flows, let’s estimate the terminal value
• Perpetuity approach – assume a 3% perpetuity growth rate.
• Exit EBITDA Approach – assume 12.5x EV/EBITDA based on a peer group analysis

Estimate Apple’s EV using the perpetuity approach Estimate Apple’s EV using the EBITDA multiple approach
1. Estimate 2025 FCF by growing 2024 FCF by 3% 1. Reference 2024 EBITDA
2. Calculate TV in 2024 using the perpetuity formula 2. Input the comps-derived average EBITDA multiple
3. Discount TV to its PV 3. Calculate terminal value in 2023 as 2023 EBITDA x
4. Calculate Apple’s enterprise value as: PV of TV + PV of EBITDA multiple
stage 1 FCFs 4. Discount TV to its PV
5. Calculate what % of total enterprise value comes from 5. Calculate Apple’s enterprise value as: PV of TV + PV of
the terminal value stage 1 FCFs
6. Calculate the implied TV exit EBITDA multiple 6. Review the implied growth rate formula…If the EBITDA
calculation approach implies a high terminal growth rate, does that
challenge the validity of the EBITDA multiple?
70
Terminal Value

Discounting cash flows – Terminal value

Check your work

71
Terminal Value

Implied Terminal Growth Rate

• When using the EBITDA multiple to calculate TV, you can calculate the
implied growth rate by using the following formula

72
From Enterprise
Value to EquityFrom
Value:
Net DebtEnterprise
Value to
Equity
Value: Net
Debt
From Enterprise Value to Equity Value: Net Debt

Net debt
• Now that we have enterprise value, we can get to equity value by
subtracting net debt
• Components of net debt

Debt and equivalents Cash and equivalents

• Debt • Cash and equivalents
Net debt = • Non-controlling - • Marketable securities and
interests investments
• Preferred Stock • Other non operating assets

74
From Enterprise Value to Equity Value: Net Debt

Standard/Traditional Debt
• Long-term debt (including convertible debt): Debt a maturity (full
repayment) exceeding 12 months is usually presented on the B/S and is
often identified in more detail in the debt footnote, along with interest
rates and dates of maturity. When debt is convertible, footnote will
often disclose the number of shares the debt is convertible into, in
addition to the conversion price. 1
• Notes payable / Commercial paper / Short term debt: May be
identified separately or included with current portion of long-term
debt. If it is lumped together, the Debt footnote will identify them
separately.
• Current portion of long-term debt: Portion of debt with an overall
maturity of more than a year due within 12 months. The Debt footnote
will usually identify if not explicitly on the balance sheet

75
From Enterprise Value to Equity Value: Net Debt

Debt: In the weeds

Debt
For simplicity, we’re using balance
sheet debt in this case study.
However, know that the balance
sheet provides debt net of any
unamortized debt discounts and debt
issuance costs.

When material, locate the principal

balance in the debt footnote

76
From Enterprise Value to Equity Value: Net Debt

Debt equivalents
• Noncontrolling interests: Portion of the consolidated business that
the common shareholders do not own
◽NCI expense should be excluded from the calculation of UFCF (if you
start the UFCF calculation with EBIT no adjustment necessary since
EBIT is before NCI expense).
• Preferred stock (including convertible preferred stock): Non-
common equity financial claim on the business with priority over
common stock. For convertible stock, footnote will often disclose the
conversion features.1
• Finance Leases: Explicitly identified on balance sheet or footnote.
Treat as debt equivalents

77
From Enterprise Value to Equity Value: Net Debt

Non-operating assets
• While we estimated the value of operating assets by present valuing
future UFCFs, what about the value of non-operating assets like idle
cash & investments?
◽Cash & equivalents: Include marketable securities and investments
◽Equity investments in affiliates: If affiliate income not captured in
the FCF forecast, include value of affiliate investments as a non-
operating asset
◽Use book value of idle cash & investments as of the latest filing
◽For affiliate investments use book value unless market value
available

78
Excel worksheet:
Net Debt

79
From Enterprise Value to Equity Value: Net Debt

Calculating Net Debt

Calculate Apple’s latest net debt using the latest 10Q
Because Apple has so much more cash than debt, it has negative net debt. This
means that the equity value is greater than enterprise value (the value of
Apple’s core business) because owners benefit from owning the operating
business and having all that cash on the balance sheet.

Does Apple have any

convertible securities
or non controlling
interests?

Make sure to get all

cash equivalents –
including investments
listed as long term!

80
From Enterprise Value to Equity Value: Net Debt

Calculating Net Debt (Continued)

Check your work

81
Shares Outstanding
Shares Outstanding

Basic shares
outstanding
• You can find the latest
outstanding number of
common shares
outstanding by looking
at the front page of the
latest filing (i.e., 10-Q
or 10-K)

92,989,772

83
Shares Outstanding

Diluted vs. basic

shares outstanding The value of a slice of pizza - given a
value for the entire pie - depends on the
• However, you should use diluted size of the slice…
shares instead of actual (basic) shares
when calculating fair value per share. $4 $2

• This is because the fair value per

share should account for not just the
actual shares outstanding, but also
potentially dilutive securities.
◽ Ignoring this in the share count Entire pie = Entire pie =
would mean you’re dividing the $16 $16
model-derived equity value by not If you get the number of slices wrong,
enough shares and thus overstate you’ll get the value of each slice wrong.
the value of each share

84
Shares Outstanding

Diluted shares outstanding

• Calculating shares correctly using source filings is critical
• Used in arriving at equity value per share in the DCF

Diluted shares outstanding = Basic shares + dilutive securities

Front cover of • Stock options & warrants

latest filing • Restricted stock and restricted stock
units (RSUs)
• Convertible bonds and convertible
preferred stock

85
Shares Outstanding

Dilutive securities
• Stock options issued to pay and motivate employees. Gives employees the option to
purchase common stock at a given price over an extended period

• Warrants are similar to options, except they are usually issued to lenders, not employees

• Restricted stock and restricted stock units (RSUs) are shares subject to vesting and,
often, other restrictions. Unlike options, there is no exercise price and employees receive
the stock free and clear after vesting.

• Convertible bonds are bonds that the company issues that can be converted into
common shares upon a certain strike price. The conversion feature allows the
corporation an opportunity to obtain equity capital without giving up more ownership
control than necessary and/or entice investors to accept lower interest rates than they
would normally accept on a straight debt issue

• Convertible preferred stock is similar to convertible debt, except that the provider of
capital usually receives a preferred stock dividends instead of interest payments

86
Shares Outstanding

Calculating shares outstanding

A business with an equity value of $500m has Share price: _______________
100m shares outstanding

Now assume option holders hold 25m exercisable

Share price: _______________
options (assume a $0 exercise price)

Now assume that in addition to the options,

convertible preferred shareholders hold 15m
shares, each convertible into 5 shares of Share price: _______________
common stock (assume no dividends and no
liquidation value).

87
Shares Outstanding

Restricted stock disclosure

For calculating diluted shares,
should we include vested restricted
stock? What about unvested?
• Vested restricted shares: Like options,
restricted stock vests over several years, but
when they vest, they automatically get included
in the actual share count, so there is no dilutive
impact

• Unvested shares: The most common approach

is to include in the diluted share count, logic
being that since it is highly likely that unvested
restricted stock will in fact vest over the next
several years (vesting periods average 1-3
years), it is more conservative to include all
unvested restricted shares in the dilutive share
count than to exclude.

88
 Excel worksheet:
Shares Outstanding

89
Shares Outstanding

Diluted Share Calculation

Locate the latest basic share count from front cover of latest filing
• Are there any restricted shares or RSUs?
• What about options or convertible securities?

90
Shares Outstanding

Diluted Share Calculation (Continued)

Check your work

91
DCF Presentation
DCF
Presen
tation
Excel worksheet:
Valuation

93
DCF Presentation

Enterprise Value to Equity Value

It’s time to present the results of our analysis
For both TV approaches, what is equity value per share. How does it compare to the
current market value?

94
DCF Presentation

Enterprise Value to Equity Value (Continued)

It’s time to present the results of our analysis
For both TV approaches, what is equity value per share. How does it compare to the
current market value?

95
Excel worksheet:
Outputs

96
DCF Presentation

Sensitivity Tables
What are the ranges of outcomes?
Build data tables that output a range of equity values per share and year 1 EBITDA
multiples at various WACC, long term growth rate, exit EBITDA multiple sensitivities

97
DCF Presentation

Sensitivity Tables (Continued)

Check your work

98
DCF Presentation

Football field
DCF Equity Valuation Range

400.00

350.00 327.85
314.36
300.00 285.87

250.00
255.11
243.66
200.00

150.00 169.50

100.00
DCF Value at 11.5x-13.5x Exit DCF Value at 2.0%-4.0% 52 Week Market High/Low
EBITDA Range at 9.0% Perpetuity Range at 9.0%
WACC WACC

99
DCF Presentation

Football field
LTM EBITDA Multiple Range

20.0x
19.0x
18.0x
17.0x
16.0x
16.0x
15.0x 14.5x
14.2x
14.0x
13.0x
13.1x
12.0x 12.8x
12.2x
11.0x
10.0x
LTM EBITDA Purchase Multiple at LTM EBITDA Purchase Multiple at LTM EBITDA Purchase Multiple at
2.0%-4.0% Perpetuity Growth at 12.8x-14.5x Exit EBITDA Multiple 8.0%-10.0% WACC at 12.5x Exit
9.0% WACC at 9.0% WACC EBITDA

100
YAY!!!!! You built a
DCF model!!!

101
DCF Presentation

Let’s Discuss…
• How does the valuation compare to Apple’s
current trading price?
• What parts of this output are more relevant for
private companies? Public?
• Why is the Exit multiple seemingly less
sensitive to WACC changes?
• Are there other important inputs that might be
helpful to present in a sensitivity?

102
Midyear Adjustment

103
Midyear Adjustment

Midyear adjustment
• Up to now, we’ve assumed all cash flows occur at the end of each period. Obviously,
that’s not usually the case unless you’re working with a very seasonal business.
• Instead it is preferable to assume cash flows occur midperiod by default.

Before modeling – how do you think assuming midyear – instead of end of year - cash
flows impacts our valuation? Will this adjustment lower or raise our valuation?
104
Midyear Adjustment

Midyear adjustment
Flip the
adjustment back to
0 to test that both
options work in
the toggle

Adjust the date header used for

discounting cash flows to show the
middle of the period if Midyear …Notice how
adjustment is selected (use the this leads to a
valuation date as the start point for higher present
the stub year)… value of UFCFs
(because the
discounting
exponent is now
lower)
105
WACC

106
WACC

WACC Calculation

Up to now we’ve used a simple har-

coded WACC. Let’s now drive this off
a schedule with explicit WACC
components and inputs.

But first, let’s make sure we

understand the basic components of
WACC…

107
WACC

Risk & return are two sides of the same coin

• Quantifying the WACC, is a critical field of study in corporate finance.
• You can spend an entire semester learning about it but over the next
few slides we summarize the core ideas:
• Cash flows we forecast are not a sure thing because companies may not
achieve the UFCFs we expect. Even worse, companies can go bankrupt.
• The WACC is an attempt to quantify out what an investor today might
be willing to pay for those uncertain future UFCFs.
• To do that, you’d need to figure out what kind of return the investors
want. And to do that, you would need to quantify the riskiness of those
cash flows somehow.

108
WACC

Both debt and equity risk & return must be reflected

• Unlevered free cash flows belong to Unlevered free cash flows
both lenders (debt) and owners (equity) $$$$$$$$$ $$$$$$$$$
Payments to Remainder
• Lenders get priority for their interest lenders to equity
and principal payments.
• The cost of debt is what lenders charge for taking the risk of lending.
It is generally observable and thus straight-forward.
• From the company’s perspective, interest payments are tax
deductible (“tax shield”), so if you have to pay 5% interest and your
tax rate is 25%, the actual cost to you is 5% x (1 – 25%) = 3.75%.

109
WACC

Both debt and equity risk & return must be reflected

• Any remaining UFCFs belong to owners. Unlevered free cash flows
• Because equity gets priority after lenders, $$$$$$$$$ $$$$$$$$$
equity investors expect a higher return Payments to Remainder
than lenders lenders to equity

• That expected equity return is called the

cost of equity and quantifying this cost is hard because the timing and
amount of equity returns is far less defined.
• Theoretically, they’ll get it eventually in the form of dividends.
However, companies have complete freedom to decide when to pay
those; Many just keep pouring the residual UFCFs back into the
business in lieu of dividends. But the money belongs to equity investors
whether it’s distributed as dividends or whether it’s sitting in the
company’s bank account.

110
WACC

Capital structure determines the capital weights

• The appropriate discount rate to use in the unlevered DCF has to blend
the cost of debt and cost of equity.
• The appropriate weight placed on both costs depends on the company’s
expected capital structure (debt/equity mix) over the discount period.
• That’s why it is called a weighted average cost of capital – it’s weighing
cost of debt and cost of equity based on the debt/equity mix in the
capital structure.

111
WACC

Putting it all together

Cost of equity
Risk free rate +β x equity risk premium
Cost of
debt Tax shield

112

The debt weight

The equity weight
Debt as a % of
Equity as a % of total
total capital
capital

112
WACC

WACC Implementation: Equity weight

The equity weight

Should reflect the market value of a company’s equity

• If market value of equity is readily observable (i.e. for a public

company), equity value = diluted shares outstanding x share price.
• If market value of is not readily observable (i.e. for a private
company), estimate equity value using comparable company analysis.
• Do not use the book value of a company’s equity value, as this
method tends to grossly underestimate the company’s true equity value
and will exaggerate the debt proportion relative to equity.

113
WACC

WACC Implementation: Debt weight

The debt weight

The book value is usually sufficiently close to the market value of debt that it can be used

• Most of the time you can use the book value of debt from the company’s
latest balance sheet as an approximation for market value of debt.
• That’s because unlike equity, the market value of debt usually doesn’t
deviate too far from the book value.

114
WACC

WACC Implementation: Cost of debt

• Compared to calculating the cost of equity, the cost of debt is easier
because loans and bonds have explicit interest rates. For example, a
company might borrow $1 million at a 5.0% fixed interest rate paid
annually for 10 years.
• The main wrinkle in calculating the cost of debt is that it’s not simply
the nominal interest rate. That’s because the nominal rate is historical
and may be different than the rate the company would pay if it
borrowed currently (remember that the WACC is applied to future
UFCFs so should reflect current anticipation for future borrowing and
equity costs).
Cost of debt ≠ nominal interest rate (i.e. coupon rate) Bloomberg is
the best source
Cost of debt = yield on the company’s debt for yields

115
WACC

WACC Implementation: Cost of debt

• So how do you estimate the cost of debt? You must estimate the yield
on existing debt. Yield doesn’t just look at the nominal rate, but factors
in the bond price to tell you what the likely coupon rate would be if the
company borrowed today. It is the internal rate of return of a bond.
• On the next slide you can see a Bloomberg bond page for a 5.7% IBM
bond, issued in 2007. Rates plummeted since the 2007 issuance so the
yield on this bond is 1.322% in 2017. That’s much closer to what IBM
would likely have to pay if it borrowed now (IBM and a few other
companies are borrowing at historically low costs of debt). The 1.322%
is thus the cost of debt to use.

116
WACC

The yield1 of 1.3% is significantly

lower than the 5.7% coupon rate

1There are several types of yield. The type of yield Bloomberg quotes in its main bond description page is a yield-to-maturity measure called “bond equivalent yield”.
Technically, another measure called the “effective annual yield” provides a slightly more accurate measure but the difference is immaterial.

117
WACC

Cost of debt when there’s no public debt

• Companies that do not have public debt but have a credit rating:
Use the default spread associated with that credit rating and add to the
risk-free rate to estimate the cost of debt.
◽Credit agencies such as Moody’s and S&P provide yield spreads over
U.S. treasuries by credit rating.
• Companies with no rating: Use the interest rate on its latest long-term
debt or calculate the company’s interest coverage ratio (EBIT/interest)
and apply the default spread for the credit rating most closely
associated with your company’s interest coverage ratio.
◽Damodaran Online1 publishes a table that lets you map a credit rating
based on interest coverage.
1 Damodaran Online: http://pages.stern.nyu.edu/~adamodar/

118
WACC

WACC Implementation: Cost of equity

• Multiple competing models exist for estimating cost of equity: Fama-
French, Arbitrage pricing theory (APT) and the Capital Asset Pricing
Model (CAPM).
• The CAPM, despite suffering from some flaws and being widely
criticized in academia, remains the most widely used equity pricing
model in practice.
• Below is the formula for calculating the cost of equity:

Cost of equity = Risk free rate + β x equity risk premium

119
WACC

Cost of equity: β (“beta”)

• β measures a company’s sensitivity to systematic (market) risk. For
example:
◽Company with a β of 1 would expect to see future returns in-line with
the overall stock market returns.
◽Company with a β of 2 would expect to see returns rise or fall twice
as fast as the market (i.e. if the S&P were to drop by 5%, a company
with a beta of 2 would expect to see a 10% drop in its stock price
because of its high sensitivity to market fluctuations).
• The higher the beta, the higher the cost of equity because the increased
risk investors take (via higher sensitivity to market fluctuations) should
be compensated via a higher return.

120
WACC

Raw beta: Colgate’s (CL) “raw” beta is 0.447

Cost of equity: Calculating β based on its last 5 years share price returns
compared to the S&P 500. If you assume that
relationship holds going forward, every time the
S&P 500 goes up by 1%, you’d expect Colgate to
There are several sources for
go up by 0.5%. That suggests Colgate is
getting a company’s β
relatively insensitive to market changes.
including Bloomberg, MSCI
and S&P.

All of these services calculate

beta based on the company’s
historical share price
sensitivity to the S&P 500,
usually by regressing the
returns of both over a 60
month period.

Raw vs adjusted beta: Many argue the raw betas are bad predictors of future beta (poor correlation)
because company specific issues uncorrelated to the market clouds the relationship. “Adjusted” beta is an
attempt to make the beta a better predictor so finance professionals generally prefer adjusted beta, but
neither one is great.

121
WACC

ERP (“Equity risk premium”) and the risk-free rate

• ERP (“Equity risk premium”): ERP measures the incremental risk of
investing in equities over risk-free securities. The ERP usually ranges
from 4-6%, and is provided by several vendors by looking at historical
returns on the S&P over risk-free bonds.
• The risk-free rate (RFR): The RFR measures the yield on a default-
free government bond. The current yield on a U.S. 10-year bond is the
preferred RFR for U.S. companies. For European companies, the
German 10-year is the preferred RFR. The Japan 10-year is preferred
for Asian companies.

122
WACC

Exercise: Calculate Home Depot’s WACC

• Home Depot trades at $50 per share
• 1.5 billion diluted shares outstanding
• $7.6 billion in debt outstanding (no cash)
• Current yield on Home Depot debt is 6%
• Home Depot’s marginal tax rate is 35%
• Β = 0.80, MRP = 6%, Risk free rate = 2%
• Calculate Home Depot’s WACC

123
WACC

Exercise: Calculate Home Depot’s WACC

Cost of equity = Risk free rate + β x equity risk premium

124
Excel worksheet:
WACC

125
WACC

Let’s calculate Apple’s WACC

Open these files:

• Equity weight: Calculate as the current • Target capital structure override:

share price x Apple’s diluted share count. Add an override so that a user can input
• Debt weight: Reference net debt from the a different target capital structure than
DCF worksheet. Apple’s current capital structure
• Negative debt capital weight? Apple’s
debt weight will be negative because Apple
has negative net debt (See appendix for
more info on this).

126
WACC

WSJ: 10-Year US treasury yield

127
WACC

Apple beta from Bloomberg

128
WACC

Apple cost of debt from Bloomberg

129
WACC

Market risk premium from Duff & Phelps

130
WACC

WACC Calculation
Check your work

Reference WACC back into the WACC

input cell
How does it change your valuation?

131
WACC

WACC Calculation (Continued)

132
WACC

Cost of equity
WACC cheat sheet Risk free rate +β x equity risk premium

WACC
Debt weight Market value of a company’s debt. Can be approximated by using a company’s book value of debt.
The equity weight Market value of a company’s equity (either market cap or comps derived equity value)
Cost of debt The yield on a company’s debt. Cost of debt ≠ nominal interest rate (i.e. coupon rate)
Tax rate The tax rate the company expects to face going forward
Cost of equity Cost of equity = Risk free rate + β x equity risk premium

Cost of equity
Risk free rate Yield on a default-free government bond. The current yield on a U.S. 10-year bond is the
preferred RFR for U.S. companies. Front page of WSJ, financial data sites all show up to date
yields
Beta β measures a company’s sensitivity to systematic (market) risk.
• β = 0 means no market sensitivity (cash, for example)
• β < 1 means low market sensitivity (consumer staples, for example)
• β > 1 means high market sensitivity (luxury goods, for example)
• β < 0 negative market sensitivity (gold, for example). Bloomberg is good source for β
Equity risk ERP measures the incremental risk of investing in equities over risk free securities. The ERP
premium (ERP) usually ranges from 4-6%.

133
Treasury Stock
Method for Options
and If-Converted
Method for
Convertibles
Treasury Stock Method for Options and If-Converted Method for Convertibles

Option basics
• Once an option is issued, it is outstanding. It is only exercisable once it has
passed its vesting period (usually 1-3 years)
• Each option has an exercise (“strike”) price, which the holder must pay the
company in order to exercise the option:

“In-the-money” options whose strike price < current stock price

“At-the-money” options whose strike price = current stock price
“Out-of-the-money” options whose strike price > current stock price

Test for calculating diluted shares: Should we include:

◽ All outstanding options or just the exercisable ones?
◽ Should we care whether options are in-the-$ or out-of-the-$

135
Treasury Stock Method for Options and If-Converted Method for Convertibles

Option basics
Test for calculating diluted shares: Should we include:
• All outstanding or just exercisable? Like restricted stock, the more
conservative assumption is to include all outstanding options even if
they are not exercisable yet. That’s because it is reasonable to assume
most options will vest shortly. Note that while this is the more common
(and our preferred approach), some firms / groups use exercisable
instead, so make sure to adhere to your team’s preference.
• In-the-$ / At-the-$ / Out-of-the-$ options? – Only include in-the-$
and at-the-$ options. Assuming the exercise of out-of-the $ options
would mean an employee gives the company an exercise price that’s
greater than the value of the common she receives in return.

136
Treasury Stock Method for Options and If-Converted Method for Convertibles

Options
disclosure
• Historically, companies
included detailed tranche-by-
tranche options information
in the 10-K and only high level
aggregate data in the 10Q

• Increasingly, companies
provide only high level
aggregate data in both 10K
and 10Q

Finding the options footnote

Search for the terms
“exercisable”, “options
outstanding”, or “granted” to
quickly find the footnote in a
long 10-K

137
Treasury Stock Method for Options and If-Converted Method for Convertibles

Calculating options using the treasury

stock method (TSM)
• An approach to calculating diluted shares that assumes that proceeds from
exercised options and warrants are used to repurchase outstanding shares at
the current share price.
• Minimizes dilutive impact of option conversion on existing shareholders.
• Most common approach in practice

138
Treasury Stock Method for Options and If-Converted Method for Convertibles

Stock splits
• When companies announce stock splits, all share count and dilutive securities counts
prior to split must be adjusted to reflect the split.

◽ Otherwise, the market share price will reflect a post-split price while the share count
will be pre-split, leading to a huge underestimation of market cap

◽ To avoid this, always confirm that no split has taken place subsequent to the latest
financial report.

• If you have access to a Bloomberg terminal, the easiest way to check is to select ‘CACS’ on
the Bloomberg terminal to review recent corporate actions.

139
Treasury Stock Method for Options and If-Converted Method for Convertibles

Dual classes
• Sometimes companies issue 2 or
more classes of common stock (A
and B), where one class has more
voting rights.

• The rationale is to allow

management, families, and other
insiders to retain voting control
without a 1-for-1 stake in equity.

• Count both classes equally in the

share base and include a footnote.

140
Treasury Stock Method for Options and If-Converted Method for Convertibles

Impact of convertible debt and preferred stock on

shares
• When co. has convertible preferred stock or convertible debt on its balance sheet,
determine whether to assume conversion when calculating diluted shares using
the “if-converted” method
• “If-converted” method
1. If convertible is “in-the-$” (current share price > conversion price)
a) Assume conversion & include converted shares in dil. share count
b) Exclude the convertible security principal amount outstanding from the
calculation of net debt
2. If convertible is “out-of-the-$” (current share price is < conversion price)
a) Do not assume conversion, treat as normal debt and do not include
converted shares in the share count

141
Treasury Stock Method for Options and If-Converted Method for Convertibles

Understanding conversion price for convertible debt

•

142
Treasury Stock Method for Options and If-Converted Method for Convertibles

Understanding conversion price for convertible

preferred
• A company with a current share price of $300 per share raises $10m by
issuing 25,000 preferred shares. Preferred shareholders can generally
exchange the preferred shares for their original investment1.
• Each preferred share is convertible into 2 shares of common stock2.
• If-converted test: Since $10m buys you 50,000 common shares if
converted, the conversion price is $200 per share. Since the current
share price is $300, the preferred stock is “in-the-$” because the
conversion price is < current share price.
• In other words, it originally cost preferred investors $200 per share to
get a share worth $300 if converted, so we assume conversion.

1 Another way this is expressed is that each preferred share has a redemption / “liquidation” value of $400 ($10m / 25,000).
2 The ratio of how many shares of common stock each preferred share is convertible into is called the conversion ratio.

143
Treasury Stock Method for Options and If-Converted Method for Convertibles

Understanding conversion price for convertible

preferred

• Redemption (Liquidation) value: The value that the firm must

pay to eliminate the preferred stock obligation assuming no
conversion. The $ amount of preferred stock outstanding can be
found in the footnote. Alternatively, use the value on the balance
sheet as a proxy.
• The conversion ratio: The number of common shares that each
convertible share can receive upon conversion
• Preferred shares outstanding: The number of preferred
convertible shares currently outstanding (do not confuse this
with shares authorized which are typically much bigger).
144
Integrated DCF
Modeling

145
Integrated DCF Modeling

It’s time to tie a DCF into a 3-statement model!

• We have built a complete standalone DCF model
• Now, we are going to tie the DCF to a fully integrated financial
statement model that we built in our prior course
• Connecting a DCF to a 3-statement model improves the reliability of the
analysis and scenario analysis in particular

146
 Excel worksheet:
2019 FSM Update Complete
Integrated DCF Empty

147
Integrated DCF Modeling

We’ve included a complete 3 statement model in the DCF model file

148
Integrated DCF Modeling

Use the 3-statement model to complete the ‘DCF Integrated Empty’ worksheet
• This tab contains the same model you’ve built, except that the unlevered free cash flow forecast
needs to be referenced from a 3-statement model
• Also add a last twelve months column (we’ll use this to calculate LTM multiples)

Linking cells from other

sheets without the mouse
1. Go to the cell you
want to bring data
into
2. Hit ‘=’ to get “inside”
the cell
3. Holding down Ctrl,
hit PageUp to go to
tabs on the left,
PageDown to go to
tabs on the right
4. Once you’re in the
desired tab, let go of
Ctrl and use the
arrow keys to find the
desired cell. Hit Enter
when done

149
Integrated DCF Modeling

Check your work

• A best practice is that margins and growth rates should still be calculated – not referenced
• The results should be similar but not identical to the standalone DCF. Why?
• LTM results simply use stub year fraction – note that while this is the simplest and most common
approach for private companies, this is not the most precise approach for public companies, for
which you can instead use quarterly filings to get exact results

150
Integrated DCF Modeling

Review the revised output

Is this output useful?
How does the valuation change if the weak operating case is selected?
What could we do to improve it?

151
 Holy cow - you just built a
fully integrated DCF model!!!

152
Appendix 1:
Normalizing Terminal
FCF

153
Appendix: Normalizing Terminal FCF

Normalizing terminal free cash flow

• The final year of stage 1 should reflect sustainable long term growth
and reinvestment rates (i.e. normalized)
• Since most real world DCF models are 2-stage models, where stage 1 is
only 5 years, the final year of stage 1 is sometimes not normalized:
◽Imagine a high growth company that is still showing double digit
operating profit growth by the end of stage 1, with significantly
higher than normalized reinvestment rates (i.e. capex >
depreciation). Is this sustainable indefinitely?

154
Appendix: Normalizing Terminal FCF

Normalizing terminal free cash flow

• Other issues that persist at the end of stage 1 include:
◽Significant cash inflows/outflows from working capital changes or
DTL/DTAs.
• Theoretically the solution to this should be to extend the stage 1
forecast period or create a 3 stage model,
• In practice practitioners simply adjust the FCF used for calculating the
TV to a “normalized” FCF by converging the capex/depreciation ratio to
1, and removing any major working capital and DTL/DTA
inflows/outflows.

155
Appendix 2:
Negative Net Debt
in Valuation

156
Appendix: Negative Net Debt in Valuation

Large cash (negative net debt) weirdness in

valuation
• Negative net debt in valuation creates a weird (but not incorrect)
outcome: the equity capital weight is > 1 and the debt capital weight is
<0

157
Appendix: Negative Net Debt in Valuation

Negative net debt quirks in valuation

• All else equal, the more cash a company the lower the observed β,
leading to a lower cost of equity
• This is an underestimation of the true cost of equity of the unlevered
FCFs, but is resolved by the >1 equity capital weight and <0 debt capital
weight which bring up the cost of capital
• There is an alternative which avoids the weirdness by using gross debt,
but then the β needs to be adjusted to remove the impact of cash (see
next slide)

158
Appendix: Negative Net Debt in Valuation

Large cash (negative net debt) weirdness in

valuation

The cost of equity is higher but cost

of capital is almost the same (the
minor difference arises from the tax
deductibility of debt)

159
Accounting Intro to Valuation, DCF & LBO

Appendix 3:
Industry Beta

160
Appendix: Industry Beta

Calculating industry β
• Betas often suffer from poor correlations making them bad predictors.
• This is only half of the problem. The other issue is that only public
companies have observable betas.
• The solution to both is using the betas of comparable companies to
estimate beta for the company being analyzed. This is called the
industry beta approach.

161
Appendix: Industry Beta

The industry β approach

• Look at β of several public companies that are comparable to the
company being analyzed and apply this peer-group derived beta to the
target company. The benefits are: 1) Eliminates company-specific noise
and 2) Enables arriving at a beta for private companies
• Industry beta process: We cannot simply average up all the raw betas.
That’s because companies in the peer group have varying leverage.
◽Unfortunately, leverage significantly impacts beta. (The higher the
leverage, the higher the beta, all else being equal.)
◽Fortunately, we can remove this distorting effect by unlevering the
betas of the peer group and then relevering the unlevered beta at the
target company’s leverage ratio.
• We do this as follows…
162
Appendix: Industry Beta

Calculating industry β
•

163
Appendix: Industry Beta

Calculating industry β
• Here’s an example of what an industry beta calculation might look like
for Apple.

164
Accounting Intro to Valuation, DCF & LBO

Appendix 4: Value
Drivers in the DCF

165
Appendix: Value Drivers in the DCF

Value drivers
• Let’s revisit the perpetuity formula
• Recall that it defines value using three value drivers:

• But how do companies generate the growth used in the equation? How
does a company’s reinvestment decision and returns on capital affect
value?

166
Appendix: Value Drivers in the DCF

Value drivers
• FCF can be thought of as operating profit – reinvestment
• Reinvestments are made to generate returns and along with the returns
on those reinvestments, ultimately determine a company’s growth rate

Example: CRT Systems

CRT Systems, a small maker of auto-parts, earned $5m in operating profits this
year. The company expects operating profit of $5.25m next year (5% growth).

This growth is expected to be driven be $250k in incremental sales from new

merchandise made using a new machine the company purchased this year for
$1m.

Below we identify key terms and relationships associated with the activities above:
Reinvestment rate (rr) = reinvestment/profit = $1m/$5m = 20%
Reinvestment = profit x rr
Return on invested capital (ROIC) = return/reinvestment = return/(profit x rr) = 250k/$1m = 25%
The growth rate (g) = return /operating profit = rr x ROIC = $0.25m/5 = 5%

167
Appendix: Value Drivers in the DCF

Value drivers
• The perpetuity formula can be re-expressed as:

Exercise
• You forecast operating profits of $100m. Assuming a reinvestment rate
of 25%, ROIC of 20% and WACC of 10%, calculate the value of this
company

168
Appendix: Value Drivers in the DCF

Value drivers
• Revisiting our hot dog stand, recall we forecast FCF of $10,500, with g
of 5% and discount rate of 10%.
• Now assume the FCF is comprised of $15,000 operating profit less
$4,500 in reinvestment.
• Calculate value, ROIC and the rr
◽If we raise the rr to 40%, what is the impact on value?
◽Can we draw a broad conclusion on the impact of rr on value? Would
the conclusion change if ROIC was lower than the discount rate? How
does ROIC affect value?

169
Appendix: Value Drivers in the DCF

Calculating multiples intrinsically

• The very same things that drive intrinsic value should be driving
multiples.

• Dividing both sides by operating profit, we get:

• Observed market multiples implicitly say what an intrinsic valuation

explicitly says

170
Appendix: Value Drivers in the DCF

Calculating multiples intrinsically

•

171
Appendix 5:
Unlevered vs.
Levered DCF

172
Appendix: Unlevered vs. Levered DCF

Two DCF approaches

• Unlevered DCF: Directly value enterprise value (common) by
forecasting operating free cash flows (UFCFs)
• Levered DCF: Directly value equity value by forecasting LFCF (free cash
flows after debt, principal, and interest income (common for banks).

Unlevered
Net Debt DCF arrives at
Levered DCF
arrives at this this directly
directly
Enterprise
value
Equity value
Discount LFCFs at Discount
the cost of equity UFCFs at the
WACC

173
Appendix: Unlevered vs. Levered DCF

Both approaches theoretically yield the same result:

• Subtract net debt from enterprise value when doing an unlevered DCF
• Add net debt to equity value when doing a levered DCF:
• The most important point is consistency: FCFs and
cost of capital (r) must consistently match the value they are
determining

174
Appendix: Unlevered vs. Levered DCF

Levered vs. unlevered DCF

DCF Approach Unlevered DCF Levered DCF
Means you are trying to find the value of the Means you are trying to find the value of the
operations to all providers of capital business to equity owners
Free Cash Flows
Unlevered FCF Levered FCF
(FCF)
• FCFs that "belong" to both debt and equity
• FCFs that "belong" to equity owners
providers
• FCF before subtracting out dividends or
• FCF before subtracting out interest and
share buybacks (but after subtracting out
debt payments, dividends or share
interest and debt payments
buybacks
Weighted average
Discount rate (r) Cost of equity (CoE)
cost of capital (WACC)
Should incorporate the costs of capital to debt Should incorporate the costs of capital to
and equity investors equity investors
Output Enterprise value Equity value
Subtract net debt to arrive at equity value Add net debt to arrive at enterprise value
Relevant
Most industries Banks
industries

175
Appendix: Unlevered vs. Levered DCF

Understanding unlevered FCF conceptually

• UFCF are operating free cash flows, before any effects of leverage or
non-operating assets are factored in
• That’s why we start with EBIAT, which completely ignores interest
expense

176
Appendix: Unlevered vs. Levered DCF

Understanding unlevered FCF conceptually

But equity value is impacted by how much debt and non-operating assets a
company has, so how is that factored in?
• By subtracting net debt from enterprise value – not by forecasting the
cash flows from debt (i.e. interest expense) and cash (i.e. interest
income)
What about the interest tax shield? You ignored that benefit in the UFCF
• True - the interest tax shield is factored in the discount rate but not in
the UFCF

177
Appendix: Unlevered vs. Levered DCF

Levered DCF
• Forecast levered free cash flows (LFCF): Cash flows that trickle down to
equity owners after all non-equity related expenses are removed
• LFCF = CFO – capex – debt principal payment
• LFCF takes out operating expenses, capex and debt related payments
(interest expense & principal)
• The appropriate discount rate is the cost of equity, which captures risk
and expected returns to equity only

178
Appendix: Unlevered vs. Levered DCF

Levered vs. unlevered DCF

• Circle the appropriate metric

Unlevered DCF Approach Levered DCF Approach

UFCF UFCF
Cash flows to use
LFCF LFCF

WACC WACC
Discount rate to use
Cost of equity Cost of equity

Enterprise value Enterprise value

Value directly derived
Equity value Equity value

For a levered firm, which UFCF UFCF

FCF is higher? LFCF LFCF

179
Discussion questions

180