DCF Approach

Free Cash Flows (FCF)

Discount rate (r)

Output
To arrive at enterprise value
To arrive at equity value
Industries typically valued using
this approach
 Unlevered DCF = cash flows
before the effect of interest

Means you are trying to find the

value of the operations to all
providers of capital

Unlevered FCF

Should calculate FCFs that

"belong" to both debt and equity
providers of capital

Weighted average
cost of capital (WACC)

Should incoporate the costs of

capital to both debt and equity
investors, blended to reflect the
capital mix
Enterprise value
NM
Subtract net debt
Most industries
Levered DCF = cash flows after
the effect of interest

Means you are trying to find the

value of the business to equity
owners

Levered FCF

Should calculate FCFs that only

"belong" to equity owners

Cost of equity (CoE)

Should incoporate the costs of

capital to equity investors
investors

Equity value
Add net debt
NM
Banks
DCF Approach Unlevered DCF

EBIT

* (1 - tax rate)

= Net Operating Profit after taxes (NOPAT)

aka Earnings before interest after-tax (EBIAT)

Plus: Non-cash charges like depreciation &

amortization
Plus/(Less): Decreases/(Increases) in working
capital assets
Plus/(Less): (Decreases)/Increases in working
capital liabilities
Less: Capital expenditures and any other
operational reinvestment

= Unlevered free cash flows

 Levered DCF

Net income

Plus: Non-cash charges like depreciation &

amortization

Plus/(Less): Decreases/(Increases) in working

capital assets

Plus/(Less): (Decreases)/Increases in working

capital liabilities
Less: Capital expenditures and any other
operational reinvestment
Plus/(Less): New borrowings/(paydown of
borrowings)

= Levered free cash flows

Fact pattern:
Invested capital 90,000.0
Cash Operating Profit 15,000.0
Reinvestment 4,500.0
Discount rate 10%

Return on Invested Capital 16.7% Cash Operating Profit/Invested capital

Reinvestment rate 30.0% Reinvestment/Cash Operating Profit

Growth rate 5.0% Reinvestment * ROIC

DCF Valuation:
Free cash flow 10,500.0
Perpetuity value 210,000.0 Free Cash Flow/(Discount rate - Growth rate)

Alternatively,
Operating profit * (1-growth/ROIC)
Value =
Discount rate - growth rate

Cash Operating Profit 15,000.0

* (1 - growth/ROIC) 70.0% Algebraically, g/ROIC equals reinvestment rate
Free cash flow 10,500.0

Perpetuity value 210,000.0 Free Cash Flow/(Discount rate - Growth rate)

Relative Valuation:
Re-arrange the above equation dividing both sides by Operating Profit:
(1-growth/ROIC)
Value/Op Profit =
Discount rate - growth rate

* (1 - growth/ROIC) 70.0%

Intrinsic multiple 14.0x

Check:
Value 210,000.0
Operating Profit 15,000.0
Multiple 14.0x
t/Invested capital
Operating Profit

count rate - Growth rate)

C equals reinvestment rate

count rate - Growth rate)

WACC = [E/(E+D)*ke]+[D/(E+D)*kd*(1-tax rate)]
E = Market value of equity
D = Book value of debt (a close approximation to market value of debt)
E + D = Total Capitalization
ke = Cost of equity
kd = Cost of debt
Multiply Cost of debt by (1-tax rate) to reflect the tax deductibility of interest expense

Cost of debt = Can generally be derived from company filings (debt footnote)
Or if the company has publicly traded debt, use the yield-to-maturity on the long-term debt

Cost of equity = Capital Asset Pricing Model = ke = Risk-Free Rate + (Beta * Market Risk Premium)
Risk-Free Rate Yield on 10-year US Treasury is the typical proxy for the default free asset
Beta Regression of company returns with a broad market index (for instance against th
Market Risk Premium Returns on the broad market index minus the risk-free rate; obtain from Mornings
default free asset
ex (for instance against the S&P 500)
ate; obtain from Morningstar (Ibottson), Duff & Phelps
Trading Comps Characteristics
Operational Characteristics
Industry/Sector
Product
Markets
Distribution channels
Customers
Seasonality/Cyclicality
Industry position
Financial Characteristics
Size
Leverage
Margins
Growth
Shareholder base
Tax rate 35%
Reinvestment rate (% of EBIT) 30%
ROIC 15%
Terminal growth 5%

Debt as a % of Total Firm Value 30%

Equity as a % of Total Firm Value 70%
Cost of debt 6%
Cost of equity 12%
WACC 9.6%

Unlevered DCF:
Period: 1 2 3 4 5
EBIT 300.0 320.0 325.0 330.0 340.0
EBIT * (1 - tax rate) 195.0 208.0 211.3 214.5 221.0
- Reinvestment (90.0) (96.0) (97.5) (99.0) (102.0)
Unlevered FCFs 105.0 112.0 113.8 115.5 119.0

Present value of Unlevered FCFs 95.8 93.3 86.5 80.1 75.4

Present value of terminal value 1,553.1

Value of firm 1,984.2

Value of debt 595.3 30.0% of Total Firm Value is Debt
Value of equity 1,388.9 70.0% of Total Firm Value is Equity

Levered DCF:
Value of firm 1,984.2 2,069.1 2,155.1 2,247.5 2,347.1 2,452.8
Value of debt 595.3 620.7 646.5 674.3 704.1 735.8

Period: 1 2 3 4 5
EBIT 300.0 320.0 325.0 330.0 340.0
-Interest Expense 35.7 37.2 38.8 40.5 42.2
Earnings before tax 264.3 282.8 286.2 289.5 297.8
- Taxes (92.5) (99.0) (100.2) (101.3) (104.2)
- Reinvestment (90.0) (96.0) (97.5) (99.0) (102.0)
+ New borrowings/(paydowns) 25.5 25.8 27.7 29.9 31.7
Levered FCFs 107.3 113.6 116.3 119.1 123.2

Present value of Levered FCFs 95.8 90.6 82.8 75.7 69.9

Present value of terminal value 974.2

Value of equity 1,388.9 1,448.3 1,508.5 1,573.3 1,643.0 1,716.9

Terminal
355.3
230.9
(106.6)
124.4

2,452.8

2,563.1
768.9

Terminal
355.3
44.1
311.2
(108.9)
(106.6)
33.1
128.8

1,716.9