Investment Banking: Financial Analysis and Valuation

Professor Rob Metzger

Module 4: Discounted Cash Flows

Table of Contents
Lesson 4-1: Discounted Cash Flows - An Introduction ....................................................................... 2
Discounted Cash Flows - An Introduction ............................................................................................................ 2

Lesson 4-2: Discounted Cash Flows - Projecting Free Cash Flows ...................................................... 9
Discounted Cash Flows - Projecting Free Cash Flows........................................................................................... 9

Lesson 4-3: Discounted Cash Flows - WACC .................................................................................... 16

Discounted Cash Flows - WACC.......................................................................................................................... 16

Lesson 4-4: Discounted Cash Flows - Terminal Value ...................................................................... 26

Lesson 4-5: Discounted Cash Flows - Calculate Present Value and Determine Valuation ................. 31

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

Lesson 4-1: Discounted Cash Flows - An Introduction

Discounted Cash Flows - An Introduction

In this session, we will begin to discuss one of the four major valuation methodologies. The
discounted cash flow method, the DCF method is the most commonly discussed valuation
methodology and finance. It is very common across all finance disciplines and is steeped in
traditional finance theory, let's take a look. The DCF is what is known as an intrinsic valuation
technique and that it is primarily based on an analysis of the company's expected financial
performance, its risks and its opportunities. This is different from valuation techniques, like the
comparable company analysis or the precedent transaction analysis as they are significantly
impacted by existing market valuation indicators for companies in the target's peer group. The
premise of the DCF approach is that the value of a company or any asset really can be derived
by taking the present value of all of its future free cash flows, also known as FCF.
Play video starting at :1:16 and follow transcript1:16
The basis for determining future free cash flow is a detailed financial projection for the company,
taking into account its future sales, profit margins, capital expenditures and networking capital
requirements. These free cash flow projections are typically done on a detailed basis for five
years. This is an amount of time that is generally considered long enough to see a business
reach a steady state level of operations, but short enough that there can be some level of
precision in the projection approach.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

For high growth or early stage businesses who maybe have not reached maturity or proven out
its profitability model in five years. We will sometimes see the projection period extended
perhaps even to 10 years. Beyond the detailed projection period the company's valuation is
captured through what we call the terminal value a concept will cover in depth at a later point.
But the basic concept behind the DCF approach is to calculate what is known as the present
value, PV for short of the projected free cash flow and terminal value to arrive at a company's
enterprise value. And we calculate the PV by discounting these items by the company's
weighted average cost of capital or what is known as the whack.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

I think the best way to learn about the DCF is to walk you through the model itself and show you
the components. But first let me provide you an overview of the steps of building a DCF model.
Play video starting at :2:55 and follow transcript2:55
The first step is to gain an understanding of the business you are seeking to value and make an
assessment of what the key performance drivers are of the P and L and the balance sheet. You
will use this information to develop a set of projections that are able to be diligence and can
stand up to review and scrutiny. Again, the projection period is generally five years. From there,
you'll calculate the whack, determine the approach and methodology for estimating the terminal
value and then calculate the present value of all cash flows using the whack as your discount
rate.
Play video starting at :3:35 and follow transcript3:35
Once that has been completed, you'll be ready to make an assessment of the appropriate
valuation range. I like to joke that this process is really like baking a cake, just follow the recipe
and that basically is the truth. The most difficult part of the DCF is to have sound judgment and
the assumptions you choose, which comes from experience and working in the job. In any
event, let's pull up a DCF model and I'll show you what it looks like. As you pull up the DCF
model, you'll see that there's four tabs and assumptions tab a DCF analysis tab, a networking
capital or NWC tab and a weighted average cost of capital or whack tab. The assumptions tab,
it lays out our fiscal year end when our quarterly filings and annual filings have been. And
whether or not we use something called a mid year convention which we'll talk about when we
do our discounting. Then we lay out our income statement metrics and drivers and our
networking capital metrics and drivers which will drive our free cash flow analysis. We compute
this based on a review of our historical figures and then we use those historical figures to project
out our free cash flows for a projection period.

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Professor Rob Metzger

Play video starting at :5: and follow transcript5:00

And those free cash flows are summarized in what we call our DCF analysis. The top part of our
DCF analysis is our free cash flow projection. We start with the company's revenues work our
way down to gross profit, develop operating income or EBIT and then calculate something
called Net operating profit after taxes also known as EBIT.

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 Investment Banking: Financial Analysis and Valuation
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These are all items that we'll discuss in much more detail in our free cash flow session but this
just gives you an overview of what we're looking at. And it's important to note that we look at
three years of historical information. We capture our current base year and then build out
usually five years of a projection period based upon the history that we built on this slide. We'll
add back depreciation and amortization, we'll deduct out capital expenditures and then we'll do
a detailed analysis in some of our balance sheet accounts in our changing networking capital
analysis. This allows us to arrive at something that we call unlettered free cash flow, also known
as UFCF and these are the items that in our projection periods will discount back to arrive at our
present value of free cash flows.
Play video starting at :6:29 and follow transcript6:29
Our weighted average cost of capital is that rate that we'll use to discount those cash flows
back. And we'll go through a deep analysis to assess what the whack is.
Play video starting at :6:42 and follow transcript6:42
Well then use the whack to develop what we call a discount period and then discount those
cash flows back to the present using what we call our discount factor. We sum up those present
values of unleavened free cash flows over the discount period to arrive at what we call our
present value of unlettered free cash flows and that's this number here. We then go through a
process to calculate what we call our terminal value and we'll use two methods to do that, our
terminal multiple method and our perpetuity growth method. Each of those are different
concepts that will explore differently and we'll use those to calculate our terminal value on a
non-present value basis and then use that same year five discount factor to calculate the
present value of the terminal value. You'll note and we'll talk about in much more depth later that
the terminal value is a significant component of the overall enterprise value. By adding the
present value of the unlettered free cash flows and the present value of the terminal value we

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Professor Rob Metzger

arrive at what we call enterprise value and we do that under both methodologies for calculating
the terminal value. And then we'll use the balance sheet again to reconcile to what we call
equity value, we'll take out debt, we'll add back cash and cash equivalents, we take out
preferred stock and non-controlling interest if there is any to arrive at equity value.

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Well then divide that number by our fully diluted share count to get to our implied share price
and this is kind of where the output is of our DCF analysis. Well then run some summary
numbers in terms of multiples of implied enterprise value to the last year's EBITDA to come up
with some multiples using both approaches. And then we'll also use the same approach to come
to our implied growth rate. And then our last part in this tab is a sensitivity analysis as we'll talk
about later, the discounted cash flow model has a significant number of assumptions tied to it. So
it's always important to run a sensitivity analysis on those assumptions that impact the value the
most, generally those are things like our terminal multiple are perpetuity growth rate and our
weighted average cost of capital. And here you can see that we do this across a number of
different ways and we come up with a variety of different ranges of values as well as multiples.
And we'll use that to calculate our range when we complete our final evaluation. The other tabs
in the model are details that we use to calculate our networking capital which is laid out on this
slide as well as our weighted average cost of capital which is a very detailed process which will
explore in a different session. But I wanted to give you a sense of what the DCF analysis looked
like at its core where we calculate the free cash flows, we calculate our terminal values, we add
them together to come up with the enterprise values and then reconciled back to our equity
values. Again, these are things that we'll explore in much more detail in other sessions.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

Lesson 4-2: Discounted Cash Flows - Projecting Free Cash Flows

Discounted Cash Flows - Projecting Free Cash Flows

In this session, we discuss the process for projecting free cash flow for the company we are
seeking the value. This is a critical step in the DCF modeling process. One that requires a firm
grasp on the business and a keen understanding of what the key drivers are for the company,
performance, cash flow, and financial position. Let's kick into the material.

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When we are projecting a company's free cash flow, we are focused on what is known as
unlevered free cash flow. By unlevered, we are focused on cash flows of the business without
regard for the capital structure of the company. In other words, it is focused on the cash flows of
the company's core operations and excludes payments for interests and dividends. We do it this
way because, as you will see later, we are focused on calculating the enterprise value of the
business, not the equity value. We do it on a capital structure neutral basis. The core items we
seek to project in this exercise are revenues, cash operating expenses, cash income taxes,
which you will see is different than what is on the income statement, capital expenditures, and
changes in working capital. This page shows the free cash flow formula at a high level. As you
will see on the next page, we will project out the income statement for a five-year period based
on the key drivers of the business. You will note, we take the income statement only to the EBIT
line. Then adjust for taxes calculated at the marginal tax rate versus taking income tax expense
off of the income statement.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

That is because income tax expense incorporates the impact of the tax shield due to the interest
rate deduction. Whereas in the DCF analysis, we are calculating an income tax charge without
regard to the capital structure. Netting the income tax is calculated in this manner from EBIT.
We arrive at a term called earnings before interest, but after tax, which is also known as EBIAT.
To be honest, this is the only time that I see this term used in the investment banking business,
but it is consistently deployed in the DCF analysis. Another term for EBIAT is NOPAT, net
operating profit after tax. NOPAT and EBIAT are interchangeable. From there, we adjust for the
three following items. Number 1, add back of depreciation and amortization to adjust for non-
cash operating charges flowing through the income statement. Number 2, deduction of capital
expenditures to account for cash outlays for operating investments. Number 3, the change in
net working capital, which reflects the amount of cash invested or generated from the change in
balance sheet accounts.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

When projecting out the income statement, it is essential to have your arms around what the
key drivers are behind the business. You should look at multiple years of historical results, and
develop a perspective on how the business will grow or contract in future years. Typically, when
projecting out revenue, you will determine what the appropriate growth rate is for each year,
using a different rate for each year based on your insights about the business. From there, you
will project cost of goods sold as a percentage of revenue. Again, taking into account your
perspective about how the business will change over time. It is not atypical to see gross margins
expand over time as the business scales. Similarly, we will project out SG&A as a percentage of
revenue. We typically expect that percentage to decline as the business scales. The D&A
projection is also generally estimated as a percentage of revenue, since the investment in
capital and the related depreciation moves in a linear fashion with the growth of the business.
One final comment on the income statement projection. It is very common and in fact important
to build out separate cases. Generally, you will have an upside case, a base case, and a
downside case. This is attributable to the fact that forecasting is an imperfect science, and it's
hard to predict the future with certainty.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

In addition to projecting out the income statement, we will also project out changes in the
balance sheet. Again, it is important to take a look at historical balances and the relationships
with the business when determining how to project the balance sheet. Accounts receivable is
projected based upon an analysis of days sales outstanding, and inventory is calculated based
on an analysis of days inventory held. Accounts payable is projected based on days payable
outstanding. The rest of the balance sheet, including CapEx, is generally projected based upon
a percentage of revenue as there is typically a linear relationship between these items and
revenue growth.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

Since the balance sheets capture point in time estimates of the business versus the income
statement that reflects the business activity of the business over the year, the DCF analysis
considers the change in current assets and current liabilities from year to year. Since we are
focused on the company's operations and the cash flow related to it, we look at only changes in
operating assets and liabilities. This means that we exclude cash and short-term debt from this
analysis. The chart on this page shows an example of two sets of balance sheet line items. One
as of the beginning of the year and one as of the end of the year. To assess the change in net
working capital, we consider increases in assets as negative cash flow items, since we are
investing cash to grow the line item. Whereas a decrease in assets results in an increase in
cash. Changes in liability accounts are opposite of that for assets. Increases in liabilities are
increases to cash, and decreases in liabilities are reductions. We then net the change in current
assets and current liabilities to assess whether it is an increase in cash or decrease in cash. If
the change in net working capital is positive, we deduct that amount from free cash flow. If the
change in the net working capital is negative, we add that amount to free cash flow. This final
page pulls it all together. You can see that we lay out the three years of historical periods to
inform how we project out the next five years. Again, we project the income statement down to
the EBIT line, reduce it for taxes at the marginal rate.

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Professor Rob Metzger

Then adjust for the D&A, CapEx, and changes in net working capital.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

Lesson 4-3: Discounted Cash Flows - WACC

Discounted Cash Flows - WACC

Once we have projected out a company's free cash flow for the determined projected period,
usually five years. We then need to determine the cost of capital rate that we use to discount the
cash flows to arrive at a present value.
Play video starting at ::26 and follow transcript0:26
We'll get into the mechanics of the present valuing process later. But first let's look at how we
derive the cost of capital. The most commonly used discount rate for the DCF valuation method
it is what is known as the Weighted Average Cost of Capital, commonly referred to as WACC.
We use this rate to discount both projected free cash flows, as well as the terminal value a
concept we will cover later.
Play video starting at ::57 and follow transcript0:57
This rate is meant to reflect the rate of return that an investor would expect to earn in an
alternative investment and with a similar risk profile. It is called weighted average because it
takes into account both the cost of the company's debt. After taking into account the effect of
the tax benefit associated with interest expense and the company's equity.
Play video starting at :1:23 and follow transcript1:23
This is a good depiction of the WACC formula

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Professor Rob Metzger

First assess the ratio of debt in the capital structure to equity in the capital structure. Then
multiply the debt percentage times the after tax cost of debt. Multiply the equity percentage by
the cost of equity and sum of the two to arrive at WACC.
Play video starting at :1:47 and follow transcript1:47
In order to complete this analysis, we need to complete the following steps. Number 1,
determine the Targets Capital Structure. In other words, percentage debt versus percent equity.
Number 2, estimate the Cost of Debt known as ("rd").

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Professor Rob Metzger

Number 3, estimate Cost of Equity known as ("re"). And number 4, calculate the WACC by
summing the cost of debt and the cost of equity.
Play video starting at :2:21 and follow transcript2:21
The first thing that we determine is the target capital structure. This is measured as the ratio of
debt and equity as a percentage of the company's total capitalization.
Play video starting at :2:33 and follow transcript2:33
Total capitalization is defined as debt typically measured as debt on the balance sheet plus the
market value of equity, which is different than the equity value on the balance sheet.
Play video starting at :2:45 and follow transcript2:45
For public companies, we generally use their existing capital structure analysis unless there is
evidence to suggest that the current structure is not going to be reflective of what it will be in the
future. For example, if the business is an early stage company and it's fully equity funded. But
the expectation is that the company will ultimately raise debt and have a mix that is consistent
with its peer group.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

For private companies since we don't have a readily observable market capitalization, we
typically use the mean or median ratio of the comparable group. This is the same group that we
will use to calculate the cost of equity and the same group we used in our comparable company
valuation analysis. After we determine the target capital structure, we then assess the cost of
debt. This is reflected on an after tax basis using the company's marginal tax rate. Companies
generally can deduct interest expense and thereby reduce its overall cost of debt. And the cost
of debt considers the numbers of factors including the company's size, sector, outlook,
cyclicality, credit ratings and credit statistics and cash flow generation.

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 Investment Banking: Financial Analysis and Valuation
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For public companies, we will typically look at their balance sheet and look at the yields on their
current debt and use a weighted average based on their debt outstanding.
Play video starting at :4:21 and follow transcript4:21
For private companies, we would look at the interest rates that similarly rated companies are
paying in the market.
Play video starting at :4:29 and follow transcript4:29
All in all determining the cost of debt is relatively straightforward and not subject to significant
judgment.
Play video starting at :4:39 and follow transcript4:39
On the other hand, the assessment of the company's cost of equity can be a little more tricky.
There is no readily observable cost of equity that you can reference as there is with debt. So we
must use more judgment and we employ a convention called the Capital Asset Pricing Model,
also known as CAPM.
Play video starting at :5:3 and follow transcript5:03
CAPM is reflected by the following formula. The Risk-Free Rate plus the product of Levered
Beta and the Market Risk Premium.
Play video starting at :5:14 and follow transcript5:14
In addition, we will consider adding a size premium for when we look at companies with smaller
capitalization. Let's look at each of these in turn. The risk-free rate is the expected rate of return
on what is considered a riskless security.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

When looking to companies based in the United States, we generally look at a Treasury rate of
either a 10 or a 30 year duration. Personally I prefer to use the 30 year Treasury since the
purpose of the DCF is to calculate the present value of all cash flows Into perpetuity and that
rate is the longest duration one available.
Play video starting at :5:57 and follow transcript5:57
This reference rate can be easily obtained from Bloomberg, Capital IQ or other online sources
for market data.
Play video starting at :6:7 and follow transcript6:07
The next part of the CAPM formula is what is known as Beta. The technical definition of beta is
a measure of stock price variability in relation to the overall stock market. If a stock has a beta
greater than 1.0 for every dollar that the stock market moves, you would expect the stock to
move more than $1.
Play video starting at :6:31 and follow transcript6:31
If the stock has a beta of less than 1.0 For every dollar that the stock market moves, the stock
would move less than $1.

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 Investment Banking: Financial Analysis and Valuation
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Hence, a higher beta signals higher volatility. It is more common in high growth stocks that are
more prone to wider stock price swings versus a more defensive or conservative company that
is considered to be much more stable.
Play video starting at :6:57 and follow transcript6:57
And the way that CAPM works all else being equal higher beta stock would have a higher
WACC. This reflects the fact that these stocks have greater risk. Similar to the risk-free rate for
public companies, beta can be obtained from Bloomberg or capital IQ.
Play video starting at :7:20 and follow transcript7:20
For private companies, we do not have an ability to readily identify beta since it is not a traded
security on an exchange.
Play video starting at :7:29 and follow transcript7:29
As a result, we calculate an implied beta from our comparable group and use that for our CAPM
analysis. One caveat however, the beta that we gather from Cap IQ or Bloomberg for a
comparable group is levered beta. Since it's calculated on an as is basis with the company's
current capital structure.
Play video starting at :7:53 and follow transcript7:53
Since the capital structure for each comparable maybe different from each other and from that
of the company we are seeking to value. We go through a process of unlevelring, all of the
selected comparable company betas, calculating a mean and medium for that group. And then
re-levering it based on the capital structure we have selected within our analysis.
Play video starting at :8:18 and follow transcript8:18
To unlevel a company's beta we take the levered beta and divided by the sum of 1 and the debt
to equity ratio, multiplied by the marginal tax rate as shown in the formula on this slide.

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 Investment Banking: Financial Analysis and Valuation
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Once we have done this for all of the comparable companies, we take the average of the newly
unlevered betas. And then Re-lever that average beta by the target capital structure of the
company we are seeking to value.
Play video starting at :8:51 and follow transcript8:51
We do this by multiplying the unlevered beta by the sum of 1 and the debt to equity ratio,
multiplied by the marginal tax rate. Basically the inverse of what we did to unlevel the beta.
Play video starting at :9:6 and follow transcript9:06
This gives us the beta that we will use in our CAPM formula. The next component of CAPM is
what is known as the market risk premium.
Play video starting at :9:18 and follow transcript9:18
This is the spread of the expected market returned over the risk-free rate.
Play video starting at :9:24 and follow transcript9:24
It is a reference rate that we can find from a firm called Ibbotson which is now owned by
Morningstar that has tracked all the way back to 1926. Frankly, I get this number directly from
the internet by typing in the market risk premium into Google. I just did that and came up with
5.6%.
Play video starting at :9:47 and follow transcript9:47
The last component of the captain formula is an optional one. It is called the size premium or
sometimes known as the small company risk premium. The concept is that smaller sized
companies are riskier and have a higher cost of equity. So we add on a size premium to the end
of cap to get our cost of equity.
Play video starting at :10:10 and follow transcript10:10
Again, this is a reference rate that we can get from a table that is published by Duff & Phelps.
This is the size premium table that I reference. It breaks companies down to mid, low and micro
CAPs or undersized deciles. I always use the deciles as I think it's a little more precise. And for

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the lowest decile, it further breaks it down into four quartertiles, which provides more precision.
So for example, if a company had an expected market capitalization of between 100 million and
185 million, I'd follow the table and see that the size premium I would use is 7.55%. Again, this
is a direct add onto the CAPM formula.
Play video starting at :11:5 and follow transcript11:05
So pulling all of this together, we can look at the output of our WACC model template.

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Professor Rob Metzger

We input all of the debt and equity related variables that we have discussed in this session and
it calculates the weighted average cost of capital that we use in our DCF.
Play video starting at :11:23 and follow transcript11:23
It is important to note that we sensitize the WACC based on the capital structure and in this
case the cost of debt. This gives us a perspective of how changes in these two items can impact
the overall WACC that we use.
Play video starting at :11:39 and follow transcript11:39
So that's the end of our WACC discussion. Thanks for hanging in there with me. Have a great
day and good luck.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

Lesson 4-4: Discounted Cash Flows - Terminal Value

Discounted Cash Flows - Terminal Value

Today we are going to discuss how we calculate terminal value as part of our DCF valuation
process. As we have reviewed previously, the theory of the DCF is that it captures the present
value of all future cash flows that the company is ever expected to produce. But it really isn't
feasible to do this with precision past a handful of years. So I used this concept called terminal
value to calculate the value of future cash flows beyond the projection period.
Play video starting at ::43 and follow transcript0:43
This is why the terminal value is often times a significant amount of the total DCF valuation.
Simply stated if a company is growing. And is expected to be around for a very long time. The
majority of the value of the company is embedded in cash flows beyond just a few years.
Play video starting at :1:5 and follow transcript1:05
We generally calculate the terminal value based upon the EBITDA or free cash flow of the
company in its last projected period. You're five.
Play video starting at :1:17 and follow transcript1:17
There are two widely accepted methods we use in practice. T he exit multiple method and the
perpetuity growth method.
Play video starting at :1:26 and follow transcript1:26
We'll explore both of these in detail next

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But I typically see that people use both methods to get a sanity check of the terminal value
calculations. And then use judgment when determining the ultimate DCF valuation range. As
I've said many times before, judgment is the most important part of the valuation. The rest of it is
really just very mechanical.
Play video starting at :1:53 and follow transcript1:53
The exit multiple method calculates the terminal value as a multiple of its terminal year EBITDA.

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We will use the LTM EBITDA multiple of our comparable companies. The same comparable
companies we use for our whack analysis and are comparable company analysis. I have also
seen people in an M and A context use the LTM EBITDA multiples of precedent transactions.
Which I think is rational if you're looking to assess what value a company maybe worth if you
are seeking to sell it. But in any event the value that you arrive at should be sensitized for a
range of terminal multiples. This is a very important assumption and it has a significant impact
on the arrived DCF value. So it's imperative to review the range of potential outcomes when
arriving at a valuation range.
Play video starting at :2:48 and follow transcript2:48
The perpetuity growth method, also known as the Gordon growth method. As a more theoretical
approach to calculating the terminal value

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It calculates terminal value by treating a company's terminal year free cash flow as a perpetuity
growing at an assumed rate.
Play video starting at :3:7 and follow transcript3:07
The formula inputs are whack and an assumption regarding the company's long term
sustainable growth rate called the perpetuity growth rate or G. The way that the formula works.
Perhaps suit growth rates are generally between two and 4%. Since it is considered non
sustainable to grow at a rate that is significantly higher than GDP.
Play video starting at :3:35 and follow transcript3:35
The calculation of the terminal value is the last projection periods free cash flow multiplied by
the sum of one. And the perpetuity growth rate and then having that product divided by the
result of the whack are less the perpetuity growth rate G.

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Both of these can be shown in this example, you'll note that in both cases we have the same
present value of unleavened free cash flows. But in the exit multiple method we take terminal
year EBITDA times and exit multiple and then discount that back to the present. Whereas with
the perpetuity growth method we apply the formula to the terminal year unleavened free cash
flow amount. We do both of these to provide a sanity check on the result. And as always we will
apply judgment when coming to our final range.

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Lesson 4-5: Discounted Cash Flows - Calculate Present Value and

Determine Valuation
Discounted Cash Flows - Calculate Present Value and Determine Valuation

In this lesson, we are going to discuss how to complete the discounted cash flow analysis and
develop evaluation range. These steps are completed after you have projected out your free
cash flow, determined your terminal value, and calculated your weighted average cost of capital.
The purpose is to determine the present value of the company or asset you are valuing and
involves discounting each year's cash flows and terminal value using the WACC as the discount
rate. We use the WACC to calculate a discount factor for each period by employing the
following formula. One divided by the sum of one plus WACC to the power of the number of
years you are discounting the cash flows. For example, if the WACC was 10 percent and you
are discounting cash flows back one year, the discount factor would be 1 divided by 1 plus 0.10
to the first power. This results in a discount factor of 0.91, and this is the number that you would
multiply Year 1 free cash flows by to arrive at a present value for them.

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Now taking this concept to the entirety of the discounted cash flow model, we would use the
same approach to present value: Year 1 cash flows, Year 2 cash flows, Year 3 cash flows, Year
4 cash flows, and Year 5 cash flows. For most businesses, the discount factor that we use for
each year would be for a period that is one-half less than the end of the year. For Year 2, we
would use 1.5, Year 3, we would use 2.5, and so on and so forth. This is because the four-year
discount factor assumes that the cash flows all occur at the end of the year when in reality, most
businesses generate cash throughout the year. By employing what is known as the mid-year
convention, we are effectively assuming ratable cash flow generation each year. In addition, to
present valuing the annual cash flows by the discount factor, we would also multiply the terminal
value by the discount factor calculated for the end of the projection period. Here we do not use
the mid-year convention because we are calculating the value of the company at that point in
time.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

When we sum the present value of free cash flows and the present value of the terminal value,
we arrive at enterprise value. This is due to the fact that we are looking at unlevered free cash
flows and multiplying EBITDA, which is an enterprise value concept by the LTM EBITDA
multiple determined through our comparable company analysis. To calculate equity value, we
simply deduct net debt, preferred securities, and non-controlling interest. To arrive at a per-
share value, we divide that number by fully diluted shares.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

This example shows how we do that, arriving at an equity value of $47,297 and a per-share
value of $47.30. As I've noted before, the DCF valuation approach, while theoretically very
sound is significantly affected by several assumptions, primarily those relating to the WACC, the
exit multiple, and the growth rate. Slight changes in each one can have a meaningful outcome
on the arrived value. It is for this reason that we always make sure to perform a sensitivity
analysis on our model to arrive at a range of valuation outcomes.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

It is this range that we will use along with the ranges develop from our other methodologies to
arrive at our ultimate company evaluation range. This table represents what the sensitivity
analysis would look like with a two percentage point spread of WACC and a four multiple points
spread of the LTM exit multiple for the exit multiple method and a two percentage point spread
of the perpetuity growth rate for the perpetuity growth method. You can see that we develop
different ranges of values for each and it is important to use your best judgment to arrive at an
ultimate valuation range. That wraps up our review of the discounted cash flow model. Before
we move on to another topic, let's review the pros and cons of this methodology. On the pro
side, the DCF approach is based on cash flows and is not impacted by non-cash items.

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 Investment Banking: Financial Analysis and Valuation
Professor Rob Metzger

It is not explicitly tied to the current market environment, although the current market does come
into play when determining the exit multiple for the terminal value and the beta for the WACC
and the model is quite flexible. You can run many different cases, scenarios, and employ it for a
variety of purposes. The cons side is primarily related to the fact that the DCF model has a
number of significant assumptions about things that are going to happen in the future. That
inherently is going to be in precise. In addition, the way that the math works, terminal value is
typically a very large percentage of the overall outcome. Once again, introducing a high level of
subjectivity, given the fact that it has such a long while out into the future. Last, the model
assumes that the capital structure of the business stays constant, which is not necessarily
reflective of reality. In conclusion, the DCF approach is a very important component of a
company valuation. But at the same time, it should not be the only approach used. It is critical
that you also apply other approaches and then come up with a valuation range that reflects your
best insight into the state of the business and the opportunities that it has in front of it.
Previously saved note: It is this range that we will use along with the ranges develop from our
other methodologies to arrive at our ultimate company evaluation range.. Press [⌘ + D] to
delete the note

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