Lecture 7 - Valuation: Discounted Cash Flow Analysis

What is discounted cash flow (DCF) valuation?

• Based on the idea that a company’s value can be represented by the present value of its future free cash flows (FCF)

• FCF projections rely on assumptions about sales growth, margins, capital expenditure and working capital needs

• DCF estimates intrinsic value, not market value

• Acts as an alternative to market-based methods

• Useful when market prices are distorted or when no good comparable companies exist

• Typically projects FCF for 5 years

• Because long-term forecasting is difficult, a terminal value captures value beyond the projection period

What are the 5 steps of this valuation?

• Step 1: Study the Target and Derive Key Performance Drivers

• Step 2: Project Free Cash Flow

• Step 3: Calculate WACC

• Step 4: Determine Terminal Value

• Step 5: Determine Valuation

Describe step 1: study the target

• Understand the business to build realistic DCF assumptions:

  • Analyse business model, financial profile, customers, markets, competitions, and risks

  • Enables credible projections, WACC and terminal value

What information can be gathered from both public and private companies?

• Public companies information:

  • SEC filings (10-K, 10-Q, 8-K)

  • MD&A for performance and outlook

  • Earnings calls and investor presentations

  • Equity research reports

• Private companies information:

  • Rely on management (CIM) in sale process

  • If no CIM, use websites, trade journals and news

  • Use filings/research of public peers, customers and suppliers

  • Check old filings if previously public

Describe step 1: determine key performance drivers (internal/external drivers)

• Identify what drives sales growth, profitability and FCF to support projections

• Internal drivers:

  • New projects/facilities/contracts

  • Operational and working capital efficiency

• External drivers:

  • Acquisitions

  • Market and consumer trends

  • Macroeconomics, regulation

What causes performance to vary by company, and where do FCF differences stem from?

• Performance varies by company due to:

  • Strategy, management, brand and customer base

  • Product mix, sales approach, scale and technology

• FCF differences stem from:

  • Capital expenditure needs (growth, assets owned v leased)

  • Working capital efficiency

For step 2: project free cash flow, how is free cash flow obtained/calculated?

What are 4 considerations for projecting free cash flow?

• Use historical performance

• Determine projection period length

• Build alternative cases

• When no management is available

Describe use historical performance

• Past growth rates, margins and ratios guide future assumptions

• 3-years historical period is commonly used

• Adjust historical data for non-recurring items and recent events to create a normalised baseline

Describe determine projection period length

• Typical projection is 5 years, enough to reach steady-state performance and cover a business cycle

• Longer projections (10+ years) if:

  • High-growth or early-stage companies

  • Long-term contracted industries (eg. utilities and natural resources)

Describe build alternative cases

• Management case - company’s projections

• Base case - bankers adjusted projections

• Requires understanding of company drivers and sector trends

Describe when no management is available

• For public companies, rely on consensus estimates and research reports

• For private companies, use historical data, sector trends and public peers

How is sales projected?

• Use consensus estimates (short-term)

• Estimate outer years (beyond 2-3 years)

• Special case - cyclical businesses

• Sanity check assumptions

• Ensure consistency across assumptions

How is COGS and selling, general and admin expenses (SG&A) projected?

• Use historical COGS (gross margin) and SG&A % of sales for early years

• Hold margins constant or adjust slightly for later years

• Some DCFs only for project EBITDA/EBIT

Why should high sales growth forecasts generally be accompanied by higher capital expenditure and working capital requirements?

Higher sales growth usually requires a company to invest in additional production capacity, equipment and resources (CapEx) to meet increased demand. It also requires more working capital to fund higher levels of inventory and accounts receivable as sales increase

Why does high sales growth not necessarily translate into high free cash flow? How might free cash flow generation differ among rapidly growing companies, mature companies, and capital-light businesses?

• High sales growth does not necessarily mean high FCF because companies may need to reinvest significant amounts of cash into CapEx and working capital to support growth

  • Rapidly growing companies: Often generate lower FCF due to significant reinvestment in expansion

  • Mature companies: Generally generate higher FCF because they have more stable sales and require less investment in growth

  • Capital-light businesses: Can generate high FCF because they require relatively little CapEx to support sales growth

How is EBITDA and EBIT projected (for public and private companies)?

• Public companies

  • Use consensus estimates for the first 2-3 years - these already reflect gross margin and SG&A performance

  • For later years, hold EBITDA/EBIT margins constant at the last estimated year

  • Slight adjustment based on product mix, cyclicality, operating leverage, pricing changes, etc

• Private companies

  • Use historical margins and peer company estimates for guidance

  • When lacking information, hold margins constant to create a baseline

How is tax projected?

• FCF starts with EBIT x (1 - t) which gives EBIAT

• Marginal tax rate is usually 25%

• Use actual historical effective tax rate when available

How is depreciation and amortisation (D&A) projected?

• Non-cash expenses are added back to FCF

• Depreciation - reduction in value of tangible assets (eg. PPE)

• Amortisation - reduction in value of intangible assets (eg. patents, licences)

• Modelled as:

  • % of sales of CapEx

  • Detailed PPE schedule

  • Difference between EBITDA and EBIT

How is capital expenditure (CapEx) projected?

• Cash outflows to acquire or improve physical assets

• Capitalised on the balance sheet, then expensed via depreciation

• Subtract CapEx from EBIAT to calculate FCF

• Base projections on:

  • Historical CapEx levels

  • Company guidance/MD&A

  • % of sales (when data is limited)

• Adjust for strategy or phase (eg. expansion v cash conservation)

Discussion: Bankers usually assume that depreciation ~ CapEx in the terminal year, discuss why

• In the terminal year, a company is assumed to have reached a stable, mature stage of growth. Capital expenditure (CapEx) is therefore expected to roughly equal depreciation, as the company mainly replaces existing assets rather than making significant investments to expand

• This assumption reflects a business maintaining its existing operations and production capacity without substantial growth in its asset base