Overview of Discounted Cash Flow Analysis (DCF), Deep Dive on WACC & Capital Asset Pricing Model (CAPM)

Walk me through how to complete a DCF.

An unlevered DCF values a company based on its cash flows, and is generally completed by i) projecting out a company's unlevered free cash flow until growth normalizes, typically over a 5 to 10 year horizon, and ii) then calculating the Terminal Value using either the Gordon Growth Method or the Multiple Method. You then discount these cash flows back to present value using WACC, which gets you the implied Enterprise Value, and from there, you subtract net debt and divide by shares outstanding to get the implied share price.

Why do you only project out cash flows 5-10 years?

You want to project the operating forecast until growth normalizes, which is usually 5 to 10 years. Continuing a DCF out 15+ years becomes very assumption-heavy and speculative, nobody can reasonably project a company's performance that far out. Once growth normalizes, we shift to valuing the business on a perpetuity basis instead.

What is Unlevered Free Cash Flow, and how do you calculate it?

ULFCF is the recurring cash flow available to all stakeholders (Equity, Preferred, and Debt), after paying tax and after all the investments and cash needs required to keep the business running (Working Capital and Capex) have already been met. ULFCF = EBITDA − Tax − Capex − Change in Working Capital

What are 2 ways to calculate Unlevered Free Cash Flow?

EBITDA − Tax (EBIT x Tax Rate) − Capex − Change in Working Capital EBIT x (1 − Tax Rate) + D&A − Capex − Change in Working Capital. Conceptual this is the more commonly used version in practice

Why do you remove Capex and Change in Working Capital from Unlevered Free Cash Flow?

We want the actual recurring cash flows a business generates forever, and that figure must include the ongoing investments and cash needs required to keep the business running, Capex and Working Capital. Without funding these, the business's cash flows would be negatively impacted, and could eventually cease to exist.

Why is Unlevered Free Cash Flow used instead of Net Income or EBITDA?

Net Income and EBITDA exclude the core investments a business needs to make, Capex and the capital required to fund Working Capital. Without accounting for these, they'd overstate what a business is really producing.

Explain how you complete the Gordon Growth Method and the Exit Multiple Method.

Gordon Growth Method: You take the final year of Unlevered Free Cash Flow, grow it one more year at the Perpetuity Growth Rate, typically 2-3%, in line with inflation, then divide by WACC minus that growth rate. Exit Multiple Method: You take the Terminal Year EBITDA, one year forward from the end of the explicit forecast period, and multiply it by a multiple sourced from comparable companies. You can use different multiples, but the most common is EV/EBITDA.

Why do you use WACC to discount an Unlevered DCF's cash flows, and Cost of Equity to discount a Levered DCF's cash flows?

Unlevered DCF: the cash flow represents what's available to all investors, debt and equity holders combined. WACC represents the required return for all of those investors together, so you use WACC. Levered DCF: the cash flow only belongs to equity holders, since debt holders have already been paid through interest and principal. The Cost of Equity represents the required return specifically for equity holders, so that's what you use.

What is the formula for WACC, and how do you generate every input in the formula? (complete only after you have finished the entire guide)

WACC = (Wd x Rd x (1 − Tax Rate)) + (We x Re) + (Wp x Rp) Wd, We, Wp (Weights of Debt, Equity, Preferred): based on the proportion of each in the company's total capital structure Rd (Cost of Debt): the current interest rate the company issues debt at (or the existing rate on outstanding debt), or the average interest rate of comparable companies' debt Re (Cost of Equity): calculated using CAPM Rp (Cost of Preferred): the company's Preferred Dividend Rate, if it has Preferred Equity

What are the pros and cons of using a DCF?

Pros Fundamental Valuation Technique: The DCF is the most sound valuation method since it relies on a company's own fundamentals and cash flows, vs value of other companies Independent of Market Sentiment: The DCF values a company independent of market sentiment Cons Assumption Heavy: Valuation is highly sensitive to key inputs like growth rate, discount rate, and multiples, small changes in assumptions can swing the output significantly Value is Concentrated in Terminal Value: In such cases, the valuation is largely dependent on TV assumptions rather than the operating assumptions for the business

What is Levered Free Cash Flow, and how do you calculate it?

Levered Free Cash Flow is the recurring cash flow to equity holders, after funding short-term operations (Working Capital) and investing in long-term assets (Capex), and after the impact of debt (i.e. interest expense) has been removed LFCF = ULFCF − After-Tax Interest Expense + Net Debt Borrowing. The more common way is starting from Net Income: LFCF = Net Income + D&A − Capex − Change in Working Capital + Net Debt Borrowing.

How is a levered DCF different from an unlevered DCF?

i) You forecast Levered Free Cash Flow instead of Unlevered Free Cash Flow ii) you discount using the Cost of Equity instead of WACC iii) when you add up the present value of these LFCFs, you arrive directly at Equity Value, since the cash flows themselves already belong only to equity holders

How often is a Levered DCF used in practice? Can't you just get to Equity Value using an Unlevered DCF anyway?

A Levered DCF is much less commonly used in practice than an Unlevered DCF, mainly because it requires forecasting a company's future capital structure, how much debt it will issue or repay each year, which is difficult to predict with any real accuracy. Yes, you can get to Equity Value from an Unlevered DCF too, you calculate Enterprise Value first, then subtract Net Debt (and Preferred/NCI, if applicable) to bridge down to Equity Value. This is why an Unlevered DCF is the standard approach for most companies, since it isolates the value of the operating business independent of financing decisions, and you can still arrive at Equity Value from there.

What is WACC, and why is it vital for companies?

WACC (Weighted Average Cost of Capital) is the blended required return across all the ways a company is financed including Debt, Equity, and Preferred equity It's vital for companies because it represents two things: i) the required return investors demand to fund the company, and ii) the risk of the company's cash flows. The higher the risk of the company, driven by factors like industry, margins, or growth potential, the higher the required return

How do you find the Cost of Debt?

You find the cost of debt of i) using the current interest rate the company issues debt at (or the existing interest rate on its outstanding debt as a proxy), or ii) if you don't have that, the average interest rate of debt for comparable companies

Walk through a $10 interest expense example with a 30% tax rate. What is the tax shield, what's the real net cost of interest, and why does this “tax shield” matter?

Say you have $10 of interest expense, that's $10 you pay to your debt holder. But since interest is deductible, that $10 also reduces your taxable income, saving you $3 in tax (10 × 30% = $3). So the net cost of that $10 of interest is only $7 (10 − 3), this $3 in tax savings is the tax shield This matters because, in addition to debt already being cheaper due to its lower risk, the tax shield gives it an added cost advantage: since interest is tax-deductible and Preferred and Equity payments aren't, debt ends up being an even more cost-effective way to fund a company

Where do you find the required return of Preferred Equity?

If a company has Preferred Equity, it should disclose its Preferred Dividend Rate, so you simply use that as the Cost of Preferred. If a company doesn't have Preferred Equity, you exclude it from the WACC formula entirely

How do you calculate the Required Return of Equity?

The Cost of Equity is calculated using CAPM and the formula is Rf (Risk-Free Rate) + (Levered Beta x Equity Risk Premium)

What is CAPM conceptually?

CAPM (Capital Asset Pricing Model) is a formula used to calculate the Cost of Equity, the return equity investors require for taking on the risk of owning a specific company's equity It does so by adding the RF Rate (usually US or Canadian government bonds) to the excess return required for investing in equity (calculated by multiplying the Equity Risk Premium by the company's Levered Beta)

What is the Equity Risk Premium, and what is Levered Beta?

Equity Risk Premium (ERP) = Expected Return of Stock Market − Risk-Free Rate. The Equity Risk Premium is the % that stocks in the US (or Canada) are expected to outperform the Risk-Free Rate. It represents the extra return investors demand for taking on equity risk instead of investing in a guaranteed government bond Levered Beta captures i) the business risk and ii) the financial risk of the individual company you're evaluating, relative to the overall stock market

What does it mean when a company has a Beta of 1, -1, or 0? Give one example for each.

Beta of 1: Moves with the market. If the market rises 1%, the stock rises 1%. Example: Coca-Cola, since it's a large, stable multinational that tends to track the broader market closely. Beta of -1: Moves opposite the market. If the market rises 1%, the stock falls 1%. Example: a gold mining company, since gold is seen as a "safe haven" asset, when stocks fall, investors push gold stocks up. Beta of 0: No correlation to the market. Example: cash, whether the stock market rises or falls, the value of a dollar in your bank account doesn't move.

What is the difference between Unlevered and Levered Beta? Why is Levered Beta used in the CAPM formula?

Unlevered Beta is the inherent risk of a specific business, due to its specific characteristics (supply chain, growth, industry, etc.). Levered Beta is the business risk plus the impact of risk associated with leverage (due to the risk of bankruptcy) Levered Beta is used in CAPM because the companies that make up the overall stock market are also leveraged, so comparing a company's Levered Beta against the market gives an accurate, apples-to-apples measure of relative risk

Company A has a Levered Beta of 0.8. Company B has a Levered Beta of 1.8. Which company has the higher Cost of Equity, and why?

Company B. A higher Beta means the stock is more volatile relative to the market, which means it carries more risk, and investors require a higher return to compensate for that risk.

How do you actually get Beta?

If a company is already public, just use its Historical Beta, available directly from sources like Bloomberg. If not, do the following:

1. Find comparable companies and their Levered Betas. 2. Unlever each peer's Beta, to strip out the effect of each company's different capital structure and isolate the business risk.
2. Average the unlevered Betas, giving you a Beta that reflects the industry's underlying business risk. 4. Re-lever using your own company's capital structure

A company has a Risk-Free Rate of 5%, an Equity Risk Premium of 5%, and a Levered Beta of 1.5. What is its Cost of Equity?

Re = 5% + (5% x 1.5) = 5% + 7.5% = 12.5%

What are the three main valuation techniques and how do you rank them from lowest to highest valuation? Note an LBO could also be a valuation technique, but it depends… we will exclude for now and will focus on the “core 3”

Comparable Company Analysis, Precedent Transactions, and Discounted Cash Flow. Precedent Transactions is typically the highest, due to the control premium. Comps and DCF can rank either higher or lower relative to each other, since Comps depends on current market conditions and DCF depends on the assumptions used (growth rate, discount rate, etc.)

What is the difference between Intrinsic Valuation and Relative Valuation?

Relative Valuation values a company based on how similar companies are priced in the market, using multiples as the tool to make that comparison. This includes Comparable Company Analysis and Precedent Transactions Intrinsic Valuation values a company based on its own fundamentals, its own projected cash flows, independent of what other companies are priced at. This is done through a Discounted Cash Flow (DCF) analysis.

How do you value an apple farm / orchard?

The same core logic applies as any valuation. Relative valuation: find what similar apple farms or orchards have sold for, or are currently selling for, and apply those values to your own farm. DCF: project out the cash flows the orchard is expected to generate each year from selling apples, then discount those future cash flows back to today and sum them up to arrive at the orchard's present value.

Walk me through how to complete a DCF

An unlevered DCF values a company based on its cash flows, and is generally completed by i) projecting out a company's unlevered free cash flow until growth normalizes, typically over a 5 to 10 year horizon, and ii) then calculating the Terminal Value using either the Gordon Growth Method or the Multiple Method. You then discount these cash flows back to present value using WACC, which gets you the implied Enterprise Value, and from there, you subtract net debt and divide by shares outstanding to get the implied share price.

What is comparable company analysis and how do you complete it?

Comparable Company Analysis is a relative valuation method where a company's value is derived from comparing it to the value of similar public companies. To complete it, you identify a peer group of comparable companies based on i) Same Industry, ii) Similar Geography, and iii) Similar Size/Financial Profile, then apply the median multiple of that peer group to your target's corresponding cash flow metric to arrive at its value. You can also apply the min or max multiple instead of the median, giving you a range of values rather than a single number.

What is precedent transaction analysis and how do you complete it?

Precedent Transactions works the same way as Comps, except instead of looking at a similar company's current stock price, you look at what similar companies actually sold for in past M&A deals. To complete it, you identify comparable past deals using the same criteria as Comps, i) Same Industry, ii) Similar Geography, and iii) Similar Size/Financial Profile, plus iv) Timing, since the deal should be relatively recent, then apply the median multiple paid in those transactions to your target's cash flow metric to arrive at its value. You can also apply the min or max multiple instead of the median, giving you a range of values rather than a single number.

Why do precedents transactions yield the highest valuation?

Precedents tend to yield higher values than Comps due to a control premium. A control premium is a premium the buyer pays to the selling company's equity holders to i) gain control of the company and ii) entice them to sell. This is usually around 15% to 20% above the company's current stock price.

Explain to me to valuation is actually completed in practice

You apply all of the relevant valuation methods (DCF, Comps, Precedents), compare the ranges each one produces using a "football field" chart, and use judgment on where the company should ultimately be valued. Valuation is not about finding one "correct" value, it's about establishing a reasonable range, and looking for where the different methodologies overlap gives you the most defensible conclusion