Your Money. Personal Finance. Your Practice. Popular Courses. Financial Analysis How to Value a Company. Key Takeaways Discounted cash flow DCF is a method of valuation used to determine the value of an investment based on its return or future cash flows. The weighted average cost of capital is used as a hurdle rate, meaning the investment's return must outperform the hurdle rate. Although DCF is the standard for valuing privately-held companies; it can also be used as an acid test for publicly-traded stocks.
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Investopedia does not include all offers available in the marketplace. Related Articles. Exit Approach. Partner Links. What Is a Hurdle Rate? A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. What Is a Discount Rate? I can refer to the interest rate that the Federal Reserve charges banks for short-term loans, but it's also used in future cash flow analysis. What Does Cost of Capital Mean?
Cost of capital is a calculation of the minimum return a company would need to justify a capital budgeting project, such as building a new factory. Thus, the first challenge in building a DCF model is to define and calculate the cash flows that a business generates.
There are two common approaches to calculating the cash flows that a business generates. The unlevered DCF approach is the most common and is thus the focus of this guide. This approach involves 6 steps:. Step 1 is to forecast the cash flows a company generates from its core operations after accounting for all operating expenses and investments.
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. The discount rate that reflects the riskiness of the unlevered free cash flows is called the weighted average cost of capital.
Once discounted, the present value of all unlevered free cash flows is called the enterprise value. If a company has any non-operating assets such as cash or has some investments just sitting on the balance sheet, we must add them to the present value of unlevered free cash flows.
The ultimate goal of the DCF is to get at what belongs to the equity owners equity value. Therefore if a company has any lenders or any other non-equity claims against the business , we need to subtract this from the present value.
Often, the non-operating assets and debt claims are added together as one term called net debt debt and other non-equity claims — non-operating assets. The equity value tells us what the total value to owners is. But what is the value of each share?
Without a 3-statement model that dynamically links all these together, it is difficult to ensure that changes in assumptions of one component correctly impact other components. The 3-statement models that support a DCF are usually annual models that forecast about years into the future.
However, when valuing businesses we usually assume they are a going concern. In other words, they will continue to operate forever. That means that the 3-statement model only takes us so far. We also have to forecast the present value of all future unlevered free cash flows after the explicit forecast period. This is called the 2-stage DCF model. The first stage is to forecast the unlevered free cash flows explicitly and ideally from a 3-statement model.
The second stage is the total of all cash flows after stage 1. This typically entails making some assumptions about the company reaching mature growth. The present value of the stage 2 cash flows is called the terminal value.
Prefer video? To watch a free video lesson on how to build a DCF, click here. In a DCF, the terminal value TV represents the value the company will generate from all the expected free cash flows after the explicit forecast period. Imagine that we calculate the following unlevered free cash flows for Apple:. Apple is expected to generate cash flows beyond , but we cannot project FCFs forever with any degree of accuracy. Suppose, for example, that working capital improvements came primarily from liquidating excess raw-materials inventories; the associated cash flow would likely contain less business risk than normal operating cash flows and so would deserve a discount rate somewhat lower than Alternatively, suppose the margin improvements came from increased automation and, hence, higher fixed costs; this would suggest that those incremental cash flows deserve a somewhat higher discount rate.
Could these extra analytical features be performed with WACC? That would force us to think about the capital structure of, say, net-working-capital improvements. And have we expressed the debt ratio for that structure in market-value or book-value terms? Does the ratio change over time? The exercise is even more prone to error than the simple formulation in the sidebar. APV is both less cumbersome and more informative.
Unfortunately, this is not as simple a procedure as textbooks often make it appear. A sketch of the approach many companies take to this analysis highlights some of its pitfalls. In a WACC-based analysis, we discount only once—the discount rate has to be adjusted to pick up all the costs and benefits of a selected capital structure. Not surprisingly, a lot of analytical energy goes into computing it.
WACC is just what it says it is: a weighted average of the after-tax costs of different sources of capital, in which each is weighted by the fraction of the capital structure it represents.
In our example, there are three kinds of debt four if you consider the refinancing in year five and one kind of equity. See the calculations in the table above to observe how we obtained a WACC of 9. When we discount the free cash flows from this business at 9. Why the difference in estimated values? There are several reasons, but the most important is that we made some common errors and miscalculated the WACC.
Another problem is that we used book values to generate the weights in the WACC, whereas the procedure is valid only with market values. And this, too, is subject to change every year. One expedient is to guess at the market value or use book values and then iterate—fill in the computed market value as the new guess, then recompute another guess, and so forth until the guess and the computed values converge. There are other difficulties as well.
In fact, every element of WACC presents computational challenges in all but the simplest, most sterile of settings. Can those problems be addressed? For the most part, yes, though demonstrating that is not the point of this article. Suffice it to say that making the indicated adjustments to the simpleminded but very common calculation shown here is at least as difficult as—and less informative than—using APV. Any value created by financial maneuvers—tax savings, risk management, subsidized debt, credit-enhanced debt—has its own cash-flow consequences.
You treat those consequences by laying out the cash flows in a spreadsheet and discounting them at a rate that reflects time value and their riskiness, but nothing else. In other words, APV is exceptionally transparent: you get to see all the components of value in the analysis; none are buried in adjustments to the discount rate. APV is exceptionally transparent: you get to see all the components of value in the analysis.
None are buried. APV has its limitations, of course. If you try to use a terminal rate higher than that, you run the risk of the company outgrowing the economy over time, and unless you want to buy car insurance and milk from Darden Restaurants, that is probably not the way to go.
Remember that the company, at some point, will have their growth come back to earth and will return to match the growth of the economy they reside in, that is why we use a lower Terminal Rate. The goal of a DCF valuation is to derive the fair value of the stock and determine whether it trades above this value overvalued or below this value undervalued. Remember that value investing is set out to find undervalued stocks, i.
Now that we have the free cash flow figured we could find the present value of those cash flows, the formula for that process is below. The next step is we need to calculate the terminal value, assuming a growth of 2. Therefore, the FCFF in the year 5 with a growth of 2. Then, you discount the terminal value to its present value using the WACC. Now that we have our net asset value or intrinsic value of the cash flows, we can determine our per-share price by dividing that number by the shares outstanding.
All of that is based on the growth rates of the free cash flow, the discount rate we calculated, and the terminal rate. Although the growth rate cannot be accurately estimated, a firm that is expanding and seeks to enter into new markets is more likely to sustain an average growth of 7.
Also, the WACC calculation may not apply to the real world. Another area that requires attention is the capex projections. In the real world, this may not be so true. If, for example, a company is expanding in year 3, its capex will be higher in year three and lower in years 1,2,4, and 5.
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