DCF Modeling & Corporate Valuation
This guide includes the key topics covered in our financial modeling classes. In this guide, we will review concepts across corporate finance, financial accounting, corporate valuation, and more.
Discounted Cash Flow Modeling
A Discounted Cash Flow (DCF) valuation is one of the tools finance professionals use to determine the value of an investment or business. DCF analysis uses future free cash flow (FCF) projections and discounts them to estimate the present value.
The basic premise behind a DCF is the concept of present value (PV), which basically states that a dollar today is worth more than a dollar later because that dollar today can be invested and earn a return. For example, suppose you are promised to receive a hundred dollars in one year from now, and you know that you could invest it at 7% return (the Discount Rate), the PV, or value today, is $93.4 = $100 / (1+0.07). You can think about this as investing $93.4 at a 7% return for one year = $93.4*1.07=$100.
When performing a DCF analysis, the analyst is modeling the future cash flows of the company, and using a discount rate (typically the Weighted Average Cost of Capital, or WACC), the analyst can estimate the value of those cash flows in today's dollar.
What is a DCF model and what is it used for?
- A Discounted Cash Flow model is a financial model used to value a company by projecting and discounting future cash flows.
What is unlevered Free Cash Flow?
- It is the free cash flow assuming the company had no leverage. Generally, it is EBITDA - Capex - Taxes - Change in Working Capital, but other items may be included as well.
- Interest expenses and debt repayments/raises should not be included. The idea is to determine the value of the whole company and later subtract out debtor claims to derive the value to equity holders.
What cash flows do I discount in a DCF model?
- There are two main methods of DCF modeling: Unlevered FCF and Levered FCF. When using the former, discount the unlevered FCF.
When I sum up the discounted cash flows in the DCF model (unlevered FCF method), what does that represent?
- The enterprise value, or total value to all stakeholders.
- To derive the stock price value, subtract any debt, preferred stock, and other claims, and add cash, short and long-term investments, and other excess assets. Divide the result by the total shares outstanding, adjusting for stock options outstanding (see the Treasury Stock Method).
After discounting cash flows in a DCF model, how do we derive a value per share?
- When using the unlevered free cash flow method (and the WACC), the discounted cash flows represent the enterprise value, or value to all stakeholders.
- To derive equity value, subtract debt (and other debt-like items like preferred stock), and add cash (and other excess assets).
- To derive the equity value per share, divide the result by the number of shares.
- What is a terminal value and how I do calculate it?
- Once the company's cash flow reaches a steady-state (growing at a steady pace), we need to calculate the terminal value, or the value in the last year of our model.
- One method is to apply an EBITDA multiple to the next year's EBITDA.
- Another method is the Gordon Growth Model: Unlevered FCF / (WACC - terminal growth rate)
What is the WACC and how do I calculate it?
- The weighted average cost of capital takes the weight of each component in the capital structure and multiples it by the cost of that component
- (Cost of equity * equity weighting) + (cost of debt * debt weighting) * (1 - tax rate) + (cost of preferred stock * preferred stock weighting)
- Since interest on the debt is tax deductible (at least to specified limits under the new tax law), we tax-adjust the cost of the debt
What is the CAPM?
Capital Asset Pricing Model is the method used to calculate the cost of equity
Cost of equity = Risk-Free Rate + Beta * Equity Risk Premium
See our full DCF Modeling tutorial for step-by-step instructions.