Discounted Cash Flow Valuation (DCF)
In this blog (July 24th 2019) I will talk about “Discounted Cash Flow Valuation” (DCF).
My last blogs on “Leveraged Buyout Analysis” (LBOs) and “M&A Analysis” (M&A model) can be found under here in case you did not read them yet:
LBO Analysis (June 9th 2019): https://www.linkedin.com/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/
M&A Analysis (June 20th 2019): https://www.linkedin.com/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/
Discounted Cash Flow Valuation: An Introduction
Discounted cash flow valuation (DCF) is an important alternative to market-based valuation techniques like “multiples” (“EBITDA multiples” is the topic of my next blog).
So DCF is very valuable when there are limited of no pure play peer companies of comparable acquisitions available.
With DCF valuation I basically look at the free cash flows of a company and we “discount these back” to get to an “enterprise value”. I will discuss all these steps in more detail.
You can image that within DCF valuation we need to make a lot of assumptions, that is why “sensitivity analysis” is a very important component of this type of valuation. Here “Microsoft excel” comes in very handy, because excel is great for sensitivity analysis.
Determine key performance drivers
For DCF valuation you need to understand the target and its sector the best way possible. Think of the business model, financial profile, value proposition, end markets, competitors, key risks etc.
This way you can determine the key drivers of a company’s performance, particularly sales growth, profitability and free cash flow (FCF) generation. This since we need to come up with projections of future free cash flows (FCFs). And here fore we need to have insight on the:
Internal value drivers: e.g. opening new facilities, developing new products, securing new customer contracts, improving operational and/ or working capital efficiency etc.
External value drivers: e.g. acquisitions, end market trends, consumer buying patterns, macro-economic factors, legislative/ regulatory changes etc.
Unlevered free cash flow
When we take a closer look at unlevered FCF then we mean the cash generated by a company after paying: cash operating expenses, associated taxes, funding of CAPEX, funding of operating working capital (OWC).
But prior to payment of any interest expense!!
This because FCF is independent of capital structure as it represents the cash available to all capital providers, so both debt and equity holders.
In order to estimate FCF we need to make a lot of projections, think of projections on:
- SALES, EBITDA and EBIT;
- COGS and SG&A;
- D&A (depreciation and amortization);
- Changes in OWC.
For the projections we study carefully the past growth rates, profit margins and other ratios. These are usually a reliable indicator of future performance, especially for mature companies in non-cyclical sectors.
The projection period is on average 5 years, but this depends on its sector, stage of development, and the predictability of its financial performance.
With DCF valuation is it very common (and wise) to use multiple scenarios. The “management case” is often received directly from the company and alongside different scenarios should be developed.
Sales, COGS, SG&A, EBITDA and EBIT projections
Top line projections in sales often come from “consensus estimates” (consensus among equity analysts around the world).
Equity research often provides projections for a two to three year period. For the time after that industry reports and studies of consultants can be consulted to estimate longer term sector trends and growth rates.
Of course these projections need to be “sanity checked” with historical growth rates as well as peer estimates and sector/ market outlooks.
With COGS and SG&A projections I often rely upon historical COGS and SG&A levels and/ or estimates from research in the projection period.
EBITDA and EBIT projections for the projection period are typically sourced from consensus estimates for public companies. Of course here it is wise to review historical trends as well.
TAX, D&A, CAPEX and OWC
EBIT typically serves as the start for calculating FCFs. To bride from EBIT to FCF, several additional items need to be determined, including “marginal tax rate”, depreciation & amortization (D&A), CAPEX and changes in OWC.
First we need to take tax out of the EBIT in order to arrive at NOPAT (net operating profit after taxes). Here fore we use the “marginal tax rate”, but the company’s actual tax rate (effective tax rate) in previous years can also serve as a reference point.
After that D&A is added because these are “non-cash” items. CAPEX is deducted because this is a real cash out and this also counts for OWC. OWC needs to be carefully studied and largely consists out of the “delta” in two subsequent years between “current assets minus current liabilities”.
When we have carefully made the above steps, this then results in for example 5 free cash flows (ideally in 5 different operating scenarios).
Now it is time to discount these FCFs with a discount factor which we also call the “WACC”.
An overview of the calculation of FCFs is given under here. The table comes from the book: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions of Joshua Rosenbaum & Joshua Pearl (chapter 3 (DCF) in the book). This is the main book I use in my training “Business Valuation & Deal Structuring” and my participants receive a hard-copy of this book when they register.
Weighted average cost of capital (WACC)
The WACC is broadly accepted as a standard for use as the discount rate to calculate the present values of a company its FCFs.
The WACC can be thought of as an opportunity cost of capital of what an investor would expect to earn in an alternative investment with a similar risk profile.
It basically represents the weighted average of the required return on the invested capital in a given company.
For the WACC you need to choose a target capital structure for the company that is consistent for its long term strategy.
In case you target company is not public then consider the capital structure of “public comparable companies”. This since it assumed that their management teams have created right capital structures since they are seeking to maximize shareholder value.
The cost of debt in the WACC represents the company’s credit profile. This is based on multiple factors like size, sector, outlook, cyclicality, credit ratings, credit statistics, cash flow generation, financial policy, acquisition strategy etc.
So for the cost of debt we can for example look at publicly traded bonds and then the cost of debt is determined on the basis of the current yield on outstanding issues. But with private debt we can also look at current yield on outstanding debt.
Cost of equity
To determine the cost of equity is a little more complex. In many cases we will use the Capital Asset Pricing Model (CAPM). With this model we will look at a suitable return for the equity of a company.
This return consists out of the risk free rate (the return that you can make while staying in bed), so for example the return on 10 year government bonds of The Netherlands.
On top of that investors want to be compensated for the “Market Risk Premium”, this is the spread over the expected market return and the risk free rate.
At last this market risk premium is affected by a Beta. A Beta is a measure of the covariance between the rate of return on a company’s stock and the overall market return, with for example the “Amsterdam Exchange Index (AEX)” used as a proxy for the market.
When the valuator has collected all info: Target capital structure, cost of debt and cost of equity the WACC can be constructed.
An overview of the calculation of the WACC is given under here. The overview comes from the book: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions of Joshua Rosenbaum & Joshua Pearl (chapter 3 (DCF) in the book). This is the main book I use in my training “Business Valuation & Deal Structuring” and my participants receive a hard-copy of this book when they register.
In DCF valuation we calculate the terminal value of all future cash flows of a company. In many case FCFs are estimated for 5 years and then we assume a company will be in a steady state.
So we can calculate the present value of the estimated 5 FCFs, but then we still have to deal with the value after these 5 years.
We can do this with two methods: the 1) Exit Multiple Method (EMM) or the 2) Perpetuity Growth Method (PGM).
With the EMM we take the EBITDA of for example year 5 and multiple it with an exit multiple. After that we need to discount back this “terminal value” to year 0 (now).
Or we can use the PGM and take the FCF year 5 and we divide it by the WACC to calculate the “perpetuity value” (with or without “growth”). Of course, this terminal value also needs to be discounted back to year 0 (now).
Eventually we discount al the FCFs of the estimation period (let’s say 5 years) and we also add the present value of the terminal value. And the outcome of this calculation is the “Enterprise Value (EV)”.
When we deduct all debt and debt-like items and add all excess cash and cash-like items we have then calculated the market value of equity.
And simply said, when this market value of equity is higher than the book value of equity, there is “goodwill”.
Then we can add the EV from DCF in the “football field” next to EV calculations from for example “comparable companies”, “precedent transactions” and a “Leveraged Buyout Analysis (LBO)”.
An overview of the “Football Field” is given under here. The overview comes from the book: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions of Joshua Rosenbaum & Joshua Pearl (chapter 3 (DCF) and chapter 6 (LBO) in the book). This is the main book I use in my training “Business Valuation & Deal Structuring” and my participants receive a hard-copy of this book when they register.
Next blog and more detail
My next blog will be on “Comparable Company Valuation” (trading comps). Stay tuned!
And when you are interested in being able to prepare all the main valuation models for real in excel, then follow my valuation training in Amsterdam South.
This training takes place from 2 until 8 October (6-day training) in Amsterdam South and here I will explain you all the valuation models in great detail with Microsoft Excel.
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Training Business Valuation & Deal Structuring
This is a practical 6-day training in “Business Valuation & Deal Structuring” (Investment Banking M&A) and the main topics are: valuation, leveraged buyouts (LBO’s) and mergers & acquisitions (M&A’s).
The training mainly focuses on giving the participant hands on tools to build financial models in excel to determine the value of a company on 1) a stand-alone basis, 2) in a LBO situation and 3) in a buy-side M&A scenario.
In the training we will look at different valuation techniques to calculate “enterprise value” like: 1) Comparable companies analysis, 2) Precedent transaction analysis, 3) Discounted cash flow analysis (DCF), 4) LBO analysis and 5) Buy-side M&A analysis.
And we will look at different techniques to get from “enterprise value” to the “value of the shares” taking (adjusted) net debt into account.
The training is very practical in a sense that the trainer will explain the concepts first and will then apply them in class to real life companies with the participants. With all the calculations “Microsoft excel” is used to build the needed financial models.
This training is meant for analysts and associates from international investment banks. Moreover, the training is meant for analysts and consultants in: M&A, private equity, venture capital and strategy. In addition, the training is meant for accountants, tax lawyers, bankers in credit analysis, financial managers, CFO’s etc.
During the training will be focused on international companies listed on the stock exchange. But the valuation techniques are also applicable to (non-listed) private firms.
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Planning & location:
1. Wednesday October 2nd 2019: 10 AM – 6 PM;
2. Thursday October 3rd 2019: 10 AM – 6 PM;
3. Friday October 4th 2019: 10 AM – 6 PM;
4. Saturday October 5th 2019: 10 AM – 6 PM;
5. Monday October 7th 2019: 10 AM – 6 PM;
6. Tuesday October 8th 2019: 10 AM – 6 PM.
Sunday April 7th: Not a training day.
Location: Crowne Plaza Hotel – Amsterdam South. George Gershwinlaan 101. 1082 MT Amsterdam.
The hotel is located in Amsterdam South (financial district), right across train station “Amsterdam South” and about 15 minutes from “Schiphol Airport”.
Price & payment:
The price for this 6-day training is 3.900 euro excluding vat. And only 2.900 euro ex vat when you book before 31st July 2019 (1.000 euro early bird discount).
This price is for the 6-day training including study materials (A hardcopy of the theory + workbook of: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions of Joshua Rosenbaum & Joshua Pearl), coffee and tea all day, luxury lunch at lunchtime and a snack in the afternoon.
There is a maximum of 20 participants for the training based on first come first served. This way there is room for interaction in class.
You can register yourself by sending an email to: firstname.lastname@example.org.
You will then receive a registration form and additional details for registration. Or download the registration form and training manual at: www.kerstencf.nl/training
Trainer & Consultant: J.J.P. (Joris) Kersten, MSc BSc RAB
· 130 recommendations on his training can be found on: www.kerstencf.nl/referenties
· His full profile can be found on: www.linkedin.com/in/joriskersten
J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium sized companies.
Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/ or sellers, organises financing for takeovers and negotiates M&A transactions in a LOI and later in a share purchase agreement (in cooperation with (tax) lawyers).
Moreover, Joris is associated to ‘AMT Training London’ for which he provides training as a trainer and assistant-trainer in Corporate Finance/ Financial Modelling at leading investment banks in New York, London and Hong Kong. This for example at Morgan Stanley New York, Morgan Stanley London, UBS London, Barclays London, Nomura London and Credit Agricole Paris.
And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf. This for example at Al Jazira Capital in Saudi Arabia and TAQA in Saudi Arabia.
In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney.
Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam and Mongolia. And at partner Universities of SP Jain in Dubai, Mumbai and Singapore.
Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. And Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.
Currently Joris is doing the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV). This title will enable Joris to give out business valuation judgements in for example court cases.
J.J.P. (Joris) Kersten, MSc BSc RAB. Email: email@example.com. Phone: +31 6 8364 0527