Finance DCF Valuation Guide

This guide outlines the steps to perform a Discounted Cash Flow (DCF) valuation for a company. This is for HBA1 Finance Course.

Step 1: WACC Calculation

Finding Cost of Equity

More often than not, we will use the CAPM model to find the cost of equity:

$$\text{Cost of Equity}=\text{Risk Free Rate}+\beta \times \text{Market Risk Premium}$$

Risk-Free Rate: This is estimated using the yield on US government bonds. In this course, we always use the 30-year bonds. In some cases we may use the 10-year bonds as they are more liquid, but the 30-year bonds is considered better for DCF analysis, as we are looking at cashflows in perpetuity.

Beta: There are 3 ways to do this, the following is the best order to do it:

1. If it is given in the case, use that.
2. If it is a publicly traded company and we have the stock prices, then use the SLOPE Function in excel (where x is the market returns and y is the stock returns).
3. Use comparable. The process is listed below.

Market Risk Premium: This will be given in the case.

Unlevering and Relevering Beta

When using comparable companies to calculate our own beta (or estimating it for private companies), you should:

1. Find similar or comparable companies to our own
2. Find their levered beta
3. Unlever the beta using the below formula

$${\beta }_U=\frac{{\beta }_L}{1+\left(1-t\right)\frac{D}{E}}$$

Where:

• ${\beta }_U$ = Unlevered Beta
• ${\beta }_L$ = Levered Beta
• $t$ = Corporate Tax Rate
• $D$ = Market Value of Debt
• $E$ = Market Value of Equity

4. Then relever all the beta values using our own capital structure:

$${\beta }_L={\beta }_U\left[1+\left(1-t\right)\frac{D}{E}\right]$$

Where:

• ${\beta }_L$ = Levered Beta
• ${\beta }_U$ = Unlevered Beta
• $t$ = Corporate Tax Rate
• $D$ = Market Value of Debt
• $E$ = Market Value of Equity

5. Finally, you can do some qualitative work, but standard practice is to take the average of these beta values.

Finding Cost of Debt

There are two possibilities when finding the cost of debt.

You will be given Yields of Corporate Bonds, in which you will use the risk rating of the firm to find the corresponding yield. This yield if your cost of debt. Sometimes, you will need to figure out the rating by comparing the firm’s ratios to other firms and estimating the rating.

If you are not given corporate bond yields, you will be given the spread. This spread can also be given in a table with risk ratings and you will follow the same procedure above, or it will be directly given for the firm. In both cases, you will then add it onto the risk-free rate to find the cost of debt.

Calculating Value of Equity

Our market value of equity is also known as the market cap, or:

$$\text{Market Value of Equity}=\text{Share Price}\times \text{Number of Shares Outstanding}$$

Calculating Value of Debt

When calculating the market value of debt, we can just look at the balance sheet. There are two requirements to meet when choosing debt:

• It must be interest-bearing
• It must be permanent (long-term)

The first is trivial to understand, the second means that year over year, the debt must have stayed on the balance sheet and we can reason that it will continue to stay on the sheet.

In general, this means that we only take long-term debt and its current portion. But always go through the two requirements before choosing your debt.

Calculating WACC

The formula for WACC is below, we assume no preferred shares:

$$\text{WACC}=r_d(1-t)\frac{D}{D+E}+r_e\frac{E}{D+E}$$

Where:

• $r_d$ = Cost of Debt
• $r_e$ = Cost of Equity
• $t$ = marginal tax rate
• $D$ = market value of debt
• $E$ = market value of equity

Step 2: Project Free Cash Flows

Free Cash Flows of a Firm (FCFF) are calculated as follows:

$$\begin{array}{rl}FCFF& =EBIT(1-t)\\ & +\text{Depreciation and Amortization}\\ & -\text{Capital Expenditures}\\ & -\Delta \text{Net Working Capital}\end{array}$$

Practically, you will grab your EBIT from the income statement, subtract your tax, add back Depreciation and Amortization, subtract Cap Ex, and subtract changes in Net Working Capital.

The first few are trivial:

• Depreciation and Amortization will be given to you. If projections are not given, you can estimate it as a percentage of sales.
• Cap Ex will also be given to you. If projects are not given, you can estimate it as a percentage of sales.
• Net Working Capital is often projected as a percentage of sales, and then the delta is this years minus the previous year’s net working capital.

Note: If there are synergies, they will be given as changes to the EBIT, just use those EBIT numbers instead.

Step 3: Terminal Value

Here we estimate the growth rate. As it’s always a perpetuity, more of than not, we will use the market’s default growth rate of $2\%\text{ to }4\%$ or 3%.

Then, on the last year, we add a terminal value of the firm which is calculated as follows:

$$\text{Terminal Value}=\frac{FCF{F}_n\times (1+g)}{(WACC-g)}$$

Step 4: Valuing the Firm

Now that we have our WACC, projected FCFFs, and terminal value, we can value the firm.

Present Value all the values and then we’ll the Enterprise Value!!

To convert this to the equity value, we use the following formula:

$$V_{Equity}=EV-V_{Debt}+\text{Excess Cash}$$

Excess cash is the sum of cash and cash equivalents and marketable securities on the balance sheet. In class, we had a term called short-term investments, this did not qualify and we didn’t include it.

Finally, to get the price per share, we divide by the number of outstanding shares:

$$\text{Price per share}=\frac{V_{Equity}}{\text{\# Shares Outstanding}}$$

Step 5: Because Why Not

Let’s do a two way data table! All valuation methods are very sensitive to percentages or small assumptions, so we can make a two way data table in excel to see how sensitive our valuation is to changes in WACC and Terminal Growth Rate.

We use this to create a range of values that we then plug into our Valuation Football Field if we choose to do one.

Additional Sensitivities To Do

• What if the buyer does not refinance the debt of the target? Then our WACC would not change when incorporating synergies.