Note, this was among one of the first finance modules I ever did years ago, so the notes may be off a little.
Here is an example of a DCF:
1. Intrinsic Valuation (DCF)
Intrinsic valuation (DCF) is based on a company's fundamental financial performance and future cash flow projections. For instance, if Apple's revenues from its services sector are expected to rise, its intrinsic value might increase.
2. Advantages of DCF Over Comps
- Widely used in practice and respected academically.
- Theoretically, a very sound method of valuation.
- Can value individual components of a business or potential synergies.
- Not influenced by current market pricing.
Counter-argument: Isn't the market the best way to value a business?
3. Terminal Value (TV) Contribution
Since the terminal value often represents a significant percentage of the value contribution in a DCF, the assumptions used are crucial.
4. Normalized Free Cash Flows
A rigorous approach involves calculating a "normalized" terminal year FCF by adjusting working capital and capex assumptions to better align with the long-term growth rate. Refer to DCF online lessons 40-41 for further details.
5. Usage of EBITDA for Comps
Use the average EBITDA when the peer group is small (e.g., 3 companies). For larger peer groups, use the median. This course utilized Factset comps. Both Factset and Capital IQ are popular data services used by analysts for comps. In practice, analysts often create their comps instead of relying on a data provider. This skill is a significant part of the analyst's role and is the focus of WSP’s comps modeling course.
Note: If you believe the comps-derived multiple today isn't appropriate for a particular year (e.g., 2018), adjust it.
6. Apple's Negative Net Debt
Apple's significant cash reserves compared to its debt result in negative net debt. Consequently, the equity value exceeds the enterprise value because shareholders benefit from owning the operating business and the substantial cash reserves.
7. Apple's Tax Considerations
There's a belief that Apple might capitalize on opportunities like the tax repatriation holiday (circa 2004) that allowed companies to repatriate cash at reduced rates. In such a scenario, a smaller adjustment might be appropriate. Additionally, consider future trapped cash. In our DCF forecast, we used a 26% tax rate instead of the 35% US statutory rate due to the lower Ireland tax rates.
8. Types of Dilutive Securities
- Convertible Bonds: These can be converted into common shares at a specific strike price. The conversion offers investors the advantage of defined interest payments and the upside potential of equity.
- Convertible Preferred: Functions similarly to convertible debt, offering benefits of preferred stock (like dividends and payment priority) with a conversion feature.
9. Finding the Options Footnote
To locate the footnote quickly, search for terms like "exercisable" or "options outstanding".
10. Real-world Exercise: Colgate’s Convertible Preferred
Convertible securities details can often be found on the balance sheet and in the footnotes of a company's 10K/10Q reports.
11. Dual Class Shares Rationale
The objective is to let management, families, and insiders maintain voting control without a 1-for-1 equity stake. Count both share classes equally in the share base and include a footnote.
12. Checking for Other Dilutive Securities
- Warrants?
13. Interest Expense and Tax Shield
So far, we've overlooked the tax advantages provided by debt through the tax deductibility of interest payments. The actual debt cost is the after-tax rate due to the tax shield offered by interest expense. Analysts should apply the marginal tax rate.
14. Industry Betas
In certain scenarios, the ideal approach is to use industry betas. Refer to lessons 42-44 for guidance on modeling an industry beta.
15. Timing of FCFs
Assuming consistent cash flows can introduce other minor yet intricate discounting issues. See lessons 39 & 45 of the online course for more information.
16. Key Terms and Relationships
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Steps to Perform a DCF:
1. Projected Future Cash Flows:
Begin by estimating the company's future cash flows. This often involves making projections for several years into the future.
2. Choose a Discount Rate:
The discount rate represents the risk associated with the future cash flows. It can be thought of as the rate of return required by an investor to invest in the company. Typically, the Weighted Average Cost of Capital (WACC) is used as the discount rate.
3. Calculate the Present Value of Future Cash Flows:
Discount each year's projected cash flow back to its present value using the chosen discount rate.
4. Calculate the Terminal Value:
This represents the value of the company after your projection period, going on indefinitely. There are various methods to calculate this, with the Gordon Growth Model being one of the most common.
5. Sum the Present Values:
Add up the present values of the projected cash flows and the terminal value to get the total present value of the company. This gives you the intrinsic value of the company.
6. Compare with Market Value:
Finally, compare the intrinsic value with the current market value of the company. If the intrinsic value is higher than the market value, the company might be undervalued, and vice versa.
