WALL STREET PREP CORE MODELING COURSE

Discounted
Cash Flow (DCF)
Modeling
CASE STUDY: APPLE

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Usage & Terms

Usage
• This is a supplementary document to be used with a Wall
Street Prep boot camp or online course.
Terms and Conditions
• This file is proprietary to Wall Street Prep. Distributing,
sharing, copying, duplicating or altering this file in any
way is prohibited without the expressed written
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“Wall Street Prep,” “Wall Street Prep,” and various marks
are trademarks of Wall Street Prep, Inc.

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Table of Contents

Chapter 1: Overview............................................................4
Chapter 2: DCF Mechanics .................................................14
Chapter 3: DCF Modeling Topics.......................................45
Chapter 4: Diluted Shares Outstanding.............................59
Chapter 5: WACC...............................................................76
Chapter 6: Bells and Whistles…………….............................98
Chapter 7: Appendix, Cash in Valuation.........................107
Chapter 8: Appendix, Value Drivers................................111

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DCF Modeling

Overview

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Overview

Introduction
• Valuation
• Fundamentals of a DCF
• Valuing a real company using the DCF
• Advanced DCF valuation issues

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Overview

Valuation perspectives
• You buy a house (investment property)
• What do you most care about?
• Equity value or total value?
• Original price (book value) or current value?
• To determine current value, do you look at comps or
discount future cash flows?
• The same questions apply to businesses

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Overview

Valuation
• I decide to start a hot dog business
• Before I can sell hot dogs, I secure
financing - $500k with debt and $450k
with equity

Liabilities
Debt $500k
Assets
Cash: $950k I incorporated my company and
Equity
$450k arbitrarily issued myself 90k
shares. Since my equity value is
$450k, I record the value of
each share as $5.

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Overview

Equity value vs. Enterprise value

• I use some of the cash to purchase inventories /
equipment
• $20k of the equipment purchased was not paid for with
cash; instead, it was invoiced.
• This put a $20k A/P liability on my B/S

Liabilities
Assets A/P $20k
Cash: $50k Debt $500k
Inventory: $500k
PP&E: $420k Equity
$450k

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Overview

Equity value vs. Enterprise value

• Enterprise value: value of the operating business
(operating assets minus operating liabilities)
• Operating assets: Usually all assets except for cash &
other investment assets
• Operating liabilities: Usually all liabilities except for
debt & debt-like liabilities
• Rather than treating cash as an operating asset, it is
netted against debt (net debt)

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Overview

Equity value vs. Enterprise value

Using the B/S below, answer the following:

Total assets 970 Enterprise
value
Total liabilities 520 Net debt
Equity value 450 Equity value

Liabilities
Assets A/P $20k
Cash: $50k Debt $500k
Inventory: $500k
PP&E: $420k Equity
$450k

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Overview

Equity value vs. Enterprise value

• Enterprise value – net debt = Equity
value is just a slight re-formulation
of the basic accounting equation
Enterprise value ≠ the
Assets -liabilities = Equity value of the entire
business
• This is a common way to discuss It measures only the
value of the core
value, so make sure you are operations, whereas
comfortable with the basic intuition equity value measures
the portion of the entire
business that belongs
to equity

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Overview

Book value vs. Market value

• Does our hot dog stand really have equity of $450 and an
enterprise value of $900?
• Most businesses are worth more than their book values
• What tools do we have to determine the value of the
business?
• For a publicly traded company, the equity market value is
readily observable via the company’s share price x shares
outstanding (market capitalization), but how do investors
determine the right price?

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Overview

Book value vs. Market value

Book value vs. market value

• Google has an equity book value of $104b per the
company’s 2014 10K
• Google shares trade at $500
• With 680m shares outstanding, this implies an equity
market value (market cap) of $340 billion
• Google has $60b in cash, $5b in debt per the company’s
2014 10K, implying (market) enterprise value of $340b +
($5b-$60b) = $285b

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DCF Modeling

DCF Mechanics

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DCF Mechanics

Intrinsic value (DCF) vs. Relative value (Comps)

• Two frameworks for valuation: Most common valuation
approaches
Intrinsic valuation (DCF) is
derived from the fundamental
Relative
analysis of the company’s cash Intrinsic (DCF)
(Comps)
flow generation potential
• Relative valuation (“comps”) is derived by comparing a
company to its comparable peers.
• DCF and comps seem quite different but they’re actually
very related – in theory a DCF should yield the same value
as comps (but rarely does)

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DCF Mechanics

DCF valuation
• DCF values a business as the sum of all the cash flows it
will generate, discounted to the PV at a rate that reflects
the riskiness of the cash flows
• Cash flows = Operating cash flows – cash reinvestment
• Discount rate: The required rate of return for the investors
and is a function of the riskiness of the cash flows

𝑡𝑡=𝑛𝑛
𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑡𝑡
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 = � 𝑡𝑡
1 + 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑡𝑡=1

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DCF Mechanics

DCF valuation

Effect on value
(higher/lower?)
Increase cash flows
Increase in discount rate

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DCF Mechanics

DCF valuation

Effect on value
(higher/lower?)
Increase cash flows Higher
Increase in discount rate Lower

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DCF Mechanics

DCF mechanics
Year Cash flow
You own and operate a hot dog
2021 10,500
stand with expected cash flows of:
2022 13,000
• In practice, you will often have 2023 15,000
2024 17,500
explicit forecasts for a few years,
2025 20,500
and then you’ll have to make
Annual growth
simplifying assumptions beyond thereafter 5%
this period. Discount rate 10%

• Based on the forecasts on the right and assuming all cash

flows are generated at the end of the period, what is the
present value of the hot dog stand?

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DCF Mechanics

Perpetual growth
• How do you value a business with perpetual cash flows?
• We use a well-established perpetuity formula in
mathematics:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑡𝑡+1
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑡𝑡 =
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟 − 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔(𝑔𝑔)

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DCF Mechanics

DCF mechanics

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DCF Mechanics

DCF in contrast to comps

• We valued our business at $323,547 based on a DCF
valuation approach. We could have valued the hot dog
stand by looking at the value of comparable businesses:
• In comps, values are typically compared relative to a
measure of the firm’s profitability (EV/EBITDA, P/E, P/B):
• These ratios are called multiples; which facilitate
comparisons for companies of different size, leverage and
other characteristics

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DCF Mechanics

DCF in contrast to comps

• Assume three nearly identical hot dog stands were
recently sold:
Comp 1 Comp 2 Comp 3

• Price: $260,000 • Price: $380,000 • Price: $150,000

• 2021 CFs: $10,000 • 2021 CFs: $14,000 • 2021 CFs: $6,000

• Value your hot dog stand using a comps approach

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DCF Mechanics

DCF in contrast to comps

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DCF Mechanics

DCF in contrast to comps

• Which approach is best? Pros/cons?

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DCF Mechanics

DCF advantages in contrast to comps

• Widely used in practice and respected
academically
• Theoretically, very sound method of
valuation
• Can value individual pieces of
business / synergies
• Not influenced by current market pricing
• Counter-argument: isn’t the market best way to value
business?

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DCF Mechanics

DCF implementation challenges

• No real consensus on implementation –
estimating cost of equity is controversial
• Requires detailed company financials
• Very sensitive to changes in operating,
terminal value, and cost of capital assumptions
• Garbage in = garbage out

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DCF Mechanics

Levered vs. unlevered DCF

• Before starting user must choose between two DCF
approaches:
1. Directly value equity (levered DCF)
2. Directly value enterprise (unlevered DCF)
• Depending on approach, FCFs, cost of capital (r), and cash
flow growth rate (g) must consistently match the value
they are determining

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DCF Mechanics

Matching cash flows to value

Value of the operations (enterprise value)

+ Cash & other investments
- Debt & other financial obligations

Value of the equity (equity value)

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DCF Mechanics

Levered vs. unlevered DCF

DCF Approach Unlevered DCF Levered DCF
Means you are trying to find the value of the Means you are trying to find the value of the
operations to all providers of capital business to equity owners
Free Cash Flows
Unlevered FCF Levered FCF
(FCF)
• FCFs that "belong" to both debt and
• FCFs that "belong" to equity owners
equity providers
• FCF before subtracting out dividends or
• FCF before subtracting out interest and
share buybacks (but after subtracting out
debt payments, dividends or share
interest and debt payments
buybacks
Weighted average
Discount rate (r) Cost of equity (CoE)
cost of capital (WACC)
Should incorporate the costs of capital to Should incorporate the costs of capital to
debt and equity investors equity investors
Output Enterprise value Equity value
Subtract net debt to arrive at equity value Add net debt to arrive at enterprise value
Relevant
Most industries Banks
industries

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DCF Mechanics

Levered DCF
• Forecast levered free cash flows (LFCF): Cash flows
that trickle down to equity owners after all non-equity
related expenses are removed
• LFCF = CFO – capex – debt principal payment
• LFCF takes out operating expenses, capex and debt
related payments (interest expense & principal)
• The appropriate discount rate is the cost of equity,
which captures risk and expected returns to equity only

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DCF Mechanics

Unlevered DCF
• Forecast unlevered free cash flows (UFCF): Cash flows that
trickle down to both debt and equity providers of capital
• UFCF = EBIAT + D&A/noncash items +/- WC changes –
capex
• UFCF takes out operating expenses, capex but not debt
related payments (interest expense & principal)
• The appropriate discount rate on unlevered FCFs is the
weighted average cost of capital (WACC), which captures
risks and expected returns to both debt and equity
providers
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DCF Mechanics

Getting from equity value to enterprise value

• In a levered DCF, the resulting PV of LFCF is the equity
value; you can easily get to enterprise value by adding net
debt
• Conversely, in an unlevered DCF, the resulting PV of UFCF
is enterprise value but you just subtract net debt to get to
equity value
• For the same company, both approaches should yield
exactly the same equity value and enterprise value

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DCF Mechanics

Levered vs. unlevered DCF

• Circle the appropriate metric

Unlevered DCF Levered DCF

Cash flows UFCF / LFCF UFCF / LFCF
Discount rate WACC / Cost of equity WACC / Cost of equity
Value directly Enterprise value / Enterprise value / Equity
derived Equity value value
Which FCF is higher? UFCF / LFCF UFCF / LFCF

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DCF Mechanics

DCF Implementation
• The prevalent form of the DCF model in practice is the
two-stage unlevered DCF model (our focus)
• Multi-stage DCFs (3-stage, high-low models) are possible
but less used in practice
Stage #1: Stage #2:
Projecting Calculating
UFCFs the TV
Forecast period is Estimate the value of = Enterprise value
typically 5-10 years the company at the
end of stage 1 then Value of the operations
discount to present

Discount using WACC

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DCF Mechanics

DCF Implementation

Nonoperating Nonequity
assets (cash) financial claims
(Debt)
Net debt

Enterprise Equity value

value Divide by dil.
Value of the shares out.
operations to get equity
value per
share

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DCF Mechanics

DCF Implementation
• Stage 1: Unlevered free cash flow projections (5-10 years)
• Annual cash flow freely Stage 1
available (but necessarily 𝑡𝑡=𝑛𝑛

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 = �
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡
1 + 𝑟𝑟 𝑡𝑡
distributed) to all providers 𝑡𝑡=1

of capital in the business,

after accounting for all
necessary reinvestments
• Linking from an integrated FSM is optimal

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DCF Mechanics

DCF Implementation
• Stage 2: Terminal value (TV) Stage 2
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡+1
• Beyond stage 1, assume a 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 =
𝑟𝑟 − 𝑔𝑔
constant growth rate and use
the perpetuity formula to
estimate a TV that represents
the PV of all the FCFs generated after stage 1
• Alternatively, analysts use ‘exit multiple’ approach
(more on this later)
• TV is present value at end of stage 1, so needs to be
discounted yet again to beginning of stage 1 (PV of TV)
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DCF Mechanics

Calculating unlevered FCF

Unlevered FCF
EBIT (Operating income)
Less: Taxes
Do not use actual taxes, rather calculate as EBIT (1 – tax rate); avoids double
counting the interest expense tax shield captured in the cost of debt part of WACC
Equals: EBIAT (also called unlevered net income, tax-effected EBIT, NOPAT)
Plus: Depreciation and amortization
Less: Increases in working capital assets
Plus: Increases in working capital liabilities
Less: Capital expenditures
Less: Other required investments
Equals: Unlevered FCF

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DCF Mechanics

Understanding unlevered FCF conceptually

• UFCF are cash flows from the operating performance of
the business, before any effects of leverage or non-
operating assets are factored in
• UFCF are a company’s cash flows AS IF it was an all-
equity financed company with no non-operating assets
• That’s why we start with EBIAT, which completely
ignores interest expense and the resulting tax shield

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DCF Mechanics

Understanding unlevered FCF conceptually

So how are the effects of leverage and non-operating assets
factored in?
• The debt related outflows (like interest payments) and
non-operating assets (like cash) are factored into the
model in the calculation of net debt but not in the UFCF
What about the interest tax shield? You ignored that benefit
in the UFCF
• True - the interest tax shield is factored in the discount
rate but not in the UFCF

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DCF Mechanics

Weighted average cost of capital

• While this will be discussed in greater detail later, below
is the basic WACC formula. Since most firms’ capital
structure includes a combination of debt and equity to
fund their operation, the overall cost of capital is the
market-based weighted average of the cost of debt and
equity. The formula for WACC is:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑟𝑟𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) ∗ + 𝑟𝑟𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 ∗
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
• Debt = market value of debt
• Equity = market value of equity
• rdebt = cost of debt
• requity = cost of equity

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DCF Mechanics

DCF Output: Sensitivity analysis

• DCF valuation is highly sensitive to future free cash flows,
terminal value, and discount rate assumptions
• Therefore, DCF output should be represented in ranges
• Key assumptions to sensitize include the discount rate,
revenue and operating margin assumptions, and terminal
value assumptions

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DCF Mechanics

It’s time to build a real DCF!

• We are going to continue to use Apple (AAPL:NASDAQ) as
our case study, and rely on the FSM that we built in our
prior course to provide us with all necessary forecasts
• As with the FSM course, assume
date of analysis is May 19, 2014

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DCF Modeling

DCF Modeling
Topics

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DCF Modeling

Terminal value (TV)

• Apple is expected to generate cash flows beyond 2018,
but we cannot project FCFs forever (with any degree of
accuracy). So how do we estimate the value of Apple
beyond 2018? There are two prevailing approaches:
• Growth in perpetuity: Assumes Apple will grow at some
constant growth rate assumption from 2018 to… forever
• EBITDA multiple method: Values Apple at 2018 using a
assumed multiple of its 2018 assumed EBITDA
• Since TV often represents a significant % of the value
contribution in a DCF, the assumptions used are important
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DCF Modeling

TV - growth in perpetuity
• Analysts calculate the Calculating terminal value using
perpetuity approach
PV of all the FCFs
generated after stage 1 𝑇𝑇𝑇𝑇2024 =
𝐹𝐹𝐹𝐹𝐹𝐹2025
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 − 𝑔𝑔
by assuming cash flows
will grow at a perpetual 𝑇𝑇𝑇𝑇2024
𝑇𝑇𝑇𝑇𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 =
1 + 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 2024 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
& constant growth rate
• The perpetuity formula yields Apple’s value at end of
stage 1, we need to discount it (further) to the valuation
date to get the PV of the TV

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DCF Modeling

What is the right long term growth rate ‘g’?

• No business can be expected to grow forever at rates
above the economy, so ‘g’ should be a sustainable rate
• In practice a 2-5% range is most frequently used
• Companies in high growth / early stage with high growth
rates during stage 1 tend to be valued with a higher LT g
than companies with lower growth rates in stage 1
• ‘Fuzziness’ of this is an often-criticized part of the DCF
• DCF outputs are frequently presented using a range of
growth rate assumptions

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DCF Modeling

Calculating FCF in the terminal year

• Recall that the perpetuity formula requires using a FCF
that is one year beyond the projection period
• The most common and simple way to deal with this is to
take FCF in the last year of the projection period (t) and
grow it one more year (t+1) at the long term growth rate.
In Apple’s case: FCF 2025 = FCF2024 * (1+g)

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DCF Modeling

Exit multiple method

• Instead of using the growth in perpetuity equation, TV is
often calculated by simply multiplying an LTM EBITDA
multiple x EBITDA in the last forecast year
• The LTM EBITDA multiple is usually derived from a
trading comps or transaction comps analysis, depending
on the purpose of the DCF (standalone valuation or for
acquisition analysis)
• Used because it requires fewer explicit assumptions about
future cash flows, growth, and more ‘realistic’

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DCF Modeling

TV: Exit multiple method vs. perpetuity

When using the EBITDA multiple to calculate the TV, you
can calculate the implied growth rate by using the following
formula:
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 −
𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑔𝑔 = 𝑇𝑇𝑇𝑇
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡
1+
𝑇𝑇𝑇𝑇

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DCF Modeling

TV: Exit multiple method vs. perpetuity

• Today’s company multiple provides a more ‘realistic’
valuation than the generic growth input in the perpetuity
formula (i.e. “all companies get the same g”)
• On the other hand, the multiple itself incorporates
implicitly all the assumptions about growth, discount
rate, and FCFs the perpetuity formula incorporates
explicitly
• The multiple selected is derived from market-based comps
analysis, which in turn, is used to determine DCF value.
(“What if the market today is wrong?”)

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DCF Modeling

Implementation caveats
• EV/EBITDA is most common multiple but can use any
enterprise value multiple in unlevered DCF (EV/Rev,
EV/EBIT, etc.)
• P/E and P/B is most common in levered DCF
• Just like with perpetuity approach, terminal value needs
to be discounted to present using the WACC

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DCF Modeling

Net debt
• Now that we calculated enterprise value, we must subtract
net debt from enterprise value to arrive at equity value
• Use the book values of these items as of the latest filing as
proxies for the market value unless instructed otherwise

Net Debt
Debt & equivalents Net Debt
1. Debt / Capital Leases
2. Non-controlling interests Enterprise
3. Preferred Stock Equity Value
Less: Non operating assets Value
1. Cash & equivalents
2. Other non op. assets

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DCF Modeling

Debt
• Use the latest book value of debt (latest 10Q or 10K)
• Long term debt (incl. current portion), short term debt
• Capital leases
• Convertible debt should be tested;
• If conversion assumed for purpose of calculating
shares do not include in net debt (double counting)
• If conversion not assumed include in net debt
• We’ll review this test shortly

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DCF Modeling

Preferred stock
• Preferred stock that isn’t convertible to common should be
included in net debt
• Use the latest book value (latest 10K/10Q)
• Convertible preferred stock should be tested;
• If conversion assumed for purpose of calculating shares
do not include in net debt (double counting)
• If conversion not assumed include in net debt
• We’ll review this test shortly

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DCF Modeling

Non-controlling interests (NCI)

• The value of the business that belongs to NCIs should be
included in net debt
• Use the latest book value (latest 10K/10Q)
• NCI expense should be excluded from the calculation of
UFCF (if you start the UFCF calculation with EBIT no
adjustment necessary since EBIT is before NCI expense).

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DCF Modeling

Non-operating assets
• The cash flows related to non-operating assets (i.e.
interest income) were not reflected in our FCF calculation
• We recognized the value of operating assets by
forecasting unlevered FCF, we haven’t recognized the
value of idle cash & investments anywhere yet
• The book value of idle cash & investments (latest 10-
K/10-Q) is used (assumes BV of cash = MV of cash)

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DCF Modeling

Diluted Shares
Outstanding

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Diluted Shares Outstanding

Basic shares
outstanding
• You can find the
latest outstanding
number of common
shares outstanding
by looking at the
front page of the
latest filing (i.e., 10-
Q or 10-K)

92,989,772

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Diluted Shares Outstanding

Diluted vs. basic shares

The value of a slice of pizza - given a value
outstanding for the entire pie - depends on the size of
the slice…
• However, you should use diluted $4 $2
shares instead of actual (basic) shares
when calculating fair value per share.

• This is because the fair value per share

should account for not just the actual
shares outstanding, but also
potentially dilutive securities. Entire pie = $16 Entire pie = $16

If you get the number of slices wrong,

• Ignoring this in the share count you’ll get the value of each slice wrong.
would mean you’re dividing the
model-derived equity value by not
enough shares and thus overstate
the value of each share

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Diluted Shares Outstanding

Diluted shares outstanding

• Calculating shares correctly using source filings is critical
• Used in arriving at equity value per share in the DCF

Diluted shares outstanding = Basic shares + dilutive securities

Front cover of • Stock options & warrants

latest filing • Restricted stock and restricted stock
units (RSUs)
• Convertible bonds and convertible
preferred stock

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Diluted Shares Outstanding

Dilutive securities
• Stock options issued to pay and motivate employees. Gives employees the option to
purchase common stock at a given price over an extended period

• Warrants are similar to options, except they are usually issued to lenders, not employees

• Restricted stock and restricted stock units (RSUs) are shares subject to vesting and,
often, other restrictions. Unlike options, there is no exercise price and employees receive
the stock free and clear after vesting.

• Convertible bonds are bonds that the company issues that can be converted into common
shares upon a certain strike price. The conversion feature allows the corporation an
opportunity to obtain equity capital without giving up more ownership control than
necessary and/or entice investors to accept lower interest rates than they would normally
accept on a straight debt issue

• Convertible preferred stock is similar to convertible debt, except that the provider of
capital usually receives a preferred stock dividends instead of interest payments

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Diluted Shares Outstanding

Calculating shares outstanding

A business with an equity value of $500m has Share price: _______________

100m shares outstanding

Now assume option holders hold 25m exercisable

Share price: _______________
options (assume a $0 exercise price)

Now assume that in addition to the options,

convertible preferred shareholders hold 15m
shares, each convertible into 5 shares of Share price: _______________
common stock (assume no dividends and no
liquidation value).

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Diluted Shares Outstanding

Restricted stock disclosure

For calculating diluted shares, should we
include vested restricted stock? What about
unvested?

• Vested restricted shares: Like options,

restricted stock vests over several years, but
when they vest, they automatically get
included in the actual share count, so there
is no dilutive impact

• Unvested shares: The most common

approach is to include in the diluted share
count, logic being that since it is highly
likely that unvested restricted stock will in
fact vest over the next several years
(vesting periods average 1-3 years), it is
more conservative to include all unvested
restricted shares in the dilutive share count
than to exclude.
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Diluted Shares Outstanding

Option basics
• Once an option is issued, it is outstanding. It is only exercisable once it has
passed its vesting period (usually 1-3 years)

• Each option has an exercise (“strike”) price, which the holder must pay the
company in order to exercise the option:

“In-the-money” options whose strike price < current stock price

“At-the-money” options whose strike price = current stock price
“Out-of-the-money” options whose strike price > current stock price

Test for calculating diluted shares: Should we include:

• All outstanding options or just the exercisable ones?

• Should we care whether options are in-the-$ or out-of-the-$

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Diluted Shares Outstanding

Option basics
Test for calculating diluted shares: Should we include:

• All outstanding or just exercisable? Like restricted stock, the more

conservative assumption is to include all outstanding options even if
they are not exercisable yet. That’s because it is reasonable to assume
most options will vest shortly. Note that while this is the more common
(and our preferred approach), some firms / groups use exercisable
instead, so make sure to adhere to your team’s preference.

• In-the-$ / At-the-$ / Out-of-the-$ options – Only include in-the-$ and at-

the-$ options. Assuming the exercise of out-of-the $ options would mean
an employee gives the company an exercise price that’s greater than the
value of the common she receives in return.

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Diluted Shares Outstanding

Options disclosure
• Historically, companies included
detailed tranche-by-tranche
options information in the 10-K
and only high level aggregate
data in the 10Q

• Increasingly, companies provide

only high level aggregate data in
both 10K and 10Q

Finding the options footnote

Search for the terms “exercisable”,
“options outstanding”, or
“granted” to quickly find the
footnote in a long 10-K

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Diluted Shares Outstanding

Calculating options using the treasury stock method

(TSM)
• An approach to calculating diluted shares that assumes that proceeds from
exercised options and warrants are used to repurchase outstanding shares at the
current share price.

• Minimizes dilutive impact of option conversion on existing shareholders.

• Most common approach in practice

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Diluted Shares Outstanding

Stock splits
• When companies announce stock splits, all share count and dilutive securities counts prior
to split must be adjusted to reflect the split.

• Otherwise, the market share price will reflect a post-split price while the share count will
be pre-split, leading to a huge underestimation of market cap

• To avoid this, always confirm that no split has taken place subsequent to the latest
financial report.

• If you have access to a Bloomberg terminal, the easiest way to check is to select ‘CACS’ on
the Bloomberg terminal to review recent corporate actions.

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Diluted Shares Outstanding

Dual classes
• Sometimes companies issue 2 or
more classes of common stock (A
and B), where one class has more
voting rights.

• The rationale is to allow

management, families, and other
insiders to retain voting control
without a 1-for-1 stake in equity.

• Count both classes equally in the

share base and include a footnote.

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Diluted Shares Outstanding

Impact of convertible debt and preferred stock on

shares
When co. has convertible preferred stock or convertible debt on its balance sheet,
determine whether to assume conversion when calculating diluted shares using the
“if-converted” method

“If-converted” method

1. If convertible is “in-the-$” (current share price > conversion price)

a) Assume conversion & include converted shares in dil. share count

b) Exclude the convertible security principal amount outstanding from the calculation
of net debt

2. If convertible is “out-of-the-$” (current share price is < conversion price)

a) Do not assume conversion, treat as normal debt and do not include converted
shares in the share count

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Diluted Shares Outstanding

Understanding conversion price for convertible debt

• Imagine a company with a current share price of $300 per
share issues a $10m convertible bond, with each $1,000
in debt principal convertible to 4 shares of common stock
(at the option of the holder)
• The conversion price is $1,000 / 4 = $250 per share
• The convertible is “in-the-$” because the $1,000 in
principal as converted is worth $1,200 (4 x $300)

Convertible debt principal amount outstanding

Conversion price =
Common shares debt is convertible into

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Diluted Shares Outstanding

Understanding conversion price for convertible

preferred
• A company with a current share price of $300 per share raises $10m by
issuing 25,000 preferred shares. Preferred shareholders can generally
exchange the preferred shares for their original investment1.

• Each preferred share is convertible into 2 shares of common stock2.

• If-converted test: Since $10m buys you 50,000 common shares if

converted, the conversion price is $200 per share. Since the current
share price is $300, the preferred stock is “in-the-$” because the
conversion price is < current share price.

• In other words, it originally cost preferred investors $200 per share to get
a share worth $300 if converted, so we assume conversion.
1 Another way this is expressed is that each preferred share has a redemption / “liquidation” value of $400 ($10m / 25,000).
2 The ratio of how many shares of common stock each preferred share is convertible into is called the conversion ratio.

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Diluted Shares Outstanding

Understanding conversion price for convertible

preferred
Redemption (Liquidation) value
Conversion price =
Conversion ratio × preferred shares outstanding

• Redemption (Liquidation) value: The value that the firm must pay to eliminate
the preferred stock obligation assuming no conversion. The $ amount of
preferred stock outstanding can be found in the footnote. Alternatively, use the
value on the balance sheet as a proxy.

• The conversion ratio: The number of common shares that each convertible
share can receive upon conversion

• Preferred shares outstanding: The number of preferred convertible shares

currently outstanding (do not confuse this with shares authorized which are
typically much bigger).

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DCF Modeling

WACC

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WACC

Weighted average cost of capital (WACC)

• Both debt and equity investors contributes capital to
businesses with the expectation that the risks they take
will be offset by an appropriate return
• Quantifying the cost of capital is different for both debt
and equity
• Cost of debt: Relatively straight-forward
• Cost of equity: Quite challenging

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WACC

Weighted average cost of capital (WACC)

• In unlevered DCF, WACC is the appropriate discount rate
because we are discounting free cash flows that belong to
all providers of capital

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑟𝑟𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) ∗ + 𝑟𝑟𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 ∗
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
• Debt = market value of debt
• Equity = market value of equity
• rdebt = cost of debt
• requity = cost of equity

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WACC

Capital structure assumptions in WACC

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑟𝑟𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) ∗ + 𝑟𝑟𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 ∗
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

• DCF assumes a constant WACC throughout

• As a result, an implicit assumption in the DCF is that the
company being valued maintain a stable capital structure
• Otherwise, users would need to adjust their WACC
assumptions for each projection period (both weights and
cost of debt and equity), making models such as the
adjusted present value more appropriate

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WACC

The equity weight

Public companies
• Use the market value of the equity (dil. shares x market
share price) to calculate the WACC
Private companies
• Use the DCF-derived equity value
• Creates a circularity because WACC is used to derive that
very equity value so be sure that iterations selected in
Excel, and insert a circuit breaker

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WACC

The debt weight

• Most of the time: Use the book value of debt as an
approximation for market value of debt
• More rarely: If interest rates have changed substantially
since debt issuance, don’t use book value, instead use the
market price of the company’s debt if it is actively traded

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WACC

Cost of debt
• Public debt: The cost of debt is directly observable in the
market as current yield-to-maturity on the company’s
long-term debt (Bloomberg good source)
• Analysts instead frequently use the weighted average
coupon rate (incorrect if coupon is significantly different
from yields
• For private companies: Use yield of debt with similar
credit rating
• Use credit agencies such as Moody’s and S&P which
provide yield spreads over US treasuries by credit rating
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WACC

Cost of debt
Impact of capital structure on cost of debt
• The cost of debt will increase with the level of debt as a
percentage of the capital structure because a more
highly levered business has a higher default risk

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WACC

Interest expense – tax shield

• Until now, we have ignored the tax Tax shield: Imagine a
benefits that debt provides via the $10m loan at a 10%
interest rate. At a 40%
tax deductibility of interest tax rate, the cost of debt
payments is not 10% but is 6%.
This is because the $1
interest expense reduces
• The true cost of debt is the after-tax earnings by $1 x (1 -
rate due to the ability of interest marginal tax rate)
because of the tax
expense to shield taxes. deductibility of interest
expense.
• Analysts should use the marginal
tax rate, such that the true cost of
debt = 𝑟𝑟𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)

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WACC

Cost of equity
• Not directly observed in the market
so difficult to estimate
• Represents the expected rate of return
for equity investors
• Expected return correlated with risk
but how is this quantified?
• Start with a risk free rate and
quantify a premium specific to the
company being valued.

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WACC

Cost of equity
• Multiple models exist for estimating the cost of equity
• Fama-French, Arbitrary pricing theory (APT), Capital Asset
Pricing Model (CAPM)
• CAPM - widely used & often criticized. Divides risk into:
1. Unsystematic (company-specific) risk: Risk that can
be diversified away so ignore this risk
2. Systematic risk: The company’s sensitivity to market
risk can’t be diversified away so investors will
demand returns for assuming this risk

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WACC

Cost of equity – the CAPM

𝑐𝑐𝑜𝑜𝑠𝑠𝑡𝑡 𝑜𝑜𝑓𝑓 𝑒𝑒𝑞𝑞𝑢𝑢𝑖𝑖𝑡𝑡𝑦𝑦 = 𝑟𝑟𝑖𝑖𝑠𝑠𝑘𝑘 𝑓𝑓𝑟𝑟𝑒𝑒𝑒𝑒 𝑟𝑟𝑎𝑎𝑡𝑡𝑒𝑒+β x ERP
• β (“beta”) = A company’s sensitivity to systematic risk
• ERP (“Equity risk premium”) = The incremental risk of
investing in equities over risk free securities

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WACC

Risk-free rate
• Should theoretically
reflect YTM of a default-free
government bonds of
equivalent maturity to the
duration of each cash flows
being discounted
• Current yield on U.S. 10-year bond is the preferred proxy
for the risk-free rate for U.S. companies
• German 10-year for European companies
• Japan 10-year for Asian companies
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WACC

The equity risk premium (ERP)

• ERP represents how much extra return investors seek for
investing in equities as a class
• Prevalent approach compares Sources for ERP

historical spreads between Ibbotson (SBBI)

Duff & Phelps
S&P 500 returns and the yield Damodaran
on 10-yr treasuries
• Still, period used, averaging technique & other issues
lead to debate around ERP calculation
• A generally acceptable range of ERPs is 4-8%

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WACC

Small-cap premium (SCP)

• In practice, an additional premium Premium above ERP

is added to the ERP when analyzing Mid cap ($800m-4b) 0.5%

Small cap ($200m-800m) 1.0%
small companies and companies Micro-cap (<$200m) 2.5%

operating in higher-risk countries Source: Ibbotson

• 𝑐𝑐𝑜𝑜𝑠𝑠𝑡𝑡 𝑜𝑜𝑓𝑓 𝑒𝑒𝑞𝑞𝑢𝑢𝑖𝑖𝑡𝑡𝑦𝑦 = 𝑟𝑟𝑖𝑖𝑠𝑠𝑘𝑘 𝑓𝑓𝑟𝑟𝑒𝑒𝑒𝑒 𝑟𝑟𝑎𝑎𝑡𝑡𝑒𝑒 + SCP +β x ERP

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WACC

Country risk premium (CRP)

• In practice, an additional Country Risk Premiums, July 2013

premium is added to the ERP United States 0.0%

United Kingdom 0.5%
when analyzing small Germany 0.0%

companies and companies Australia 0.0%

France 0.5%
operating in higher-risk China 1.1%
countries India 3.4%
Middle East 1.4%

• 𝑐𝑐𝑜𝑜𝑠𝑠𝑡𝑡 𝑜𝑜𝑓𝑓 𝑒𝑒𝑞𝑞𝑢𝑢𝑖𝑖𝑡𝑡𝑦𝑦 = 𝑟𝑟𝑖𝑖𝑠𝑠𝑘𝑘 𝑓𝑓𝑟𝑟𝑒𝑒𝑒𝑒 Eastern Europe 3.1%

Brazil 3.0%
𝑟𝑟𝑎𝑎𝑡𝑡𝑒𝑒+ CRP +β x ERP Africa 5.9%
Source: Damodaran

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WACC

Interpreting Beta (β)

• A company whose equity has a β of 1 has on average seen
returns in line with the overall stock market (S&P 500 is
the proxy)
• Company with a β of 2 has on average seen returns rise
twice as fast or drop twice as fast as the overall market
• Higher β = Higher cost of equity because the increased risk
investors take (via higher sensitivity to market
fluctuations) should be compensated via a higher return
• β is the only company specific variable in the CAPM

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WACC

Interpreting Beta (β)

What asset would you expect to carry a β of 0?
What asset would you expect to carry a negative β?
What assets would you expect to carry a very low β?
What type of company would you expect to carry a very high β?

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WACC

Interpreting Beta (β)

What asset would you expect to carry a β of 0? US treasuries and cash
What asset would you expect to carry a negative β? Gold and insurance
What assets would you expect to carry a very low β? Consumer staples
What assets would you expect to carry a very high β? Highly discretionary items like luxury watches

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WACC

Exercise: Calculate Home Depot’s WACC

• Home Depot trades at $50 per share
• 1.5b diluted shares outstanding
• $7.6 billion in debt outstanding (no cash)
• Current yield on Home Depot debt is 6%
• Home Depot’s marginal tax rate is 35%
• β = 0.80, MRP = 6%, Risk free rate = 2%
• Calculate Home Depot’s WACC

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WACC

Home Depot WACC

Shares outstanding 1,500.0
Share price $50.00
Debt 7,600.0
Cost of debt 6.0%
Marginal tax rate 35.0%
Beta 0.8
Market risk premium 6.0%
Risk free rate 2.0%

Debt weight 9.2%

Equity weight 90.8%
WACC 6.5%

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 = 𝑟𝑟𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) ∗ + 𝑟𝑟𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 ∗
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒐𝒐𝒐𝒐 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 = 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + β x market risk premium

96
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WACC

Calculating β
Online Lesson: Industry (bottom up β)
The problem with the observed
• For a public company, finding (regression-derived) β is that there are
often high standard errors with this
β is easy: Barra and other approach (company specific events
reduce the quality of the correlation)
services such as Bloomberg and
The other problem is that for private
S&P provide it companies there is no observed β.

In these cases, the preferred solution is

• All of these services calculate industry βs (see lessons 42-44 to learn
how to model an industry beta)
β based on the company’s
historical share price sensitivity to the S&P 500, usually,
by regressing the returns of both over a 60 month period

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DCF Modeling

DCF Bells
& Whistles

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DCF Bells & Whistles

Normalizing terminal free cash flow

• The final year of stage 1 should reflect sustainable long
term growth and reinvestment rates (i.e. normalized)
• Since most real world DCF models are 2-stage models,
where stage 1 is only 5 years, the final year of stage 1 is
sometimes not normalized:
• Imagine a high growth company that is still showing
double digit operating profit growth by the end of stage
1, with significantly higher than normalized
reinvestment rates (i.e. capex > depreciation). Is this
sustainable indefinitely?

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DCF Bells & Whistles

Normalizing terminal free cash flow

• Other issues that persist at the end of stage 1 include:
• Significant cash inflows/outflows from working capital
changes or DTL/DTAs.
• Theoretically the solution to this should be to extend the
stage 1 forecast period or create a 3 stage model,
• In practice practitioners simply adjust the FCF used for
calculating the TV to a “normalized” FCF by converging
the capex/depreciation ratio to 1, and removing any major
working capital and DTL/DTA inflows/outflows.

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DCF Bells & Whistles

Calculating β
• Despite various vendor algorithms to mitigate the problem
(Bloomberg’s forward / adjusted β), this limits the
usefulness of historical β as a predictor
• In addition, for private companies, no β is available
because there are no observable share prices

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DCF Bells & Whistles

Industry β
• For private companies and for when public company βs
have a high standard error, one solution is to use an
industry β.
• By looking at historical βs of a company’s peer group with
similar sensitivity to market fluctuations, a private
company’s β can be derived, and a public company β with
high standard error can be improved as the impact of
uncorrelated company-specific events that raise the
standard error will cancel each other out the more peers
are added

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DCF Bells & Whistles

Delevering and relevering βs of industry peers

• Industry peers can still have different capital structures
• We must undo the distorting impact of different capital
structures on β as, all else equal, more highly leveraged
companies will have higher observed βs
• Cash flows to equity holders are more volatile due to the
higher fixed interest payments
• To eliminate this distortion, we de-lever βs of comparable
companies and re-lever them at the target company’s
target capital structure

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DCF Bells & Whistles

Delevering βs

β(observed)
β 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
1 + 1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

Re-levering β
• Once you have derived the unlevered β, you need to
relever it at the target capital structure using the reverse of
the formula:

𝑁𝑁𝑁𝑁𝑁𝑁 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
β 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = β 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 ∗ (1 + 1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 )
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

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DCF Bells & Whistles

Exercise
• Determine β for a private drug store
given the following information:
Private Co. WAG CVS RAD
β 1.21 0.93 1.71
Share price $30 71.76 77.04 7.09
Diluted shares outstanding (mm) 400.0 956.6 1,170.0 963.3
Market cap 12,000.0 68,642.7 90,136.8 6,830.0
Cash (mm) 100.0 2,130.0 2,850.0 166.0
Gross debt (mm) 5,000.0 4,550.0 13,410.0 5,700.0
Tax rate 35% 37.0% 39.0% 0.0%

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DCF Bells & Whistles

Solution
Private Co. WAG CVS RAD
β 1.21 0.93 1.71
Share price $30 71.76 77.04 7.09
Diluted shares outstanding (mm) 400.0 956.6 1,170.0 963.3
Market cap 12,000.0 68,642.7 90,136.8 6,830.0
Cash (mm) 100.0 2,130.0 2,850.0 166.0
Gross debt (mm) 5,000.0 4,550.0 13,410.0 5,700.0
Tax rate 35% 37.0% 39.0% 0.0%

Delevered β 1.18 0.87 0.94

Industry average β 1.00
Private co. β 1.26

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DCF Modeling

Appendix 1:
Cash in Valuation

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Appendix 1: Cash in Valuation

Large cash (negative net debt) weirdness in valuation

• Negative net debt in valuation creates a weird (but not
incorrect) outcome: the equity capital weight is > 1 and
the debt capital weight is < 0

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Appendix 1: Cash in Valuation

Negative net debt quirks in valuation

• All else equal, the more cash a company the lower the
observed β, leading to a lower cost of equity
• This is an underestimation of the true cost of equity of the
unlevered FCFs, but is resolved by the >1 equity capital
weight and <0 debt capital weight which bring up the cost
of capital
• There is an alternative which avoids the weirdness by
using gross debt, but then the β needs to be adjusted to
remove the impact of cash (see next slide)

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Appendix 1: Cash in Valuation

Large cash (negative net debt) weirdness in valuation

The cost of equity is higher but

cost of capital is almost the same
(the minor difference arises from
the tax deductibility of debt)

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DCF Modeling

Appendix 2: Value
Drivers in the DCF

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Appendix 2: Value Drivers in the DCF

Value drivers
• Let’s revisit the perpetuity formula
• Recall that it defines value using three value drivers:
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡+1
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 =
𝑟𝑟 − 𝑔𝑔

• But how do companies generate the growth used in the

equation? How does a company’s reinvestment decision
and returns on capital affect value?

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Appendix 2: Value Drivers in the DCF

Value drivers
• FCF can be thought of as operating profit – reinvestment
• Reinvestments are made to generate returns and along
with the returns on those reinvestments, ultimately
determine a company’s growth rate
Example: CRT Systems
CRT Systems, a small maker of auto-parts, earned $5m in operating profits this
year. The company expects operating profit of $5.25m next year (5% growth).

This growth is expected to be driven be $250k in incremental sales from new

merchandise made using a new machine the company purchased this year for
$1m.

Below we identify key terms and relationships associated with the activities above:
Reinvestment rate (rr) = reinvestment/profit = $1m/$5m = 20%
Reinvestment = profit x rr
Return on invested capital (ROIC) = return/reinvestment = return/(profit x rr) = 250k/$1m = 25%
The growth rate (g) = return /operating profit = rr x ROIC = $0.25m/5 = 5%

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Appendix 2: Value Drivers in the DCF

Value drivers
• The perpetuity formula can be re-expressed as:
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡+1 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑡𝑡+1 × 1 − 𝑟𝑟𝑟𝑟
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 = =
𝑟𝑟 − 𝑔𝑔 𝑟𝑟 − (𝑟𝑟𝑟𝑟 𝑥𝑥 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)

Exercise
• You forecast operating profits of $100m. Assuming a
reinvestment rate of 25%, ROIC of 20% and WACC of 10%,
calculate the value of this company
$100𝑚𝑚 × 1 − 25% $75𝑚𝑚
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 = = = $1,500𝑚𝑚
10% − (20% 𝑥𝑥 25%) 5%

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Appendix 2: Value Drivers in the DCF

Value drivers
• Revisiting our hot dog stand, recall we forecast FCF of
$10,500, with g of 5% and discount rate of 10%.
• Now assume the FCF is comprised of $15,000 operating
profit less $4,500 in reinvestment.
• Calculate value, ROIC and the rr
• If we raise the rr to 40%, what is the impact on value?
• Can we draw a broad conclusion on the impact of rr on
value? Would the conclusion change if ROIC was lower
than the discount rate? How does ROIC affect value?

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Appendix 2: Value Drivers in the DCF

Calculating multiples intrinsically

• The very same things that drive intrinsic value should be
driving multiples.

𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑡𝑡+1 × 1 − 𝑟𝑟𝑟𝑟

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 =
𝑟𝑟 − (𝑟𝑟𝑟𝑟 𝑥𝑥 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)

• Dividing both sides by operating profit, we get:

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 𝑂𝑂𝑂𝑂. 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑡𝑡+1 × 1 − 𝑟𝑟𝑟𝑟 1
= 𝑥𝑥( )
𝑂𝑂𝑂𝑂. 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑡𝑡 𝑟𝑟 − 𝑟𝑟𝑟𝑟 𝑥𝑥 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑂𝑂𝑂𝑂. 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑡𝑡+1

• Observed market multiples implicitly say what an intrinsic

valuation explicitly says
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Appendix 2: Value Drivers in the DCF

Calculating multiples intrinsically

• So what does it mean when the DCF-derived multiple ≠
comps-derived multiple?
• Suggests there are differences between the implicit
ROIC, rr and discount rate assumptions baked into the
comps analysis and those baked into the DCF analysis.
• Had the hot dog stands we used earlier in the course as
comps truly been comparable in growth, ROIC, and
discount rate characteristics, the derived multiple
should have been identical to our stand’s multiple.

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