Contents DCF Like a Banker Intodution Some Background 2017-11-07 (/2017111/0TIaeH) Koy Assumptions Intraduction RU ry Th mc wt tsar en macn Ucraansl ane Be TCE calculation. if yeu have to ask what a DCF is, or how it works, this article isnot for you. Brittle Methed ve Chock Your Work ‘This aricle assumes you have already made at least a couple DOF and understand the core concepts, This aE IWR You through a high-quality DCF template and some of the key considerations. Some Background ‘The DCF is the most subjective form of valuation -it i subject the most judgment and potential for ‘maripulation. When we compare it to other valuation methodologies, ithas the most unknown variables. What are the variables in a DCF? 1. Financial projections 2, WACC (with is own numerous levers and inputs) 3. Exit Muliple / Terminal Grow Rate “The WACC ane the Exit Multple/ Terminal Growth Rate are the big unknowns, where investment bankers must ‘exercise judgment. The financial projections are usually supplied by the client, or are created with the client's input and are subsequently blessed by the lent. Investment bankers are not inthe business of creating projections, and the client should have a stronger bass lo project thelr own performance. ‘Compare these unknowns to those of other valuation methodologies: 1. Public trading comparables 2, Acquistion comparables: 3,L80 In public trading comparables and acquisition comparables, there are fewer distinct areas of judgment. The ‘most substantial decision is the frst question: which companies or deals are comparable? Some would argue the LBO isnot a valuation methodology, but Id argue that a LBO performed by a bankers a DCF without the uncertainty ofthe WACC. The cost of capital fer a LBO is mechanical. The ilusratve sponsor retum threshold is 20 - 25%, and the cost of debtis govemed by prevailing debt market conditions - whatever yur Leveraged Finance team deems reasonable. ‘Ok, background aside, let's check out the template (htps:/mltipleexpansion com/excelict xls). Key Assumptions Its a best practice to list out your key variables atthe top ofthe file. This allows you to easly Keep track of them, ‘and it makes your assumptions explicit to anyone else who might open up the fle Atow notes: «© Perpetuity Growth Rate is ust another name forthe Terminal Grow Rate.‘® Mid-year discounting: This is a boolean switch to turn on mid-year discounting. Mid-year discounting means that for each period of projected cash flows, you assume the cash lows occur inthe midle of the projected period, instead of at the end. Otherwise, you're unfairly penalizing a company’s value if its cash flows occur steady throughout the year. Here's an article discussing mid-year convention (12020105125imic-year-siscounting) in depth. Projected Cash Flows “This section is prety straightforward. Typically, you would link the financial projections from your standalone projection model instead of hard-coding them here. ‘One nuance is the “Terminal” year construct, We use this terminal period to normalize the last year of projected {ree cash flow, and in tur, we use normalized free cash flow to caloulate the terminal value via the Perpetulty Growth Method. One common ajustment isto set DBA equal to @ cerain % of CapEx. Remember, not all Capex is expensed as D&A. For example, land acquisition costs are not depreciated. All else being equal, a higher % of DBA leads toa higher valuation, because D&A reduces cash taxes pai, thereby increasing cash flow, ‘Also, the fee cash low is labeled Unlavered Free Cash Flow, because itis unburdened by leverage (debt), i.e, its before interest expense. This means these cash flows are the cash flows availabe tothe ent firm, regardless of capital structure, That should tell you that we're calculating the enterprise value. ‘You should always ask yourselt Who are these cashflows for? Have any pieces of the capital structure already been paid their due? For example, if we subtracted interest expense and debt amortization, these ‘cash flows would be for equilyholders rather than the entice frm, Terminal Value ‘As a reminder, enterprise value = PV of projected cashflows * PV of terminal value We calculated the PV of projected cash fows in the Projected Cash Flows section of the template. Now we need to calculate the terminal value and then the PY of the terminal value. The two aparoaches far calculaing the terminal value are the Exit Multiple Method and the Perpetuity Growth Method. Iti important to calculate the terminal value using both methods, even if only one of them is appropriate for the valuation e.g, there are no good comparables, so you can' find a reasonable exit multiple). Each method acts as a check upon the other Perpetuity Growth Method ‘The perpetuily growth method calculates the terminal value with a perpeluly. How much would this cash fow be worth, grown at X% in perpertulty and discounted at Y%7 “The formula (ignoring mid-year discounting) is terminal value= terminal free cash flow x (1 + g)/(WACC-g) PY of terminal value = terminal value /(11* WACG) 5 But per the discussion of mid-year discounting above, this unfit penalizes the value ofthe company - ‘assuming the company’ cash flows eccur relatively evenly throughout the year.The adjusted formula (accounting for mid-year discounting) is: PV of terminal value = terminal value /(1 + WACC) “4.5 Reasonable Growth Rates 50 you have to be careful with your growth rates. US GDP grows < 3% / year, 80.8 Perpotuly means foreve ‘company growing at 5% in perpetuity would eventually overake the US GDP. Usually up to 3.00% is standarc practice, Here we're showing 1.00% - 2.50%. You must have a vety good reason to go above 3.00%, Disclaimer: the selection of growth rates and appropriate discount rates can be quite nuanced. The comments ‘above specifically apply to US-based companies and companies in mature economies. I may be appropriate to select higher growth rates for companies based in emerging economies or countries with high inflation, but that is beyond the scope ofthis aricte. Implied Exit Multiple Using the terminal value (not PV of terminal value), we can calculate the implied exit mutiple range. Be it Multiple Method, you Consistent with the multiples you're showing - fyoute using a LTM multiple for the ‘should caleulate the implied LTM muliple here. Implied Exit Multiple = Terminal Value /LTM EBITDA Unfortunately, mid-year discounting makes things more complicated. We assume that the terminal value calculated using the Perpetuity Growth Method (PGM) occurs mid-year, consistent with mid-year cashflow discounting. The Exit Multiple Method (EMM) terminal value, onthe other hand, occurs at period ene ‘To calculate an apples-to-apples implied ext multiple, we need to grow the PGM-lerived terminal value by the discount rate for hal a period ~ shifing the value haf @ period into the future —to make it consistent wth the EMM terminal value. Here's the revised formula: Implied Exit Multiple = (POM Terminal Value x (1 + WACG) *0.5)/ LTM EBITDA ‘A couple notes: 1. The calculation ofthe implied exit multiple itustrates the intrinsic value relationship between growth and multiples. A higher grow rate leads to a higher value, which leads toa higher implied multiple, and vice 2. Ithere is a material diflerence between your implied multple range and the exit multiple range you're using, you need lo understand why. You may need to adjust your multiple range or your grow rates to achieve consistency Exit Multiple Method ‘The exit multple method calculates the terminal value by using a mutple atthe end of the projection period ‘You have some flexibility here on which multiple to use. Typically, you use the NTM or LTM EBITDA multiple, but you could also use a revenue multiple, The one constrain is that f you're performing a DCF analysis on the ‘enterprise value of a company, the multiple should be an enterprise value multiple (so not PE}, ‘The formula is simple (using LTM EBITDA multiple here)terminal value = projected LTM EBITDA x exit multiple PY of terminal value = terminal value /(11* WACC) 5 ‘Since the terminal value is calculated for period-end, mid-year discounting does not apply tothe terminal value. You ciscountit by the full 5 years, (Check Your Multiple Selecting an appropriate exit multple range is key, and ithelps to have knowledge of the industry, 1. Is this a oylical industry? If current muliples are 12,0x, but the historical average is 8.0x, itis NOT ‘appropriate to solect 11.0x- 13.0% as your exit mutple range. 2, How are you deriving the exit mutiple? Ave there good comparables? Implied Perpetuity Growth Rate Here is where things get tricky. We know the formula for terminal value using the Perpetulty Growth Method: Terminal Value = terminal FCF x (1 + g)/(WACC -9) We need to factor out the g in order to calculate the implied growth rate. Steps below: TV= (FCF + FCF xg)! (WACC-g) TVxWACC -TVxg = FOF * FOF xg TV xWACC - FOF = (FCF + 1V) xg (TV x WACG - FCF) / (FCF + TV) (Ok, not so bad. But wait Remember from our discussion ofthe implied exit multiple that terminal values calculated using the PGM and EMM are inconsistent when we apply mid-year discounting: PGM terminal values occur mié-period, ‘and EMM terminal values occur end-ot period, We need to adjust he terminal values by hal @ period of discounting - we ae taking the EMM terminal value ‘and discounting ito get the implied PGM terminal value, which can then be used to derive the implied growth rale. The revised formulas as follows: (TV (1 + WACC) 0.5) x WACG - FCF) (FCF + (TV (1+ WACC) *0.5) Basically the same as belore, bul we substiute TV /(1 + WACC) * 0.5 wherever we had TV previously Check Your Work It you're rebuilding his template from scratch, oF madiying it, check your work. ‘One efcient way to check the implied exit multiples and implied grow rate isto plug them into the opposing section. Ill explain what | mean. ‘Checking Impliod Exit Multiples 1. Copy the row of implied exit multiples (cow 65 inthe template) 2. Paste the copied values into the row of LTM Exil multiples (row 78 in the template).3. You should see your assumed perpetuity growth rate range in the implied perpetuity growth rate row (row: 82 in the template) 4. Contrlz to undo the pasted values. ‘Checking Implied Perpetuity Growth Rates 1. Copy the row of implied perpetuity growth rates (row 82 in the template), 2. Paste the copied values into the Perpetuly Growth Rate row (row 59 inthe template). 3. You should see your assumed exit mutiple range in the implied exit multiple row (row 8 in the template). 4, Control z to undo the pasted values. It your implied values do not match your assumed values when you perform these checks, there isan error, Example Outputs ‘The outputs are actuslly therel They/re just shifted fo the righ to avold messing up the column widths of the other sections. ‘These are the types of outputs | would show for DCF -a simple presentation of the build to enterprise value, NEWER (201810173 /Dividend-Recap!) OLDER Private Equity Recrting (fr Banking Analysts) (2017/10/28/PE-Recruiting/) Copyright© 2024 Muticlaéxparson com. Al Rigs Reserved. | Abou about) | Library (xa) | Privacy Ply (prvacy) | Tem of Servic (terms)