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- DCF Analysis – Calculating Free Cash Flow

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- DCF Analysis – Walking Through and Explaining It

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WEAK POINTS: KEY #3 AND #4

Key Rule #1: The Big Idea Behind DCF Analysis and Valuation

- Since the Discount Rate and Cash Flow Growth Rate change over time, valuation is
more complicated than this simple formula.
- There are two main ways to reflect this reality more accurately:
o 1. Project the company’s cash flows in detail over the next 5, 10, or 15 years.
Discount these cash flows to their Present Value and add them up. After
that, assume that the company’s Cash Flow Growth Rate and Discount Rate
stay the same in the Terminal Period and value the company in that period
using the formula above. Discount the company’s “Terminal Value” to its
Present Value and add it to the discounted cash flows from the first 5, 10, or
15 years. (Since you’re valuing the company based on its cash flows rather
than external factors like other companies, this method is often called
intrinsic valuation.)
o 2. Use valuation multiples for the company’s near-term financial results,
such as the next 1-2 years, and don’t rely on long-term cash flow projections.
Valuation multiples are shorthand for cash flow-based valuation, assuming
that you’ve picked the proper comparable companies and financial metrics.
(s relative valuation. To use it, you collect sets of “comparable” companies
and M&A transactions, calculate their valuation multiples, and then apply
those multiples to the company you’re valuing.)
- Key Rule #1: The Big Idea Behind DCF Analysis and Valuation
- At its core, a Discounted Cash Flow (DCF) analysis values a company based on
the present value of its future cash flows. This is calculated using the formula:
- Company Value=Cash FlowDiscount Rate−Cash Flow Growth Rate,where Cash Flow
Growth Rate < Discount Rate.\text{Company Value} = \frac{\text{Cash
Flow}}{\text{Discount Rate} - \text{Cash Flow Growth Rate}}, \text{where Cash
 Flow Growth Rate < Discount Rate.} Company Value=Discount Rate−Cash Flow
Growth RateCash Flow ,where Cash Flow Growth Rate < Discount Rate.
- However, in real life, cash flow growth rates and discount rates change over time,
making this formula too simplistic.
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- How to Reflect Reality More Accurately:

- Intrinsic Valuation (DCF):

o Project detailed cash flows for the next 5–15 years and discount them to
their present value.
o Assume constant growth and discount rates in the terminal period,
calculate the terminal value, and discount it to the present.
o Example: A company’s projected cash flows have a Present Value (PV) of
$1,200, and its Terminal Value PV is $1,500, giving an Implied Value of
$2,700.
o This method is intrinsic valuation, as it relies on the company’s own cash
flows rather than external factors.
- Relative Valuation:
o Use comparable companies or transactions and apply their valuation
multiples (e.g., EV/EBITDA) to your company.
o Example: If similar companies trade at 10x–12x TEV/EBITDA and your
company’s EBITDA is $200, its Implied TEV is $2,000–$2,400.
o This method depends on external benchmarks, so it’s called relative
valuation.
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- Comparing the Methods:

- After performing both methods, compare the Implied Value to the company’s
Current Value.
- Example: If a DCF gives an Implied TEV of $2,700 and comparable multiples suggest
$2,000–$2,400, but the company’s Current TEV is $2,000, it may be undervalued.
- As an investment banker, this analysis can guide strategic decisions, such as
pricing for an M&A deal.
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 - Summary:

- Intrinsic valuation (DCF) uses projected cash flows and a terminal value to
estimate the company’s fundamental worth.
- Relative valuation compares the company to others using valuation multiples.
- Combined, these methods provide a comprehensive view of the company’s value to
guide decision-making.

Key Rule #2: Components of Unlevered Free Cash Flow

- DCF MODEL STEPS

o 1. Explicit Forecast Period
▪ 5 – 10 years, but can be longer depending on the company and
industry
o 2. Find UCFC
▪ Consistency – Since UFCF does not depend on the company’s capital
structure, you will get the same results even if the company issues
Debt or Equity, repays Debt, etc
▪ Ease of Projecting – You do not need to project items such as Debt,
Cash, and the interest rates on Debt and Cash because you ignore
the Net Interest Expense in the analysis. That means less research
and a faster conclusion.
▪ UCFC consists of
• 1. Revenue (addition). 2. COGS and Operating Expenses
(deductions) (deduct the full Lease Expense as well!). 3. Taxes
(deduction). 4. Depreciation & Amortization (addition) (and
sometimes other non-cash add-backs). 5. The Change in
Working Capital (could be an addition or a deduction). 6.
Capital Expenditures (deduction).
• But you have a formula known
• Stock-based compensation, the other common, recurring item
in this section, is NOT a real non-cash expense and should not
be added back to calculate UFCF.
- Other Definitions
o Note – non cash adjusments are ONLY FOR RECURRING PAYMENTS
 o Free cash flow is net income + non cash adjusment - working capital - capital
expenditure
o LFCF=Net Income+Non-Cash Adjustments−Change in Working
Capital−Capital Expenditures (CapEx)−Principal Debt Repayment (if any).
▪ Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you
subtract the Net Interest Expense before multiplying by (1 – Tax Rate),
and you also factor in changes in Debt principal.
o Unlevered Free Cash Flow = (revenue - operational expense)(1 - tax rate) +
non cash adjustments +/- working capital - capital expenditure
▪ so mathematically the formula for UFCF is ebit (1- tax rate) + non cash
adjustment - change in working capital - capex
▪ ΔWC=Net Working Capital (Current Period)−Net Working Capital
(Previous Period)
• If the current period is smaller, that means you need less cash
• If the current period is bigger, that means you need more cash

Key Rule #3: Figure Out the Company’s Business and Your Financial Model

- The next step in a DCF is to analyse the company’s filings and presentations to
identify revenue and expense drivers that influence its financial performance.
- 1. Understand the Business Context
- Key Industry Drivers:
o Identify the industry the company operates in (e.g., manufacturing, tech,
retail, etc.).
o Research trends and macroeconomic factors affecting the sector.
- Revenue Streams:
o Break down the company’s main revenue streams.
o Identify growth drivers (e.g., volume, price, market expansion).
- Cost Structure:
o Separate costs into COGS (variable) and Operating Expenses
(fixed/variable).
o Check for scalability or margin trends over time.
- Capital Intensity:
o Note if the business requires high CapEx (e.g., manufacturing, energy) or
operates asset-light (e.g., software).
- Peer Comparison:
o Compare the company’s size, margins, and growth rates to competitors.
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- 2. Gather Historical Data

- Financial Statements (Last 3-5 Years):

o Download and review the Income Statement, Balance Sheet, and Cash
Flow Statement.
o Highlight key trends (e.g., revenue growth, margin expansion/contraction,
working capital cycles).
- Key Metrics:
o Collect ratios such as Revenue CAGR, Gross Margin, EBIT Margin, and
Return on Invested Capital (ROIC).
- Filings and Presentations:
o Look for investor presentations and annual reports to identify key revenue
drivers and cost breakdowns.
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- 3. Simplify Revenue and Cost Projections

- Revenue:
o Project revenue using either a simple percentage growth rate or specific
drivers (e.g., price × volume).
o Use historical growth rates or management guidance to set assumptions.
- Costs:
o COGS: Link to revenue (as a percentage).
o Operating Expenses: Split into fixed (e.g., salaries, rent) and variable (e.g.,
commissions) components.
- Working Capital:
o Calculate historical Days Receivable, Days Payable, and Inventory
Turnover.
o Use these to project changes in working capital.
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- 4. Build a Simple Financial Model

- Income Statement:
o Project Revenue, COGS, and Operating Expenses.
o Calculate EBIT, EBITDA, and Net Income.
- Cash Flow Statement:
o Start with Net Income or EBIT.
 o Add back non-cash adjustments (depreciation, amortisation).
o Subtract CapEx and adjust for working capital changes.
- Balance Sheet:
o Forecast Assets and Liabilities, linking CapEx to PP&E and working capital
to operational needs.
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- 5. Validate Key Assumptions

- Scenarios and Sensitivities:

o Run different cases (e.g., optimistic, base, pessimistic) for revenue growth
and margins.
o Test sensitivities to key drivers (e.g., price, volume, CapEx).
- Compare Against Peers:
o Ensure revenue and margin assumptions are realistic by comparing to
competitors in the same industry.
- Simplify as Needed:
o Focus on major drivers (e.g., one or two segments that dominate revenue).
o Treat smaller segments or less relevant data as percentages of the total.
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- 6. Summarise Outputs

- KPIs and Insights:

o Highlight key metrics like Revenue Growth, EBITDA Margins, and FCF
Trends.
o Include valuation metrics (e.g., EV/EBITDA, P/E) if required.
- Charts and Graphs:
o Use visuals to summarise key trends (e.g., revenue growth, margin trends,
cash flow generation).
- Key Takeaways:
o Provide 2-3 concise insights about the company’s financial health and
growth potential.
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Key Rule #4: DCF – How to Project Unlevered Free Cash Flow
Terimal Value

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Key Rule #5: DCF – The Discount Rate and WACC

- The most important Discount Rates for valuation/DCF purposes are: • Cost of
Equity: This represents the “opportunity cost” for the company’s common stock –
what investors could earn from stock price increases and dividends. • Cost of Debt:
This one is for the company’s outstanding debt, and it represents the “yield”
investors could earn from interest payments and the difference between the market
value of the debt and the amount the company will repay upon maturity. • Cost of
Preferred Stock: This one is similar to the Cost of Debt, but it’s for Preferred Stock,
which tends to have higher coupon rates; Preferred Dividends are also not
taxdeductible, which makes Preferred Stock more expensive than Debt.
- WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt * + Cost of
Preferred Stock * % Preferred Stock

9. People say that the DCF is intrinsic valuation, while Public Comps and Precedent
Transactions are relative valuation. Is that correct? No, not exactly. The DCF is based on
the company’s expected future cash flows, so in that sense, it is “intrinsic valuation.” But
the Discount Rate used in the DCF is usually linked to peer companies (market data), and if
you use the Multiples Method to calculate Terminal Value, the multiples are also linked to
peer companies. The DCF depends less on the market than the other methodologies, but
there is still some dependency. It’s more accurate to say that the DCF depends more on
your views of the company’s long-term prospects and less on market data than the other
methodologies.
Unlevered DCF over Levered DCF as it is much less depended on companies capital
structure