Mastering Discounted Cash Flow Analysis: A Comprehensive Guide

Understanding Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis is a powerful valuation method used by investors and financial analysts to estimate the value of a company or investment. At its core, DCF involves projecting future cash flows and discounting them back to present value.

The basic premise is that a dollar today is worth more than a dollar in the future, due to its earning potential. By estimating future cash flows and applying an appropriate discount rate, we can determine the present value of those future cash flows.

DCF analysis is commonly used to:

• Value publicly traded companies
• Evaluate potential investments or acquisitions
• Determine fair value for a private business
• Assess the viability of specific projects or capital expenditures

While DCF models can become quite complex, the fundamental concept is straightforward. Let's break down the key components and steps involved in DCF analysis.

Key Components of DCF Analysis

1. Projected Cash Flows: Estimate future free cash flows the company will generate

2. Discount Rate: Determine the appropriate rate to discount future cash flows (often using WACC)

3. Terminal Value: Calculate the value of cash flows beyond the explicit forecast period

4. Present Value: Discount projected cash flows and terminal value back to present day

Steps to Perform a DCF Analysis

1. Analyze historical financial performance
2. Project future cash flows (typically 5-10 years)
3. Calculate the discount rate (WACC)
4. Estimate terminal value
5. Discount cash flows and terminal value to present
6. Sum the present values to determine enterprise value
7. Adjust for debt, cash, and other factors to arrive at equity value
8. Divide equity value by shares outstanding for per share value

Now that we've covered the basics, let's dive deeper into each component and explore how to build a DCF model in practice.

Projecting Future Cash Flows

Accurately forecasting future cash flows is critical to DCF analysis, but also one of the most challenging aspects. Here are some key considerations:

Revenue Forecasting

• Analyze historical growth rates and trends
• Consider industry outlook and competitive dynamics
• Review management guidance and analyst estimates
• Model different scenarios (base case, upside, downside)

Expense Projections

• Forecast cost of goods sold (COGS) and gross margins
• Project operating expenses like SG&A
• Consider fixed vs variable costs
• Account for expected efficiency gains or cost inflation

Capital Expenditures

• Review historical capex spending
• Consider industry capex-to-revenue benchmarks
• Factor in planned expansions or investments

Working Capital

• Project changes in accounts receivable, inventory, payables
• Consider impact of revenue growth on working capital needs

Taxes

• Use appropriate tax rate (often differs from statutory rate)
• Account for tax credits, loss carryforwards, etc.

The goal is to arrive at projected free cash flow to the firm (FCFF) for each forecast year. This represents cash available to all capital providers after accounting for operating expenses, taxes, and reinvestment needs.

Determining the Discount Rate

The discount rate used in DCF analysis should reflect the company's cost of capital and risk profile. The most common approach is to use the weighted average cost of capital (WACC).

WACC represents the blended cost of debt and equity financing, weighted by the company's target capital structure:

WACC = (E/V * Re) + (D/V * Rd * (1-T))

Where: E = Market value of equity D = Market value of debt V = Total market value (E + D) Re = Cost of equity Rd = Cost of debt T = Tax rate

Calculating an accurate WACC involves several steps:

1. Determine market value of equity and debt
2. Estimate cost of equity (often using CAPM)
3. Determine pre-tax cost of debt
4. Calculate effective tax rate
5. Compute WACC using the formula above

For public companies, you can often find WACC estimates from financial data providers. For private companies, you may need to use industry benchmarks or comparables.

Estimating Terminal Value

The terminal value represents the present value of all future cash flows beyond the explicit forecast period. There are two main approaches:

1. Perpetuity Growth Method

Assumes the company will grow at a stable rate indefinitely.

Terminal Value = FCF(t+1) / (WACC - g)

Where: FCF(t+1) = Free cash flow in first year after forecast period g = Perpetual growth rate (often 2-3%)

2. Exit Multiple Method

Assumes the company will be valued at a multiple of earnings or cash flow.

Terminal Value = Financial Metric * Exit Multiple

Common multiples include EV/EBITDA or P/E ratios.

The perpetuity growth method is more commonly used in DCF analysis. The assumed growth rate should not exceed long-term GDP growth expectations.

Discounting Cash Flows and Determining Value

Once you have projected cash flows, discount rate, and terminal value, the final steps are:

1. Discount each year's cash flow to present value
2. Discount terminal value to present value
3. Sum discounted cash flows and terminal value
4. Adjust for non-operating assets/liabilities
5. Subtract net debt to arrive at equity value
6. Divide by shares outstanding for per share value

This process yields an estimated intrinsic value for the company or investment. However, it's crucial to remember that DCF analysis is highly sensitive to input assumptions. Small changes in growth rates or discount rates can lead to large swings in valuation.

Building a DCF Model: Verizon Case Study

To illustrate the DCF process in action, let's walk through building a basic model for Verizon Communications (VZ). We'll use historical financials and some simplifying assumptions to create a 5-year DCF model.

Step 1: Analyze Historical Performance

Let's start by examining Verizon's recent financial performance:

Revenue ($ billions)
2021: $133.6
2022: $136.8
2023: $134.0

Free Cash Flow ($ billions)
2021: $20.3
2022: $14.7
2023: $18.7

We can see relatively flat revenue growth and some volatility in free cash flow. Let's dig deeper into the components:

Gross Margin %
2021: 59.8%
2022: 56.6%
2023: 57.5%

Operating Margin %
2021: 22.3%
2022: 22.2%
2023: 17.3%*
*Impacted by goodwill impairment

Capex ($ billions)
2021: $20.3
2022: $23.1
2023: $18.8

This gives us a baseline to work from for our projections.

Step 2: Project Future Cash Flows

Now let's create some basic projections for the next 5 years:

Revenue Growth: 2% per year
Gross Margin: 57.5% (in line with 2023)
Operating Margin: 22% (returning to pre-2023 levels)
Capex: $18 billion per year
Tax Rate: 23%

Using these assumptions, we can project free cash flow:

         2024E   2025E   2026E   2027E   2028E
Revenue  136.7   139.4   142.2   145.0   148.0
EBIT     30.1    30.7    31.3    31.9    32.5
Tax      (6.9)   (7.1)   (7.2)   (7.3)   (7.5)
Capex    (18.0)  (18.0)  (18.0)  (18.0)  (18.0)
FCF      5.2     5.6     6.1     6.6     7.0

Step 3: Determine Discount Rate

For simplicity, let's assume a WACC of 7% based on:

• Cost of equity: 8%
• Cost of debt: 4.5%
• Target debt/equity mix: 60% equity, 40% debt
• Tax rate: 23%

WACC = (60% * 8%) + (40% * 4.5% * (1-23%)) = 6.98%

Step 4: Estimate Terminal Value

We'll use the perpetuity growth method, assuming 2% long-term growth:

Terminal Value = 7.0 * (1.02) / (0.07 - 0.02) = $142.8 billion

Step 5: Discount Cash Flows and Calculate Value

Now we discount each cash flow and the terminal value:

         2024E   2025E   2026E   2027E   2028E   Terminal
FCF      5.2     5.6     6.1     6.6     7.0     142.8
PV FCF   4.9     4.9     5.0     5.0     5.0     101.7

Sum of PV of cash flows: $24.8 billion PV of terminal value: $101.7 billion Enterprise Value: $126.5 billion

To get to equity value, we adjust for net debt:

Net Debt (as of Q4 2023): $130.3 billion Equity Value: $126.5 - $130.3 = -$3.8 billion

Divided by 4.2 billion shares outstanding, this yields a per share value of -$0.90.

Interpreting the Results

Our simple DCF model suggests Verizon is overvalued at its current price around $40 per share. However, this highlights the limitations of DCF analysis and the importance of testing assumptions:

1. Our growth assumptions may be too conservative
2. We didn't factor in potential margin improvements
3. The terminal value is highly sensitive to small changes
4. Balance sheet adjustments can have major impacts

By tweaking assumptions - for example, assuming 3% revenue growth and gradual margin expansion - we could easily arrive at a much higher valuation. This underscores the importance of sensitivity analysis and considering multiple scenarios when using DCF.

Best Practices for DCF Analysis

To get the most value from DCF analysis, keep these best practices in mind:

1. Use realistic assumptions: Base projections on thorough research and analysis.

2. Consider multiple scenarios: Model base, upside, and downside cases.

3. Perform sensitivity analysis: Test how changes in key inputs impact valuation.

4. Compare to other valuation methods: Use DCF alongside multiples-based valuation.

5. Update regularly: Revise models as new information becomes available.

6. Understand limitations: DCF is a tool, not a crystal ball. Use it in conjunction with qualitative analysis.

7. Document assumptions: Clearly state all assumptions and sources.

8. Use appropriate time horizon: 5-10 years is typical; longer periods increase uncertainty.

9. Be conservative: It's often better to underestimate than overestimate.

10. Consider competitive dynamics: Factor in industry trends and competitive positioning.

Conclusion

Discounted cash flow analysis is a powerful tool for valuing companies and investments. While it requires careful consideration of assumptions and inputs, DCF provides a structured framework for estimating intrinsic value.

By mastering DCF techniques and combining them with other valuation methods and qualitative analysis, investors and analysts can make more informed decisions and gain deeper insights into company valuations.

Remember that DCF is just one tool in the valuation toolkit. Use it wisely, in conjunction with other methods, and always be prepared to revisit your assumptions as new information becomes available.

Article created from: https://www.youtube.com/watch?v=Wez6_1-9WiU