Discounted Cash Flow (DCF) Valuation
- Spread historical financial statements (input historicals) and derive historical ratios, trends and variables (drivers of future performance; margins and growth rates). Project financial statements (proforma). Revolver modeling to link IS, BS, and SCF
- Project free cash flow (FCF)
- Determine Weighted Average Cost of Capital (WACC) – Discount rate
Cost of equity:
Rf = 10 year treasury
Market risk premium = Rm – Rf. Refer to Ibbotson. Ultimately this is S&P returns over 70, 80, or 90 years
Beta = Levered beta of comps to unlevered median and mean of comps (unlevered beta); should be .5 to 2.5; 2 year to 5 year betas (taking out capital structure and relever to actual capital structure. With beta, we are putting capital structure on unlevered beta mean and median of comps to calculate WACC of own company.
Cost of debt: weighted average of tranches of debt tax effected; found in 10K. Rates from the notes. If private company, get from clients the tranches and to get rates, go to DCM to get approximation.
Cost of equity 20% to 25% in private markets. No use of debt is an inefficient use of capital. Trying to optimize the D/E ratio to minimize cost of financing.
- Determine PV of explicit projection period free cash flows
- Determine terminal value – EBITDA multiple which is going to be almost 80% of the company value. Terminal value = LTM multiple from comps x EBITDA. Perpetuity growth rate should be 2.5% to 3% and should not be larger than the size of the GDP of the country
- Calculate net present value (NPV) and determine implied valuation
Need the valuation date; this determines stub year fraction (i.e. period left in the year). Stub year fraction – investor does not have claim on revenues before that. DCF value always moving through time consistent with valuation date.
IB interviews test you on DCF. Everything else that you know is a bonus.
Do DCF to find yield to decide whether or not to invest principal.