Step 1 - Calculate Historical Free Cash Flows
You may be asking yourself, "what's the point of calculating historical Free Cash Flows, when we are supposed to be valuing the company with future free cash flows?". The answer lies in the fact that to establish the assumptions to project those free cash flows you need a baseline.
Free cash flow is all of the cash available for distribution to investors from a business' operations. There are are two types of FCF's:
1. Unlevered Free Cash Flows - these are the cash flows available to investors in the whole capital structure of the business
UFCF = EBIT(1-T) - CapEx + D&A - Net Change Non-Cash WC + One Time Cash Expenses
2. Levered Free Cash Flows - these are the cash flows available to only investors in the equity portion of the capital structure
LFCF = EBIT(1-T) - CapEx + D&A - Net Change Non-Cash WC + One Time Cash Expenses - Interest Exp
With both formulas you will notice that you begin with EBIT (earnings before interest and taxes), and not Net Income. EBIT is called Operating Profit as it is the best representation of the company's operations. Since FCF's are all of the Cash available to investors from Operations, it makes sense to begin with Operating Profit.
The additions and subtractions from EBIT are all to make EBIT into a representation of the Cash available to investors. You subtract Taxes, and Capital Expenditures because they are cash operating expenses, not represented in EBIT. You add back Depreciation and Amortization because D&A is a non-cash expenditure that is accounted for in EBIT. You subtract the net change in working capital because an increase in WC is essentially the business extending more interest free cash financing to its buyers (Acc. Receivables) and a decrease in WC is essentially the business receiving interest free cash financing from its suppliers (Acc. Payable). Finally you add back any one-time cash expenses because they do not represent the firm's day to day operations if they are one-time and non-recurring.
With Levered free cash flow you will also subtract interest expense because you want to calculate the cash available for distribution to only the equity investors, and any outlays to those on the debt side would be represented through interest expense.
Why do investment bankers typically use UFCF?
It allows for comparison between companies of all types of capital structures, while LFCF's would require adjustments for capital structure.
Sources of Historical data required to calculate FCF's:
- 10-k's and 10-q's - the consolidated statements will contain just about all of the information you need (search the SEC's EDGAR database to find company fillings)
- Bloomberg Terminals
Scroll down and Replace the cells with blue font with the Historical data in the Unlevered Free Cash Flow portion of the model and section just below it "assumptions"
Step 2 - Project Cash Flows
For the this step you have to realize what exactly you are projecting, or forecasting into the future. All of the elements of the free cash flow formula need to be projected for the next 5 years and then some measure of all free cash flows into perpetuity after that must also be projected.
First we will discuss the forecasting FCF's for the next 5 years. The FCF formula begins with EBIT, which comes from the income statement, so it makes sense that first and foremost you must project the income statement for the next five years. Then you realize the formula includes change in working capital which is a function of current assets and current liabilities both of which come from the Balance sheet, so it makes sense that you must also project the balance sheet for 5 years. Logically you realize that you must also project the cash flow statement for the next 5 years for the cash expenses such as Capital Expenditures. However projecting items like Depreciation and Amortization are a function of the company's asset life and depreciation schedules, which you must also reference...creating all of these forecasted statements is called projecting Pro-forma statements, however for the purpose of this tutorial and using the learning model below we will use a much more simplified method of projecting.
Start by projecting Revenue for the next 5 years. A simple way of doing this is applying a revenue growth rate for each of the next 5 years. A better method is breaking down revenue by segment and applying growth rates for each individual business segment. Sources for deriving a revenue growth rate/projection are:
- 10-k - management will sometimes indicate where they see various line items such as revenue going in the next few years. Commonly found in the "management's discussion" section
- Equity Research Reports - analysts will include projections of where they see operations going
- Bloomberg - bloomberg terminals will have projections based on various research reports
Projecting EBIT - as discussed above to project EBIT you should create a proforma income statement however another method is to assume that EBIT will grow as a % of Sales. You derive this percentage by taking the average EBIT/Sales revenue for the each of the historical years you inputted, and holding it constant going forward for the next 5 years.
Projecting the other components of FCF's - as mentioned above, technically you have to create pro-forma balance sheets and cash flow statements, etc. however a simplified method as applied in the model below is simply taking each function as a % of Sales. You take the average % of each metric such as D&A to Sales for the inputted historical years and apply that average to the projected years. Now as Sales grows so will each of the expenses and adjustments, proportionately. Technically each will have it's own driver other than sales. Such as CapEx is going to be related to D&A.
Projecting Taxes - here you can apply the last full year's tax rate for the next five years, although any indications by management should take priority.
Scroll down and apply a revenue growth rate within the assumptions section for each of the next 5 years - the model will compute the rest of the projections for FCF's using the assumptions explained above...only input into cells with blue font
Step 3 - Calculate Discount Rate
The Discount Rate, or Hurdle Rate is the rate at which cash flows are made equivalent to their present value. Essentially it is the rate that the investors in the firm require for their funding. You use this rate to discount the FCF's because the investors are giving up their capital to you, and could be investing it elsewhere. The rate they require is the rate they could be growing their money at in an equivalent investment.
When conducting a DCF using UFCF's you use the Weighted Average Cost of Capital (WACC) as the discount rate.
WACC = (E/V)*Re + (D/V)*Rd*(1-Tc)
You are multiplying the weight of equity in the capital structure (E/V) by the Cost of Equity. The weight of debt in the capital structure (D/V) multiplied by the Cost of Debt times 1 minus the Effective Tax Rate is the debt portion of the discount rate*.
*You multiply the Cost of Debt times 1 minus the Tax Rate because Interest Payments on the Debt are Tax Deductible. This is called Tax-effecting the Cost of Debt. You can Tax-effect other metrics as well.
The Cost of Equity is derived from the Capital Asset Pricing Model (CAPM).
Re = rf + (b * mrp)
The CAPM is a function of the risk-free rate (rf) plus the beta (b) of your company's stock multiplied by it's market risk premium (mrp).
- rf - the risk-free rate is the rate of return on an investment that has no risk. Since this only exists in theory, the rate on the U.S. 3-month Treasury Bill (T-bill) is used as the risk-free rate (rf)
- beta - beta is the volatility or riskiness of a stock compared to the market
- mrp - like the name suggests it is the premium expected, due to the riskiness of the security, by the market over the risk-free rate
The Cost of Debt is derived by taking the weighted average of the effective interest rates on every outstanding note and bond and loan that the company has on its books.
The total value of the capital structure will equal the market value of equity (Price * Shares outstanding) + market value of debt.
Sources for deriving these values:
- 10-k & 10-q's - include debt schedules that will provide key information to calculate cost of debt
- Bloomberg - Bloomberg terminals can provide a calculation of the WACC or the pieces required to calculate it on your own. Shortcut: Company Ticker -> (F8) Equity -> WACC -> GO
*If you were conducting your DCF with LFCF's your discount rate would simply be the Cost of Equity (CAPM), because you are only calculating the FCF's distributable to equity investors.
Input the Cost of Equity, Cost of Debt, and MV of Debt values into the WACC Inputs portion of the model below...only input into cells with blue font
Step 4 - Calculate Terminal Value
The Terminal Value, or Horizon Value, is the value of the firm for all years beyond the last projected year given the idea that the business runs forever. There are two ways to calculate the Terminal Value.
1. Perpetual Growth method (Gordon Growth Model) - this method applies a growth rate to the last projected year's FCF assuming it will grow at the same rate forever. An appropriate growth rate is typically relatively close to inflation considering every company has to mature at some point.
TV = [Last Projected FCF * (1 + Perpetual Growth Rate)] / [Discount Rate - Perpetual Growth Rate]
2. Multiple Method (Exit Multiple Method) - similar to the comps analysis you determine a valuation multiple that can be multiplied by an operating metric from the final projected year. Typically EV/EBITDA is used.
TV = Exit EV/ EBITDA Multiple * Last Projected Year's EBITDA
The Exit Multiple is typically derived by using Comparable Company analysis however, a sector multiple can also work. Follow the the link below to Aswath Damodaran's, leading NYU professor on Valuations, compilation of sector multiples
Input an appropriate perpetual growth rate and sector specific Exit EV / EBITDA multiple in the model below......only input into cells with blue font
Step 5 - Discount Cash Flows
Next you must discount each individual projected cash flow and terminal value to the present value and take the sum. This is called taking the Net Present Value (NPV) of future cash flows. You accomplish this by dividing the projected future cash flows by a discount factor.
Discount Factor is (1 + WACC) ^ Period
Period is equal to the time from the present in terms of years. If the second projected FCF is 18 months from the present the Period would be equal to 1.5.
You take the average of the two Terminal Values derived in the last step and add them to the last projected FCF and discount it just like you would any of the other FCF's. To learn more about Present Value and discounting cash flows, visit our supplementary videos.
The Sum of these Discounted Cash Flows is equal to the Enterprise Value.
Step 6 - Calculate a Target Price
The Enterprise value calculated as a result of Step 5 is the Value of the Firm's operations attributable to all parts of the Capital Structure. To reach a target price you need to back out the equity value of operations.
Enterprise Value = Equity Value + Net Debt
...so to get to Equity Value we can just re-arrange the formula.
Equity Value = Enterprise Value - Net Debt
Net Debt being Total Debt minus Cash & Equivalents. The logic behind subtracting the cash and equivalents is that in an acquisition any cash on the target's books will be used to pay off debt.
Once you have derived Equity Value you simply divide by fully diluted shares outstanding and derive a target price.
Sources for this information:
- 10-k's, 10-q's - search SEC's EDGAR
- Bloomberg - the Bloomberg terminal will have the same info as the financial statements
Input the Cash & Equivalents, Total Debt, and Shares Outstanding into the model below...only input into cells with blue font
The Discounted Cash Flow Model above beautifully and magically took all of your data inputs and spit out a cozy target price. In reality the model would require you to derive your own assumptions and input the formulas for yourself, additionally many of the concepts have been simplified for the purpose of understanding the general concepts of a DCF e.g. to go from Equity Value to price per share you divide by fully diluted shares outstanding, not shares outstanding. Additionally note that the above model is merely a piece of what should be used when doing a DCF. You should create full-blown operating model, with balance sheet, statement of cash flows, and income statement projected out as well. The discounted cash flow model is very subjective as any assumptions are the analysts own, and as a result the DCF can result in a valuation that is way above or below any of the other valuation methodologies depending on how optimistic or conservative the analyst's estimates are.
Please continue learning with our other models.