Financial Modeling Quick Lesson: Building a Discounted Cash Flow (DCF) Model - Part 2

welcome back to Wall Street preps DCF modeling lesson this is part two of a two-part series in this video we're going to cover how to calculate wack how to go from enterprise to equity value and as well as answer this last question here just to recap what we did in video 1 we forecast that free cash flows 5 years into the future and we will discount those cash flows back to the present to arrive at the present value of what we call stage 1 we then estimated what the value beyond the explicit period will be using growth and / petty growth and perpetuity method the value beyond the explicit period is what we call terminal value now again these values look a little bit funny because we haven't yet calculated discount rate or wack that's something that we're going to actually calculate in this video coming up so now that we have a recap of the first video let's now tackle we want to take on this video which is wack as well as going from enterprise value to equity value so before we even begin what I want to do is just discuss what whack is and why we use it so whack is the weighted average cost of capital it is a blended rate of return for all the capital providers of a company technically they're if a company had preferred stock you could include that in the whack calculation now many practitioners don't do this because preferred is not a very common part of capital structure and if it is it's it's usually pretty small but nonetheless from an academic standpoint yes you would want to include it now you're probably saying well why are we using black as the discount rate for our cash flows well just to recall this is an unlevered free cash flow analysis to recall what an unlevered free cash flow analysis is it is before the payments of interest EBI is before interest expense in other words these are cash flows that are available to all providers of capital not just the equity investors had we used a levered free cash flow approach the appropriate discount rate would have been cost of equity now whack as you can see accounts for everyone that and so to make this an apples-to-apples analysis we should use wack to discount these cash flows back to the present now that we understand uh why we use wack let's now start tackling this section so the first thing we're going to have to do is reference share price so given that our valuation date is january 1st 2013 let's reference the $25 share price on that date regarding the diluted share count we're going to use the 500 that you see now what do we mean by diluted shares outstanding well company has basic share account but you typically get from the front page of the filing but that's not really all the claims of ownership on a company dilution accounts for all the different ownership claims so those claims are rising from options warrants convertible debt or convertible preferred that are in the money so we want to account for all the different ownership claims that's why we're using diluted share account next in our list you see cost of debt and we've got tax rate and then after-tax cost of debt well you're probably wondering well why are we using after-tax cost of debt well to answer that question let's take a look at our free cash flow build up as we mentioned before this is an unlevered free cash flow approach which is before the payments of interest but we know something very special about debt and that is interest expense provides a real tax yield to companies who pay taxes of course so that interest expense reduces taxable income in some cans in some cases a substantial amount so because we're doing an unlevered free cash flow analysis some might think we're ignoring the effect of interest tax shields the fact is we are accounting for it we're accounting for it in our whack calculation and that's why we take the after-tax cost of debt this after-tax cost of debt represents the interest tax shield that the company experiences by using debt in their capital structure so to calculate after-tax cost of debt would take cost of debt times 1 minus the tax rate and we get 3.1 percent so you can see that that is significantly though lower than the 5.2 percent and again it's because of the interest tax yield now cause of debt is not a very highly debatable topic if you're dealing with a company usually use yield to worst and if you're using comparable company debt you usually use yield to maturity practitioners as well as academics don't really butt heads on this cost of equity on the other hand is a highly debatable topic and you know Business School professors versus practitioners tend to disagree on what should what cost of equity should be and it's highly debatable compared to cost of debt because with cost of debt you know what you're getting principal plus interest expense with cost of equity you don't really know what you're getting because it's a combination of potential dividend payments and price appreciation so some of the competing models that exist are farm of french-- dividend discount model as well as capital asset pricing model now we're going to focus on what practitioners use which is capital asset pricing model and that is equal to the risk-free rate plus beta times the market risk premium now this is essentially the formula for the security market line of a given market so assume that we did that analysis and we came up with 15% so debt holders request well 3.1 percent after tax while cost of equity or equity holders demand a 15 percent required rate of return so now that we know what our costs are for debt and equity let's now figure out what our capital structure what our target capital structure will be now that's sort of an important point you want to in your whack calculation use what's the target capital structure for most mature companies which we will assume for our model here the existing capital structure is the target capital structure and the other thing to note is that you typically want to use market values for both debt and equity but many times you don't have market values for debt so what you want to do is if you know your valuation date is let's say in this case January 1st 2013 the 2012 balance sheet numbers will be the latest numbers available before that valuation date so we could go ahead and use our debt as well debt figure from 2012 given that that book value is a good proxy for market value so to summarize if you don't have market value figures for debt book values and acceptable proxy so let's go ahead and reference the book value which is for forty four thousand two hundred fifty while our equity is going to be share price times the diluted share count if we go ahead and add those together we get our total capital of sixteen thousand seven hundred and fifty so my debt weighting is going to be the debt divided by total capital while the equity weighting is equity divided by total capital you can see that this adds up to one hundred percent and it should and again if there were preferred stock you would do the same thing figure out the amount of preferred that's in the capital structure and apply pile waiting there as well so now that we have our after-tax cost of debt our cost of equity our our I'm sorry our debt weighting as well as our equity weighting we can calculate whack so rack again it's going to be a blended rate of return so if we have our equity weighting we can multiply that by cost of equity plus our debt waiting times after-tax cost of debt and this should give us twelve percent so that's going to be our cost of capital now if we go ahead and link that into our model you'll see that our cash flows will start to update with the appropriate present values because we've now inserted the discount rate and now we're going to assume that rack doesn't change in the terminal value period I mean for the terminal value so we're going to use twelve percent again and again our stage two has now been updated with the correct present value so now that we've actually calculated Wak and brought that into the model we could go ahead and calculate enterprise value which is the sum of our stage one Plus stage 2 but again we're concerned with equity value so we need to go from enterprise value to equity value how do we do that we need to subtract out net debt in other words equity value equals enterprise value less net debt okay so keeping this formula in mind we'll go ahead and calculate this so regarding net debt I know most of you are thinking well we'll just use plain vanilla debt the truth is you want to use all gross debt or all non equity claims so such items could include gross debt I mean debt as well as preferred stock minority interest really anything that's considered an on equity claim we want to subtract out from enterprise value to arrive at equity value in our case we're using a simple example all we have is debt and we're going to subtract out cash because we're dealing with net debt in other words net debt is equal to debt less cash and cash equivalents and the whole idea with net debt on Wall Street is that practitioners believe that if you have excess liquidity you can go ahead and pay off some of that debt so we're going to assume that so enterprise value less net debt provides our equity value now if we bring in our diluted share count 500 we can figure out on a per share basis what the equity value per share is and that becomes that is 35 dollars and 15 cents so if we take a look at this question if the stock is trading at 25 bucks a share and we believe that the DCF analysis is accurate would we buy or sell the stock I believe that if if our DCF analysis is indeed correct what we're going to want to do is we're going to want to buy this stock well the reason is because if we believe that the stock should be valued at 35 dollars and 18 cents and it's valued at 25 a share then the stock is considered cheap so we would want to go ahead and buy it okay so now you can see how you can use this this really powerful analysis to make decisions for investments or trading or whatever it is you might be doing with the DCF so just to quickly recap what we did again we forecast it free cash flows into the future we discounted them back to the present using a discount rate that reflects the riskiness of the capital that gave a stage 1 we then went ahead and calculated stage 2 which is value beyond the explicit forecasted period and that gave us a stage 2 value of fourteen thousand five hundred ninety five point eight after calculating stage one and stage two we calculated Wak we're using whack because we want to use a discount rate that's available to all providers of capital so then we did worry about the discount stage one and stage two back to the present adding both together gives us enterprise value subtracting out all mod equity claims it gives us equity value and dividing by the looted share account gives us an equity value per share to which we can compare market value to make a decision this concludes the second video to the DCF modeling lesson I hope you enjoyed this lesson thank you very much

Channel: Wall Street Prep

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Keywords: dcf, discounted cash flow model, wall street prep, financial modeling, dcf model

Id: fGb7BYMXjN0

Length: 12min 32sec (752 seconds)

Published: Fri Feb 22 2013