The DCF Model: The Complete Guide… to a Historical Relic?

so i think it's fair to say that we live in interesting times cryptocurrencies based on dog memes suddenly spike up in price by 500 and then fall meme stonks seem to dominate the market discussions on reddit and other online forums seem to pump up stock prices people go on cnbc and talk their own book to boost stock prices there and then celebrities tweeting about stocks can make a huge impact on the price in either direction with that background i want to ask whether or not the traditional discounted cash flow model or dcf model actually matters when it seems like stocks are valued based on memes and tweets these days is the dcf model still useful or is it just a historical relic now the purpose of this lesson is that we have published many tutorials related to the discounted cash flow analysis so we have tutorials on unlevered free cash flow and terminal value for example but we haven't ever published anything on the entire analysis from start to finish including whether or not it's still valid and how we would respond to criticisms over this analysis so my goal here is not to just walk you through the whole process but to also give you the tools to do it quickly with limited resources in other words what you should do if you have no paid subscription services like capital iq i'm also going to point you to a few example dcf models from our previous coverage we have valued companies like snap or snapchat and uber before and the dcfs for those can also be good references for this process if you want this entire tutorial in writing and the excel files and the example dcfs from previous tutorials go to mergers inquisitions.com dcf dash model that's mergers and inquisitions.com dcf dash model and you can get everything right there this is going to be a longer lesson and so to save you some time i'm going to give you the table of contents here so you can skip around to the timestamps you want or need to look at i'm going to start with the big idea behind a dcf then we'll go into company and industry research then we will look at step one of the process which is projecting the company's unlevered free cash flow we'll go into step two which is how to calculate or estimate the discount rate and then we'll look at step three how to calculate the terminal value in the analysis we'll be using walmart and a simple walmart dcf in all these examples and then finally in part six we'll go through some common criticisms of the dcf such as the fact that it's hard to predict the future and how to respond to them and what you might do to get around some of these limitations and other issues let's start with part one the big idea behind a dcf you can use the following formula to value any company or asset that generates cash flows you take its cash flow and divide by the discount rate minus the cash flow growth rate and that's what gives you the company's implied value or intrinsic value now the cash flow growth rate needs to be less than the discount rate otherwise this formula doesn't work you get it divided by zero if it equals the discount rate and you get nonsensical results if it is greater than the discount rate so that is one constraint but this is the basic idea the discount rate measures the risk and the potential annualized returns a higher rate means that there's more risk but also higher potential returns the intuition here is that the company is worth more when it's cash flow or its cash flow growth rate or higher and it's worth less when it's riskier or when the expectations for the company are higher now if a company's discount rate and cash flow growth rate stay the same forever then you can just use that formula and it will stay good forever the problem is that in real life though that doesn't happen because companies tend to grow quickly early on and then they slow down as they reach maturity so there's higher risk and higher potential returns early on but then both of those decline as the company matures valuation therefore is more than just the simple formula because we need to project changes in the discount rate and changes in the cash flow growth rate over time now the discount rate doesn't always change especially if the company's already mature but the cash flow growth rate will almost certainly change in any type of dcf analysis to handle this issue then we divide the dcf into two periods in the first period we project a company's cash flows until it reaches maturity over a 5 10 15 or even 20 year period this is called the explicit forecast period and in this time the company's cash flows its cash flow growth rate and its discount rate could all be changing when you open up a dcf analysis this is what you typically see when you have the unlevered free cash flow projections or just the free cash flow projections whatever they call them you'll have a five to ten year period here where you try to project what the company will look like over that time and that is the first key part of the analysis right here now the second period is where you assume that the discount rate and the cash flow growth rate stay the same into the future this is called the terminal period and in this period the company's cash flow can and does change each year but the growth rate and the discount rate do not change and typically this is not an actual explicit part of the excel file instead it's just something that you project at the top or on the side and it's sort of an accessory you project what the company will look like in that period and since it doesn't really change it's actually fairly simple and you can just do it with a few simple assumptions and a few simple rows in excel so that's the big idea behind a dcf let's now go into part two and talk about some of the required industry and company research the truth is if you just open excel and you start entering numbers you're going to waste a lot of time before you do anything quantitative you need to get a sense of the company's key drivers and how they've changed over time along with the overall industry and what the growth rates and the margins and the cash flow profiles look like for companies in that industry for example for a retailer the key drivers might be sales per store or sales per square foot it might be number of customers and revenue per customer it might be something like available seat miles or available seat kilometers or revenue per available seat mile or revenue per available seat kilometer for an airline you need to read through the company's filings their annual report and investor presentations to get a sense of what these key drivers might be now for walmart i've just taken their annual report their 10k which is public and it's pretty obvious from reading through this that the key drivers here are going to be either the number of stores or the number of square feet they have repeated references to the number of square feet in the filing including up at the beginning so this is clearly one of the most important drivers and it makes sense because it's a retail company the more square feet they have the more they can sell but also the more it will cost to operate the company so you always want to start with the annual report or investor presentation to get a quick sense of the key drivers for the company now you can also look at similar companies in the industry so for something like walmart we might look at kroger or costco or best buy for example and you can check their growth rates their margins their cash flows and other items like that we get a lot of questions about the amount of time required and the detail that's required and it really depends on how you're using the dcf are you just using it to quickly value the company is it part of a short case study is a part of a comprehensive client presentation the amount of detail required depends on the time you have and the resources you have and how important this task is in most cases as a general rule you want more than just a simple percentage growth rate for the company's revenue and more than just a simple percentage for its expenses but not too much more for example maybe you could come up with five to ten key drivers for the company's revenue expenses and cash flows but you don't need 50 or 100 key drivers or assumptions for example for walmart we have their retail square feet which is a top level driver we have the sales per square foot the operating expenses per square foot and then we have capital expenditures per square foot growth capex per new square foot we have depreciation and amortization per square foot and then we have a simple percentage growth rate for their membership and other income for that segment of the business so we have around five to ten key drivers here they have growth rates and they have numbers and we'd say this is reasonable for an analysis that you could complete in maybe a few hours maybe up to a day if you don't already have an existing template or an example file for this type of thing of course you could always make it more complicated you could divide it into different segments and do something like that but as a baseline something like this is fine let's now go into part three and talk about unlevered free cash flow now we have a whole separate tutorial on this which you can look at if you want but i'm going to summarize here and give you some of the key points and show you how to make some of these calculations for walmart we always start the dcf by projecting the company's cash flows over 5 10 or maybe even 15 or 20 years depending on the company and industry now there are many different types of cash flow or free cash though but in a dcf you almost always use the unlevered free cash flow because it gets you the most consistent results and results that don't depend on the company's capital structure to be counted in unlevered free cash flow line items on the financial statements must be related to or available to all the investor groups in the company so you can think of it as free cash flow to all investors and these items must be recurring for the company's core business operations in practice that means that unlever free cash flow should include revenue cost of goods sold or cost of sales and operating expenses taxes depreciation and amortization and sometimes other non-cash charges but we'll get into that the change of working capital and capital expenditures now there are some exceptions but if you have something outside of these that's part of unlevered free cash flow you really need to think twice about what you're doing you should ignore items like the net interest expense other income and expenses most non-cash adjustments on the cash flow statement most of cash flow from investing most of cash flow from financing and so if you look at walmart's statements for example we're not really including that much if you look at their income statement we definitely want their revenue we want their cost of sales and operating expenses but then below that we don't want items related to the capital structure we do want taxes but we're going to calculate them a bit differently so i have not highlighted them here and then moving down to the cash flow statement yes we need to add back depreciation and amortization yes we want deferred income taxes other operating activities maybe change your working capital right below that yes we want this and then we do want the capital expenditures or as they call it payments for property and equipment but other than those items we're leaving a whole lot blank here i'm not highlighting these because these are either related to the company's capital structure or their non-recurring items or items that maybe recur but are very difficult to predict and project in a 10 15 or 20 year model like we have here now revenue for a retailer depends on the number of square feet and the sales per square foot those are going to be the key drivers and then there could be other channels as well like e-commerce or memberships for example now in a more complex model you might break it into regions or segments such as u.s stores versus non-us stores but here we're going to keep things very simple so you can see i've already projected the company's retail square feet growing at around point five percent to two percent we've also projected their sales per square foot which is also at a low single digit percentage growth rate so to get walmart's net sales we can then take their retail square feet multiplied by the sales per square foot and then for the membership another income we just take the old number and multiply by one plus the growth rate to get the new number we can add these up we can copy across our revenue growth formula and then here i'm just going to set up a frame so you can see the labels here and we can just copy this all the way across we can see that the revenue growth rate starts out around 5 percent and falls to more like 1.5 percent by the end of this period which is what we want on the expense side these could be on a dollar per square foot figure as well or they could just be a simple percentage of revenue and again you could break it out by segment if you want to do something more complicated we tend to assume gradual changes over time and keep in mind how the company should be moving toward stabilization over time as well so here for example we can go up and let's start by taking the company's net sales and then we want to subtract the opex per square foot times the number of square feet so let's go up and take their operating expenses per square foot and then multiply by the retail square feet as the company grows yes it can sell more but also has to spend more on rent and hiring employees and i.t and infrastructure costs and so on and so forth we can then take our operating margin here and copy this over and we can see that we stay at just around a four percent operating margin here which is reasonable for a mature company like walmart in the historical period it's been around three point nine percent to four point three percent so we'd say four percent going forward is a reasonable estimate for the company one other issue i want to mention here is the lease expense now under usgap this is not an issue because rent is a standard operating expense on the income statement but under ifrs you have to be careful to deduct all the components of the lease expense which means amortization and depreciation that should already be deducted in operating income but then also the lease interest which is not deducted in operating income so for example for vivendi this company that follows ifrs when we calculate unlevered free cash though we have to actually deduct the operating lease interest element to get a comparable number and then later on when we add back the depreciation and amortization we don't want to add back the least depreciation and amortization we want to make sure that the entire lease expense is fully deducted in the unlevered free cash flow calculation moving on the next major item to discuss here is capital expenditures these represent long-term reinvestment into the business usually opening and maintaining stores for a company like walmart we're going to split into growth capex for new stores and then maintenance capex for existing stores that the company needs to maintain and upgrade over time so let's go down to the capital expenditures so we can get this and let's go up first now the first category here is maintenance capex per square foot the company needs to spend something on its existing store so we can take this and multiply by the retail square feet from the previous period and then the other thing is that we need to take the growth capex as well so we're saying 150 per new square foot here and we can take this and multiply by the retail square feet in this period minus the retail square feet from the previous period and that gives us a sense of the growth cap expanding we can also look at this as a percent of revenue we'll need this later on so i might as well set it up now and then we can copy and paste this over as well and we can see how their capex changes over time and it's usually around two percent of the company's revenue again very much in line with the historical numbers right here and so with that set up we can now calculate the net operating profit after taxes or no pat we can take the operating income and multiply by one minus the tax rate or just calculate taxes separately and subtract them from operating income so let's go in and the tax rate here is an assumption up at the top so let's use a negative sign take the operating income and then multiply by the tax rate here this is just the company's average tax rate on the income statement over the past three years so i just pulled it from the company's filings we have that and then to get to notepad we just take operating income and subtract taxes and we can copy this over so that's in place now moving down the next item here is depreciation and amortization which represents the recognition of previous capex spending over many years in general if the company is still growing we want to make sure that dna stays slightly under capex because the company's assets its net pp plants property and equipment should be expanding at least slightly if the company is growing over time here we choose to project this by looking at a dollar per square foot figure so the dna per square foot you take that and multiply by the retail square feet and add that back we can also look at this as a percent of revenue and then just doing a quick check here we can see that capex is about two percent of revenue dna is about 1.9 percent of revenue by the end so capex is indeed slightly ahead of depreciation and amortization here deferred income taxes represent the difference between taxes on the income statement and then what the company actually pays in cash to the government with this one we calculated this based on some of the historical numbers so we looked at the percent differences historically and then recalculated the numbers in the past three years based on those differences the problem is that since the taxes here are based on operating income it's not going to match up exactly if we just use the numbers as is on the cash flow statement so we recalculate them and in the future period we don't want this to represent a huge percentage of the company's free cash flow so a modest percentage of book taxes here like the five percent that we end at is fine but you don't want this to be something like 50 for example so this should never be huge unless you're dealing with a very unusual situation let's take our number i'll use a negative sign in front and then we'll multiply by the taxes and so now we can see that the company pays slightly less in cash taxes because this number is a positive adjustment and the taxes are normally shown as a negative right here and then finally if there are other recurring operating activities on the company statements you could include them here for example i chose to include other operating activities it's not 100 required but it seemed quite modest here and so i chose to keep it in it did seem to be a recurring activity in the prior periods so let's take it as a percent of revenue and then multiply by the total revenue and then we'll copy this across and then for the next item here the change in working capital we have a whole tutorial on this which you should review if you want to learn more but in short this relates to timing differences between recording revenue and receiving it in cash and then recording expenses and paying for them in cash for example if a customer orders a product and gets the product but the customer doesn't pay in cash right away the company records the product price as revenue even though it's cash balance has still not gone up it's delivered the product or service but it hasn't received anything in cash from the customer working capital and the change in working capital tends to reduce cash flow for say retailers that need to order products before selling them this is called inventory but it often increases cash flow for companies that collect cash in advance now for walmart it has actually been positive historically as a percent of revenue and the change in revenue which is unusual but it's also because the company has a lot of bargaining power if you look at its numbers you can see that the inventory purchases make it very negative but the accounts payable going up in other words getting products and services from suppliers but not paying them upfront only paying them at some later date actually boosts this and is responsible for the change of working capital being so positive for walmart the numbers are a little bit weird in the recent years but if you go back much further it's usually around five to ten percent of the change in revenue so we're sticking with that in these forecasts i'll take the 10 percent and then i'll multiply by the new revenue minus the old revenue in parentheses and i'll copy that across and we have that now at this point we have enough to put together all the pieces and calculate unlevered free cash though just notepad plus the non-operating lease depreciation and amortization plus or minus deferred income taxes plus or minus the change in capital minus capex let's make the calculation right now notepad plus dna plus the deferred income taxes other operating activities the change of working capital and capital expenditures we have this and let's copy this across and so there we have our on level free cash flow each year and i've already calculated the present value of this right below just to save it some time later on if you're working under ifrs you have to make sure that the ebit used to calculate notepad deducts the full lease expense usually what that means is that you have to deduct the operating lease interest element and then make sure that's deducted when you multiply the ebit by 1 minus the tax rate to get to notepad and then when you add back dna in the rest of this calculation you don't want to add back the least depreciation and amortization you just want to add back the depreciation and amortization on actual own assets once you have this you should check to make sure that the growth slows down over time at the end of say a 10-year period it should be around the gdp growth rate or the inflation rate in the region which usually means low single digit percentages so here for example the growth rate slows down to around one percent to two percent maybe slightly below one percent in some years and so we'd say that is an acceptable outcome here so that's it for unlevered free cash flow let's now go into the discount rate i'm not going to go through the whole process here but i will give you a quick overview of what this means so traditionally the discount rate is based on the percentage of each form of capital in the company's capital structure times the cost of that capital the cost of equity the cost of debt the cost of preferred stock and so on now to a company these costs represent how much it's paying to use the capital so for example if it has debt with a six percent interest rate it's a six percent cost of debt because that's how much it's costing the company and to investors these costs represent how much they could earn on different forms of capital so again if it's a six percent interest rate on the debt that means the investors could earn six percent so from their perspective it's earnings from the company's perspective it's costs cost of equity represents the potential returns from the company's common stock price increasing and from dividend issuances or how much it costs the company to issue shares for example if a company issues dividends representing three percent of its current share price and its stock prices increase by maybe six to eight percent historically each year on average then the cost of equity might be the six percent plus the three percent which is nine percent and it might be anywhere from nine percent up to eleven percent because eleven percent is the e percent plus the three percent right here now with cost of debt if a company is paying six percent interest on its debt and the market value of the debt is very close to what's shown on the company's balance sheet the cost of debt might be around six percent also you should multiply by one minus the tax rate because the interest on debt is tax deductible in most countries so if the company's tax rate is 25 and the cost of debt pre-tax is six percent the after-tax cost is six percent times one minus 25 which is around 4.5 percent the idea with whack or the weighted average cost of capital for the discount rate is that you invest proportionally in the company's entire capital structure and that gives you your expected long-term annualized return so if the company uses 80 equity and 20 debt and it has a 25 tax rate and you invest a thousand dollars you put 800 into equity and 200 into debt if similar company stock prices have increased by eight percent per year and an additional two percent has come from dividends then the cost of equity here should be the eight percent plus the two percent or about ten percent then whack here would be the 10 times the 80 percent and then the 20 times the six percent times one minus 25 percent which gives us around 8.9 percent or nine percent we could say per year which means that if we invest 1 000 in the company then theoretically we should earn about 89 per year on average from this investment this does not mean that you'll earn a literal 89 per year in cash on a 1 000 investment it means that if you count everything interest dividends selling the shares at a higher price in the future then the long-term annualized average might be around 89 if you look at this over the long term 10 15 20 years something like that the important thing to note the discount rate is that the approximate range so ten to twelve percent versus five to seven percent is a lot more important than the exact rate that you choose to use now the traditional approach is quite complicated because you have to find peer companies look at their capital structures and then unlever and re-lever beta and we actually do that in this walmart model we look at these companies and we calculate the unlevered beta for each one of them based on a formula and then we re-lever it based on walmart's capital structure and that gets us to walmart's cost of equity we calculate walmart's pre-tax cost of debt by taking the average interest rate on all their debt tranches and then we use the formula that i just showed you whack equals the percent of each form of capital times the cost of each form of capital and we adjust for taxes for the cost of debt and that gets us to whack for the company and this approach is fine but i don't think it's necessary and i think in a very quick time pressured case study you can actually get similar results using something much much simpler for the cost of debt there's no real way to simplify this a lot you have to look at something like the company's current average interest rate or yield on its debt and here i just went to walmart's filings and highlighted the key sections and took them from there yes it takes a few minutes of work but i don't really think there is a quicker or simpler way of doing that so you have to do a little bit of work for that but for the cost of equity if you take this formula the risk-free rate plus the equity risk premium times leveraged beta you can get a very good estimate of the cost of equity just by using the company's own data without doing anything fancy or special and the idea here is that you're looking at what you could earn on a risk-free government bond like a 10-year us treasury then you're adding whatever additional amount the stock market should return over that and then you're multiplying by however much the company moves in relation to the rest of the market so to prove to you that this works let's go through a quick example for the equity risk premium professor de moderan at nyu collects data and he has country default spreads and risk premiums if we go down and look at the united states we can see that he's listing it as around 4.72 for the equity risk premium right here so we could just take some of the data from this page and then for the risk-free rate we can look up 10-year government bond yields quite easily here they are saying around 1.7 percent or so for the 10-year government bond yield as of the time of this video and then finally for levered beta we can just look this up on google or yahoo finance so i have pulled up walmart's profile in yahoo finance and they give the beta as 0.48 what this means putting this all together is the following we can just go in and we can say something like this 1.7 percent for the risk-free rate plus four point seven two percent for the equity use premium times .48 for walmart and look at that we get to a cost of equity of around four percent very similar to the cost of debt and we could just use that in the wac formula down here for the cost of equity and we get similar results we get a whack of around four percent up to five percent maybe maybe we could say four percent to four point five percent something in that range the point is that you don't need to do this complicated exercise to estimate the discount rate you could do something much shorter and simpler as i just showed you on screen in excel and so then with the discount rate in place what we can do is calculate the present value of unlevered free cash language period by taking the unlevered free cash flow dividing by 1 plus the discount rate raised to the power of the year number as i'm doing right down here and of course the discount rate will come up in other parts of this analysis such as the calculations for the terminal value which is the next part of this on that note let's now go into part 5 and discuss the terminal value in this analysis now this goes back to the big idea behind valuation and the dcf model company value equals cash flow divided by discount rate minus cash flow growth rate where the cash flow growth rate must be less than the discount rate company value is the terminal value so it's exactly the same formula it's just that to calculate it we need to look at the terminal period so we need to get the company's cash flow cash flow growth rate and discount rate in that terminal period so it's the same basic formula that drives everything else it's just that it applies to only one specific period in this model it's not quite as easy as just inputting numbers directly from the dcf because in an unlevered dcf the terminal value equals the unlevered free cash flow in year one of the terminal period divided by whack the weighted average cost of capital the discount rate we use minus the terminal unlevered free cash flow growth rate of course you rarely forecast the terminal period at all in a dcf at most you'll do what we did here and just have a brief area up at the top that has these calculations we can apply a tweaked formula here and we can just say that the terminal value equals the final year unlevered free cash flow in the explicit forecast period times 1 plus the growth rate and then we divide by whack minus that growth rate so we're assuming that the growth rate stays the same between the last year of the explicit forecast period and every single year in the terminal period and this is the approach you normally see used to calculate terminal value and again as always the growth rate needs to be less than the discount rate whack in this case now this terminal growth rate should be low definitely below the long-term gdp growth rate especially when you're working in developed countries you could also calculate it with the multiples method where you take the company's final year ebit ebitda or notepad and you multiply by 5x or 10x or whatever multiple is in line with the public comps let's go in and see examples of both these right now so here i am saying that walmart's terminal free cash flow growth rate is zero percent so it's going to stay stagnant and not even grow at all right here to calculate this we can go down and get our unlevered free cash flow from right here and then we can multiply by one plus this growth rates and then we'll divide by the discount rate minus growth rate and that is one calculation we can also look at the implied multiple just take this and divide by the ebitda in the final year so that's one way to do this and then another way to do this is to apply the multiples method so if i take this 12.3x multiple for example i can take this and then multiply by the final year ebitda and that gets us to the same value right here so this is the first step of the process and we want the numbers from both these methods to be consistent we often use both these methods to cross check our results and make sure that they make some amount of sense if you get an implied growth rate of 10 your multiple is way too high and if you get a multiple that is far out of line with the public comps or the other similar peer companies in the market then maybe your growth rate assumption is off once we have this we can discount the terminal value to its present value because it represents the company's value 10 years into the future but we want what it is worth today and then we can add it to the present value of the unlever free cash flows to get the implied enterprise value let's see how that's done so we'll take our baseline terminal value here and i'll divide by 1 plus the discount rate and i'll raise it to the power of the number of years in our analysis so the last year number here year 10. we have that and i'll anchor this and we can copy and paste it over here as well and then for the sum of the present value of the free cash flows let's go down and go to where i calculated it down here can sum these up and then copy and paste it over here and so we have that and then you can see the rest of this we go across the normal bridge we back into the implied equity value and the implied share price from there it's not too complicated we take all the normal items in the equity value to enterprise value bridge whereas we normally subtract cash and add debt to go from equity value to enterprise value here we do the opposite because we're going from enterprise value to equity value once we have that then we divide by the share count and we can see that according to this it's telling us that walmart might be undervalued by around 30 percent maybe 30 to 40 percent somewhere in that range currently once we have that we can then set up sensitivity tables to look at the outcome in different cases and see the full range of values the company might be worth i've already set these up down here and essentially these tell us that even if we assume much lower growth rates or a significantly higher discount rate then at worst it seems like the company might be appropriately valued right now because its share price at the time of this analysis was around 140 per share and if you go down almost all this table is at or above 140 per share so if we actually believe our assumptions and the drivers in this analysis it's telling us that walmart seems modestly undervalued based on the current market environment and our projections for its unlevered free cash though over 10 years that's about it for the analysis itself but i want to conclude by going through some common criticisms of the dcf and then discussing whether or not it actually holds up in the current crazy market environment so the first criticism is that it's very difficult to predict a company 5 10 or 15 years into the future no one can do that and i agree you can't predict exactly what a company is going to do that far into the future let alone even a year or two into the future but it's not about exact numbers it's about ranges you should have an idea of whether a company is going to grow between say two and five percent or between five and ten percent or between ten and fifteen percent and if you don't know you can look at how similar companies have done in the past and how long their growth periods lasted and what they slowed down to over time there are some examples of how to do this in the models for snap and uber if you want to see some high tech or tech startup like examples you can also use scenarios and sensitivities to deal with uncertainty it's not wrong if you have a very wide range of values in your analysis now if the company is mature like walmart you probably don't want that you probably don't want this going from five dollars per share to 500 per share that would be way too wide for a company like this but if the company is less mature and is growing quickly then yes there is going to be a lot of uncertainty and that's fine a dcf doesn't eliminate uncertainty it just tells you how big the window really is and what the company would have to be valued at for you to be certain that they're actually undervalued or overvalued or at least more confident that they're undervalued or overvalued a second criticism is that the dcf is too sensitive to small changes in assumptions such as growth rates and margins my first response here is that are you sure you are using reasonable assumptions is the final year free cash flow growth rate close to the terminal growth rate because in a lot of cases when this happens what's actually going on is that the growth rate at the end here we have around one to two percent is very different from the growth rate up here the terminal free cash flow growth rate so that's the first thing that you want to check my second response is once again use scenarios and sensitivities it's fine if you have a very wide range if you're valuing a tech startup then sure maybe it's worth anywhere from twenty dollars per share to a hundred dollars per share and right now its share price is fifty or sixty dollars it's fine if the range is very wide that just reflects more uncertainty and how no one really knows what's going to happen in the future but you still want some kind of range so that you can say even with highly optimistic assumptions no this company is not worth a thousand dollars per share or five hundred dollars per share or something like that a third critique of the dcf is that it ignores market conditions and comparable companies so it might not give you the accurate market value my first response is that this is sort of the whole point of the discount rate and using comparable companies for the terminal multiple if you choose to do that it is true that the dcf is less reflective of market conditions than public comps and precedent transactions but it's also true that if you take a terminal multiple based on what comparable companies are trading at and you calculate a discount rate that is also largely based on comparable companies and recent market data you are reflecting at least some of the recent market trends in your analysis so while it's true that it's not as market-based as other methodologies it's completely false to say that it doesn't reflect the market at all and then a fourth critique the dcf is no longer applicable because stocks are valued based on memes or crypto or twitter or reddit no one cares about cash flow anymore so i have three responses to this one first off yes it is true that cash flow doesn't really matter for a few highly speculative meme stocks if you're actually buying and selling based on what people are saying online on reddit then sure who cares about cash flow all that matters is the hype and how many people quickly pile into the stock but i would point out that even though these types of situations get a huge amount of attention they represent a tiny percentage of the overall market there are tens of thousands maybe hundreds of thousands of publicly traded companies out there and most of them are not meme stocks most of them people don't even talk about online so yes there are some cases where dcf may not be applicable but this represents a pretty small percentage of everything out there and then finally of course if the asset doesn't generate cash though the dcf doesn't apply so if you want to use it to value a company the company needs to eventually generate cash flow you can't use a dcf for bitcoin or gold or silver because they don't generate cash flow so you're not really saying anything here all you're saying is that of course if you're looking at a commodity like this then a dcf is not applicable but we've already known that for decades if not centuries that's about it for this tutorial so let's go through and do a quick recap and summary now i know this has been quite long but i want to present all this material about a dcf in one lesson so you could get everything all at once the big idea behind a dcf is that the company's value equals the cash flow divided by the discount rate minus the cash flow growth rate where the cash flow growth rate needs to be less than the discount rate now of course companies change over time so that is insufficient to value companies on its own you have to separate it into the change period or the explicit forecast period and then the terminal period where the company stops changing its discount rate and cash flow growth rate and then combine them to get the company's implied value from a dcf in terms of company and industry research i always recommend starting with the company's annual filings and investor presentations and figuring out maybe five to ten key drivers from those as we did in this walmart example you can also look at other companies in the industry it's usually pretty easy to find comparable companies by looking up competitor names in the company's filing for example you don't need to go crazy but you want something that is a little bit more in depth than just using a simple percentage growth rate for the company's revenue for example unlevered free cash flow as you saw in this analysis is defined as the company's recurring cash flow from its core business operations ignoring the company's capital structure so here we took revenue we subtracted operating expenses and cogs to get to operate income subtracted taxes to get to notepad or net operating profit after tax and then we added back depreciation memorization we adjusted for deferred taxes other operating activities the change in working capital and capital expenditures and that got us to the unlevered free cash flow the discount rate represents the potential returns and the risk of the company or asset and you could go through a lot of work and calculate it in a complicated way especially with the cost of equity here where you look at each part of the company's capital structure and the cost of it and you do a weighted average based on that or you could do something much simpler as i showed you and just estimate the cost of debt from the company's filings take the equity risk premium and the risk-free rate from recent data and just look up the company's beta on sources like yahoo finance and you can estimate it like that the risk-free rate plus the equity risk premium times levered beta and you could make a very good estimate for cost of equity just from that without doing anything more complicated here and then put together the pieces to get to the discount rate for the company and then finally the last part here the terminal value the idea here is that you have to look at the first year's unlevered free cash flow in the terminal period you normally do this by taking the last year's free cash flow from the forecast period multiplying by one plus the growth rate dividing by the discount rate minus that growth rate and then you discount the terminal value to its present value today you sum up the present value free cash flows get to the applied enterprise value and then work backwards to get the implied equity value and the implied share price and then we went through some common criticisms of the dcf the short answer is that yes if you set up the analysis inappropriately or you use it to value assets or companies that don't generate cash flow or you use the incorrect assumptions it's very easy to get bad results garbage in garbage out but if you set it up correctly then you will use it as intended which is to get a very rough valuation range for the company and to see if it is dramatically undervalued or overvalued that's really the best way to use a dcf it's not especially scientific but it should be able to give you an idea of whether the company's current valuation is reasonable at least assuming that it is an actual company that generates cash flow and not a meme stock that's it for this tutorial i hope you now know a lot more about the dcf as i said in the very beginning go to mergers inquisitions.com dcf-model to get all the files and resources for this tutorial as well

Channel: Mergers & Inquisitions / Breaking Into Wall Street

Views: 69,774

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Id: Ul1ajfFtJSM

Length: 43min 24sec (2604 seconds)

Published: Wed Apr 07 2021