Questions and Answers
What is the first step in a high-level DCF walk-through?
Project out cash flows for 5 - 10 years depending on the stability of the company.
How do you determine the present value of cash flows in a DCF?
Discount these cash flows to account for the time value of money using WACC.
What is the terminal value in a DCF analysis?
A way to predict the value of the company/assets for the years beyond the projection period.
What are the two methods for calculating terminal value?
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What formula is used to calculate WACC?
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How do you calculate terminal value using the Gordon Growth method?
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What do you need to do with the terminal value in a DCF analysis?
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What does summing the discounted values in a DCF yield?
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What is the final step to find an intrinsic share price in a DCF?
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Study Notes
High Level DCF Walk Through
- Project cash flows for 5 to 10 years based on company stability.
- Discount projected cash flows using the Weighted Average Cost of Capital (WACC) to reflect time value of money.
- Determine terminal value to estimate future value post-projection period.
- Discount terminal value back to its present value.
- Sum discounted cash flows and terminal value to calculate enterprise value.
- Subtract net debt and divide by diluted shares outstanding to calculate intrinsic share price.
Step 1: Project Free Cash Flow
- Free cash flow formula: EBIT - taxes + depreciation & amortization (D&A) - capital expenditures - change in working capital.
- Unlevered free cash flow is independent of debt and reflects the company's operational health.
Step 2: Discount Cash Flows using WACC
- Calculate present value of cash flows using WACC, which incorporates cost of debt and equity.
- WACC formula: Cost of debt x % of debt x (1 - tax rate) + Cost of equity x % of equity + Cost of preferred equity x % of preferred equity.
Step 3: Determine Terminal Value
- Terminal value predicts company value beyond the projection period, typically calculated using:
- Gordon Growth Method: Assumes perpetual growth; multiply last year's free cash flow by (1 + growth rate) and divide by (discount rate - growth rate).
- Terminal Multiple Method: Use last projected period's operating metric (like EBITDA) and multiply by an appropriate valuation multiple based on comparable company analysis.
Step 4: Discount Terminal Value
- Just like cash flows, discount the terminal value to its present value using WACC to reflect its true worth today.
Step 5: Sum Discounted Values
- Add the present values of projected cash flows and terminal value to obtain the DCF value, representing enterprise value.
Step 6: Calculate Intrinsic Share Price
- To find intrinsic share price, subtract net debt from enterprise value and divide the result by diluted shares outstanding.
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Description
Test your understanding of the Discounted Cash Flow (DCF) method with this flashcard quiz. Learn the steps involved in projecting cash flows, discounting them, determining terminal value, and finding the overall value of a company. Essential for finance students and professionals alike.