DCF Model Training

Introduction to the DCF Model

A discounted cash flow model (“DCF model”) is a type of financial model that values a company by forecasting its’ cash flows and discounting the cash flows to arrive at a current, present value. The DCF has the distinction of being both widely used in academia and in practice. Valuing companies using the DCF is considered a core skill for investment bankers, private equity, equity research and “buy side” investors.

This DCF analysis suggests that Apple might be overvalued (or that our assumptions are wrong!)

The DCF model estimates a company’s intrinsic value (value based on a company’s ability to generate cash flows) and is often presented in comparison to the company’s market value. For example, Apple has a market capitalization of approximately $909 billion. Is that market price justified based on the company’s fundamentals and expected future performance (i.e. its intrinsic value)? That is exactly what the DCF seeks to answer.

In contrast with market-based valuation like a comparable company analysis, the idea behind the DCF model is that the value of a company is not a function of arbitrary supply and demand for that company’s stock. Instead, the value of a company is a function of a company’s ability to generate cash flow in the future for its shareholders.

Who this DCF guide is for

We wrote this guide for those thinking about a career in finance and those in the early stages of preparing for job interviews. This guide is quite detailed but it stops short of all corner cases and nuances of a fully fledged DCF model. For that, you can enroll in our full scale modeling course.

DCF basics: The present value formula

The DCF approach requires that we forecast a company’s cash flows into the future and discount them to the present in order to arrive at a present value for the company. That present value is the amount investors should be willing to pay (the company’s value). We can express this formulaically as (we denote the discount rate as r):

So, let’s say you decide you’re willing to pay $800. We can solve this as:

If I make the same proposition but instead of only promising $1,000 next year, say I promise $1,000 for the next 5 years. The math gets only slightly more complicated:

In Excel, you can calculate this fairly easily using the PV function (see below). However, if cash flows are different each year, you will have to discount each cash flow separately:

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6 steps to building a DCF

The premise of the DCF model is that the value of a business is purely a function of its future cash flows. Thus, the first challenge in building a DCF model is to define and calculate the cash flows that a business generates. There are two common approaches to calculating the cash flows that a business generates.

1. Unlevered DCF approach
   Forecast and discount the operating cash flows. Then, when you have a present value, just add any non-operating assets such as cash and subtract any financing related liabilities such as debt.
2. Levered DCF approach
   Forecast and discount the cash flows that remain available to equity shareholders after cash flows to all non-equity claims (i.e. debt) have been removed.

Both should theoretically lead to the same value at the end (though in practice it’s actually pretty hard to get them to exactly equal). The unlevered DCF approach is the most common and is thus the focus of this guide. This approach involves 6 steps:

1. Forecasting unlevered free cash flows

Step 1 is to forecast the cash flows a company generates from its core operations after accounting for all operating expenses and investments. These cash flows are called “unlevered free cash flows.”

2. Calculating terminal value

You can’t keep forecasting cash flows forever. At some point, you must make some high level assumptions about cash flows beyond the final explicit forecast year by estimating a lump-sum value of the business past its explicit forecast period. That lump sum is called the “terminal value.”

3. Discounting the cash flows to the present at the weighted average cost of capital

The discount rate that reflects the riskiness of the unlevered free cash flows is called the weighted average cost of capital. Because unlevered free cash flows represent all operating cash flows, these cash flows “belong” to both the company’s lenders and owners. As such, the risks of both providers of capital need to be accounted for using appropriate capital structure weights (hence the term “weighted average” cost of capital). Once discounted, the present value of all unlevered free cash flows is called the enterprise value.

4. Add the value of non-operating assets to the present value of unlevered free cash flows

If a company has any non-operating assets such as cash or has some investments just sitting on the balance sheet, we must add them to the present value of unlevered free cash flows. For example, if we calculate that the present value of Apple’s unlevered free cash flows is $700 billion, but then we discover that Apple also has $200 billion in cash just sitting around, we should add this cash.

5. Subtract debt and other non-equity claims

The ultimate goal of the DCF is to get at what belongs to the equity owners (equity value). Therefore if a company has any lenders (or any other non-equity claims against the business), we need to subtract this from the present value. What’s left over belongs to the equity owners.

In our example, if Apple had $50 billion in debt obligations at the valuation date, the equity value would be calculated as:

$700 billion (enterprise value) + $200 billion (non-operating assets) – $50 (debt) = $850 billion

Often, the non-operating assets and debt claims are added together as one term called net debt (debt and other non-equity claims – non-operating assets). You’ll often see the equation: enterprise value – net debt = equity value. The equity value that the DCF spits out can now be compared to the market capitalization (that’s the market’s perception of the equity value).

6. Divide the equity value by the shares outstanding

The equity value tells us what the total value to owners is. But what is the value of each share? In order to calculate this, we divide the equity value by the company’s diluted shares outstanding.

Now let’s break down each step into more detail.

Calculating the unlevered free cash flows (FCF)

Here is the unlevered free cash flow formula:

FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures

• EBIT = Earnings before interest and taxes. This represents a company’s GAAP-based operating profit.
• Tax rate = The tax rate the company is expected to face. When forecasting taxes, we usually use a company’s historical effective tax rate.
• D&A = depreciation and amortization.
• NWC = Annual changes in net working capital. Increases in NWC are cash outflows while decreases are cash inflows.
• Capital expenditures represent cash investments the company must make in order to sustain the forecast growth of the business. If you don’t factor in the cost of required reinvestment into the business, you will overstate the value of the company by giving it credit for EBIT growth without accounting for the investments required to achieve it.

FCFs are ideally driven from a 3-statement model

Forecasting all these line items should ideally come from a 3-statement model because all of the components of unlevered free cash flows are interrelated; Changes in EBIT assumptions impact capex, NWC and D&A. Without a 3-statement model that dynamically links all these together, it is difficult to ensure that changes in assumptions of one component correctly impact other components.

Because this takes more work and more time, finance professionals often do preliminary analyses using a quick, back-of-the-envelope DCF model and only build a full DCF model driven by a 3-statement model when the stakes are high, such as when an investment banking deal goes “live” or when a private equity firm is in the later stages of the investment process.

The 2-stage DCF model

The 3-statement models that support a DCF are usually annual models that forecast about 5-10 years into the future. However, when valuing businesses we usually assume they are a going concern.  In other words, they will continue to operate forever.

That means that the 3-statement model only takes us so far. We also have to forecast the present value of all future unlevered free cash flows after the explicit forecast period. This is called the 2-stage DCF model. The first stage is to forecast the unlevered free cash flows explicitly (and ideally from a 3-statement model). The second stage is the total of all cash flows after stage 1. This typically entails making some assumptions about the company reaching mature growth. The present value of the stage 2 cash flows is called the terminal value.

Calculating the terminal value

In a DCF, the terminal value (TV) represents the value the company will generate from all the expected free cash flows after the explicit forecast period. Imagine that we calculate the following unlevered free cash flows for Apple:

Apple is expected to generate cash flows beyond 2022, but we cannot project FCFs forever (with any degree of accuracy). So how do we estimate the value of Apple beyond 2022? There are two prevailing approaches:

1. Growth in perpetuity
2. Exit EBITDA multiple method

The growth in perpetuity approach

The growth in perpetuity approach assumes Apple’s UFCFs will grow at some constant growth rate assumption from 2022 to … forever. The formula for calculating the present value of a cash flow growing at a constant growth rate in perpetuity is called the “Growth in perpetuity formula.” It is:

If we assume that after 2022, Apple’s UFCFs will grow at a constant 4% rate in perpetuity and will face a weighted average cost of capital of 10% in perpetuity, the terminal value (which is the present value of all Apple’s future cash flows beyond 2022) is calculated as:

At this point, notice that we have finally calculated enterprise value as simply the sum of the stage 1 present value of UFCFs + the present value of stage 2 terminal value.

Exit EBITDA multiple method

The growth in perpetuity approach forces us to take a guess as to the long-term growth rate of a company. The result of the analysis is very sensitive to this assumption. A way around having to guess a company’s long term growth rate is to guess the EBITDA multiple the company will be valued at the last year of the stage 1 forecast.

A common way to do this is to look at the current EV/EBITDA multiple the company is trading at (or the average EV/EBITDA multiple of the company’s peer group) and assume the company will be valued at that same multiple in the future. For example, if Apple is currently valued at 9.0x its last twelve months (LTM) EBITDA, assume that in 2022 it will be valued at 9.0x its 2022 EBITDA.

Growth in perpetuity vs. exit EBITDA multiple method

Investment bankers and private equity professionals tend to be more comfortable with the EBITDA multiple approach because it infuses market reality into the DCF. A private equity professional building a DCF will likely try to figure out what he/she can sell the company for 5 years down the road, so this arguably provides a valuation that factors the EBITDA multiple in.

However, this approach suffers from a significant conceptual problem: It uses current market valuations in the DCF, which arguably defeats the whole purpose of the DCF. Making matters worse is the fact that the terminal value often represents a significant pecentage of the value contribution in a DCF, so the assumptions that go into calculating the terminal value are all the more important.