Investment Banking Series: Valuation Part 2

Investment Banking Series

Post 5 Valuation, Part 2

DCF Valuation

Discounted Cash Flows (DCF) analysis looks at the amount of cash the company generates and discounts it back from a fixed point in time (usually 5 or 10 years, depending on the sector) along with the terminal value. Specifically, company's Free Cash Flow is projected for every year of the valuation period, the terminal value is calculated for the last year of the valuation period and the sum of the two is discounted by the Weighted Average Cost of Capital (WACC) of the company.

This process involves a lot of projections, and therefore requires very detailed understanding of company business, because in the end the valuation is determined by how accurate these estimates are. CFA prep guides (official guide, Schweser notes, etc.) provide in-detail explanation of how FCF is calculated and what can serve as a proxy for it, but in principle its formula is as follows:

FCF = EBITDA - Tax Expenses - CAPEX - change in Net Working Capital

So the problem is to accurately estimate how each component will change over the valuation period. Company investor presentations and mid-term management plans that are generally available to the public for listed companies can provide important clues on how much the company is going to spend on investment (CAPEX) and how much profits it can be expected to generate (EBITDA) . As for Tax Expenses and Net Working Capital, financial statement analysis is crucial to arrive to a meaningful estimate.

With regards to the terminal value, the only method that I have encountered is the Exit Multiple. It is simply

Terminal Value = EBITDA(last year) x Exit Multiple

Exit Multiple is determined in a similar manner as it is in Comps: by averaging the multiples of the comparable companies.

WACC is the minimum rate of return that the company has to achieve in order to be profitable. Its calculation involves several stages (for equity, preferred shares and debt), and I will not go into it here, but in rare cases it may be found in company annual reports or other publicly available documents.

Now, to arrive to the valuation, we discount FCF and Terminal Value by WACC.

FCF part = [FCF1 / (1 + WACC)] + [FCF2 / (1 + WACC)^2] + ...
+ [FCFn / (1 + WACC)^n]

where n is number of years

Terminal Value part = EBITDAn x Exit Multiple / (1 + WACC)^n

The resulting Enterprise Value is the sum of the parts.

3. Lessons

Valuation is not very difficult in terms of the math involved. What is important is to be able to arrive to the set of assumptions about the numerous inputs into the eqasions. This is the diificult part that requires experience and understanding of eveluated company's business. Some of the assumptions may be obtained for the research analyst reports (when available).

Valuation techniques are also widely used outside investment baking world, for instance in private equity, corporate finance and investment management. Among all the skills investment bankers have, I would say this is the most important.


Links to other posts in investment banking series:
Post 1: Series Introduction
Post 2: Deal from Sourcing to Completion
Post 3: Pitch Books
Post 4: Valuation, Part 1
Post 6: Equity Story
Post 7: Roadshows