Determining Value & Interprating Results

Unlevered free cash flows (FCFF) and terminal value are discounted using WACC. The sum of discounted cash flows and discounted terminal value gives Enterprise Value  (EV).  

 In order to get equity value subtract net debt from EV, where Net debt is all interest bearing debt minus cash and cash equivalents, then subtract non controlling interest, add associates and affiliates.  Make these adjustments at market values if available or at book values from the consolidated financial statements.

Divide equity value by the fully diluted shares outstanding to get the implied price per share.

SENSITIVITY

DCF valuation is highly sensitive to terminal value and cost of capital assumptions. Therefore, it is best practice to include a sensitivity analysis and present output for a range of scenarios for terminal value and cost of capital.

  • As terminal growth rate or exit multiple increases, valuation increases as well
  • As cost of capital increases, valuation decreases. So there is an inverse relationship between cost of capital and value
  • Maximum value is achieved when the highest terminal growth rate or exit multiple assumption is combined with the lowest cost of capital
  • Similarly, valuation will be lowest, when the lowest terminal growth rate or exit multiple assumption is combined with the highest cost of capital

PROS & CONS

Pros:

  • DCF relies on cash flows as opposed to accounting profits which can be easily manipulated
  • DCF gives the intrinsic value of a company which is independent of market bias and noise unlike comparables
  • DCF can be used to value companies with negative earnings or net worth
  • It also provides a better picture for the long term

Pros:

  • On the flip side, DCF valuation depends on a number of assumptions which may or may not come true
  • DCF valuation is highly sensitive to both the discount rate and terminal growth assumed. Even a small change in these numbers can lead to significant changes in valuation
  • Finally, if exit multiples are used to calculate terminal value then valuation is impacted by market noise under-mining the notion of intrinsic value