Alternatively, suppose the margin improvements came from increased automation and, hence, higher fixed costs; this would suggest that those incremental cash flows deserve a somewhat higher discount rate.
Could these extra analytical features be performed with WACC? That would force us to think about the capital structure of, say, net-working-capital improvements. And have we expressed the debt ratio for that structure in market-value or book-value terms? Does the ratio change over time? The exercise is even more prone to error than the simple formulation in the sidebar. APV is both less cumbersome and more informative. Unfortunately, this is not as simple a procedure as textbooks often make it appear.
A sketch of the approach many companies take to this analysis highlights some of its pitfalls. In a WACC-based analysis, we discount only once—the discount rate has to be adjusted to pick up all the costs and benefits of a selected capital structure.
Not surprisingly, a lot of analytical energy goes into computing it. WACC is just what it says it is: a weighted average of the after-tax costs of different sources of capital, in which each is weighted by the fraction of the capital structure it represents.
In our example, there are three kinds of debt four if you consider the refinancing in year five and one kind of equity. See the calculations in the table above to observe how we obtained a WACC of 9. When we discount the free cash flows from this business at 9.
Why the difference in estimated values? There are several reasons, but the most important is that we made some common errors and miscalculated the WACC. Another problem is that we used book values to generate the weights in the WACC, whereas the procedure is valid only with market values.
And this, too, is subject to change every year. One expedient is to guess at the market value or use book values and then iterate—fill in the computed market value as the new guess, then recompute another guess, and so forth until the guess and the computed values converge.
There are other difficulties as well. In fact, every element of WACC presents computational challenges in all but the simplest, most sterile of settings.
Can those problems be addressed? For the most part, yes, though demonstrating that is not the point of this article. Suffice it to say that making the indicated adjustments to the simpleminded but very common calculation shown here is at least as difficult as—and less informative than—using APV.
Any value created by financial maneuvers—tax savings, risk management, subsidized debt, credit-enhanced debt—has its own cash-flow consequences. You treat those consequences by laying out the cash flows in a spreadsheet and discounting them at a rate that reflects time value and their riskiness, but nothing else. In other words, APV is exceptionally transparent: you get to see all the components of value in the analysis; none are buried in adjustments to the discount rate.
APV is exceptionally transparent: you get to see all the components of value in the analysis. None are buried. APV has its limitations, of course. Some amount to technicalities, which are much more interesting to academics than to managers. All rights reserved. PitchBook is a financial technology company that provides data on the capital markets. Log in Request a free trial. Request a free trial Log in.
PitchBook Blog. How does discounted cash flow DCF analysis work? October 8, View comments 5. Finance, I would've began with instead. The important thing here is that you use a revenue growth rate that makes sense, which is where your understanding of the business plays a large role in.
So, a large and established company will likely have a smaller growth rate than an early-stage company with more growth potential. Moreover, the further you project a company's revenue growth, the more uncertain its revenue will become, simply because the future is impossible to predict.
So, if you have a forecast growth period of 10 years instead of 5 like I'm doing, using a smaller and more conservative revenue growth rate figure may be smart. Now that you have revenue projections, the next step would be to find net income. One method is to find "net profit margins," which determines the proportional profitability of a business, expressed as a percentage of revenues:.
Net income and revenue are found on the income statement. Doing this for Intel from gives me the net profit margins below:. If I average out these 5 years, I'll get Again, you can also use a lower percentage if you want to be more conservative.
Next, take your FCFE rate found before Note that you can also calculate a figure called " owners earnings " each year, favored by Warren Buffett, and use this to replace the FCF figures found above. However, this can be even more involved, but can provide you with a potentially more accurate valuation. The next step is to calculate the discount rate, or required rate of return. The required rate of return is the minimum return an investor will accept for owning stock in a company, accounting for the risk of holding the stock.
Because we're using FCFE, our discount rate should be based on our individual perspectives as an investor. Therefore, the required rate of return I prefer using will most likely be different than yours, simply because the return I require on the companies I purchase may be higher or lower than yours.
In other words, my required rate of return will differ from yours because of the differences in our risk tolerance, investment goals, time horizon, and available capital, among other things. So, if you've done valuation before and know a required rate of return that works for you, then use this.
However, if you don't have a personal required rate of return, then we can go through a more involved process and come up with a basic required rate of return using the "weighted average cost of capital" WACC , which is essentially a default required rate of return.
Personally, I try to avoid using the WACC because it relies on an asset-pricing model called the "capital asset pricing model" CAPM , which comes with a number of assumptions. The main issue with this model for valuation, is that it assumes investors act rationally on the latest available public data and that markets are efficient, which is obviously not true in the stock market. So, to use the asset-pricing model in this regard may lead to misleading figures in your valuation.
That being said, the WACC is still the next-best alternative if you do not have a personal required rate of return. I will also use the WACC found below for Intel in this article because I cannot apply my required rate of return to every investor. I will show you two methods of estimating the cost of debt, but the second method can only be used if your company did not issue a lot of debt net borrowings in its current year. The method I prefer using when I'm building models is the debt rating approach, where you are simply adding the company's default spread depending on its credit rating to the current risk-free rate.
Then, you'd multiply by one minus the effective tax rate:. The risk-free rate is the year treasury yield figure, and is the rate of return an investor would expect to receive from an absolutely risk-free investment. This rate changes daily, so use the most recent date from the USDT website. The default spread is the difference between the yields of two bonds with different credit ratings, and a bond's credit rating is just a letter-based credit score used to judge the quality and creditworthiness of a bond.
So, an investment grade bond like "AAA" will have a lower default spread and will be considered safer than any bond rated lower, such as "BBB. Before you determine the default spread, you first have to find the company's credit rating through Moody's, Morningstar, or FitchRatings among others , and determine what rating the company has.
See my dividend investing article to learn more about credit ratings, view a credit ratings table, and know how to find credit ratings. Then, we can use a default spread table to determine the cost of debt, using a default spread table and the formula shown above. However, because it's difficult to find an up-to-date, free, and accurate default spread table, the next-best option is to estimate a synthetic rating instead.
The thing to keep in mind with this table is that default spreads will fluctuate due to changes in the market inflation, liquidity, demand, etc. Therefore, it's in good practice to use an updated table.
Intel's interest coverage ratio is Then, if we add 0. However, in most countries, interest expense is a tax-deductible item, meaning companies will pay less in taxes due to these interest payments. Therefore, this 1. To find the tax rate t , find it on the company's most recent K annual report or use the following formula with figures found on the income statement:.
Doing so for Intel will give us an effective tax rate of This is usually found in the "Notes to Financial Statements" section on the K:. As you can see, this effective tax rate is also Again, this method only works if the company did not issue a lot of debt net borrowings in its current year:.
As the previous method covers, this is the before-tax cost of debt, and we must apply the effective tax rate of Both approaches resulted in roughly the same answer for Intel's cost of debt, although this obviously is not always the case.
Moreover, because method 1 has more variability to it, and because Intel does not have a lot in net borrowings, I will choose to use the result from method 2 1. The next step is to calculate the cost of equity r e. We already found the risk-free rate r f before, using the USDT website.
More is discussed on calculating Terminal Value later in this chapter. UFCF is the industry norm, because it allows for an apples-to-apples comparison of the Cash flows produced by different companies. This means that the LFCF analysis will need to be re-run if a different capital structure is assumed.
In effect, UFCF allows the analyst to separate the Cash flows produced by the business from the structure of the ownership and liabilities of the business. The analyst should test several reasonable assumption scenarios to derive a reasonable valuation range. The following sources can help provide needed information to produce a high-quality DCF analysis:. In order to calculate Free Cash Flow projections, you must first collect historical financial results.
This derives a much more accurate representation of the Cash that a company generates than does pure Net Income:. The good news is that these Cash flow figures are the least difficult to project, because the closer we are to an event, the more visibility we have about that event. The bad news, of course, is that any error in projecting these figures will have a large impact on the output of the analysis.
FCF is derived by projecting the line items of the Income Statement and often Balance Sheet for a company, line by line. The assumptions driving these projections are critical to the credibility of the output. Below, we will walk you through a simple example of how to do this.
Depreciation is a non-Cash expense, meaning the company books Depreciation as an expense on the income statement for GAAP Generally Accepted Accounting Principles purposes but in reality, no Cash was actually spent.
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