DCF Like a Banker

Introduction

Let’s start with a disclaimer. This article will not serve as an introduction to DCFs, and will not cover the WACC calculation. If you have to ask what a DCF is, or how it works, this article is not for you.

This article assumes you have already made at least a couple DCFs and understand the core concepts. This article is going to walk you through a high-quality DCF template and some key considerations.

Some Background

The DCF is the most subjective form of valuation - it is subject to the most judgment and potential for manipulation. When we compare it to other valuation methodologies, it has the most unknown variables.

What are the variables in a DCF?

  1. Financial projections
  2. WACC (with its own numerous levers and inputs)
  3. Exit Multiple / Terminal Growth Rate

The WACC and the Exit Multiple / Terminal Growth Rate are the big unknowns, where investment bankers must exercise judgment. The financial projections are usually supplied by the client, or are created with the client’s input and are subsequently blessed by the client. Investment bankers are not in the business of creating projections, and the client should have a stronger basis to project their own performance.

Compare these unknowns to those of other valuation methodologies:

  1. Public trading comparables
  2. Acquisition comparables
  3. LBO

In public trading comparables and acquisition comparables, there are fewer distinct areas of judgment. The most substantial decision is the first question: which companies or deals are comparable?

Some would argue the LBO is not a valuation methodology, but I’d argue that a LBO performed by a banker is a DCF without the uncertainty of the WACC. The cost of capital for a LBO is mechanical. The illustrative sponsor return threshold is 20 - 25%, and the cost of debt is governed by prevailing debt market conditions - whatever your Leveraged Finance team deems reasonable.

Ok, background aside, let’s check out the template.

Key Assumptions

It’s a best practice to list out your key variables at the top of the file. This allows you to easily keep track of them, and it makes your assumptions explicit to anyone else who might open up the file.

A few notes:

  • Perpetuity Growth Rate is just another name for the Terminal Growth Rate.
  • Mid-year discounting: This is a boolean switch to turn on mid-year discounting. Mid-year discounting means that for each period of projected cash flows, you assume the cash flows occur in the middle of the projected period, instead of at the end. Otherwise, you’re unfairly penalizing a company’s value if its cash flows occur steadily throughout the year. On the other hand, if you’re working with a company whose cash flows occur at the end of the year, it wouldn’t make sense to use mid-year discounting. One hypothetical example is a specialty holiday retailer that does the bulk of its business at the end of the year.

Projected Cash Flows

This section is pretty straightforward. Typically, you would link the financial projections from your standalone projection model instead of hard-coding them here.

One nuance is the “Terminal” year construct. We use this terminal period to normalize the last year of projected free cash flow, and in turn, we use normalized free cash flow to calculate the terminal value via the Perpetuity Growth Method. One common adjustment is to set D&A equal to a certain % of CapEx. Remember, not all CapEx is expensed as D&A. For example, land acquisition costs are not depreciated. All else being equal, a higher % of D&A leads to a higher valuation, because D&A reduces cash taxes paid, thereby increasing cash flow.

Also, the free cash flow is labeled Unlevered Free Cash Flow, because it is unburdened by leverage (debt), i.e., it’s before interest expense. This means these cash flows are the cash flows available to the entire firm, regardless of capital structure. That should tell you that we’re calculating the enterprise value.

You should always ask yourself: Who are these cashflows for? Have any pieces of the capital structure already been paid their due?

Terminal Value

As a reminder,

enterprise value = PV of projected cash flows + PV of terminal value

We calculated the PV of projected cash flows in the Projected Cash Flows section of the template. Now we need to calculate the terminal value and then the PV of the terminal value. The two approaches for calculating the terminal value are the Exit Multiple Method and the Perpetuity Growth Method.

It is important to calculate the terminal value using both methods, even if only one of them is appropriate for the valuation (e.g., there are no good comparables, so you can’t find a reasonable exit multiple). Each method acts as a check upon the other.

Perpetuity Growth Method

The perpetuity growth method calculates the terminal value with a perpetuity. How much would this cash flow be worth, grown at X% in perpertuity and discounted at Y%?

The formula (ignoring mid-year discounting) is:

terminal value = terminal free cash flow x (1 + g) / (WACC - g)
PV of terminal value = terminal value / (1 + WACC) ^ 5

But per the discussion of mid-year discounting above, this unfairly penalizes the value of the company - assuming the company’s cash flows occur relatively evenly throughout the year.

The adjusted formula (accounting for mid-year discounting) is:

PV of terminal value = terminal value / (1 + WACC) ^ 4.5

Reasonable Growth Rates
Perpetuity means forever, so you have to be careful with your growth rates. US GDP grows < 3% / year, so a company growing at 5% in perpetuity would eventually overtake the US GDP. Usually, up to 3.00% is standard practice. Here we’re showing 1.00% - 2.50%. You must have a very good reason to go above 3.00%.

Disclaimer: the selection of growth rates and appropriate discount rates can be quite nuanced. The comments above specifically apply to US-based companies and companies in mature economies. It may be appropriate to select higher growth rates for companies based in emerging economies or countries with high inflation, but that is beyond the scope of this article.

Implied Exit Multiple
Using the terminal value (not PV of terminal value), we can calculate the implied exit multiple range. Be consistent with the multiples you’re showing - if you’re using a LTM multiple for the Exit Multiple Method, you should calculate the implied LTM multiple here.

Implied Exit Multiple = Terminal Value / LTM EBITDA

Unfortunately, mid-year discounting makes things more complicated. We assume that the terminal value calculated using the Perpetuity Growth Method (PGM) occurs mid-year, consistent with mid-year cash flow discounting. The Exit Multiple Method (EMM) terminal value, on the other hand, occurs at period end.

To calculate an apples-to-apples implied exit multiple, we need to grow the PGM-derived terminal value by the discount rate for half a period – shifting the value half a period into the future – to make it consistent with the EMM terminal value.

Here’s the revised formula:

Implied Exit Multiple = (PGM Terminal Value x (1 + WACC) ^ 0.5) / LTM EBITDA

A couple notes:

  1. The calculation of the implied exit multiple illustrates the intrinsic value relationship between growth and multiples. A higher growth rate leads to a higher value, which leads to a higher implied multiple, and vice versa.
  2. If there is a material difference between your implied multiple range and the exit multiple range you’re using, you need to understand why. You may need to adjust your multiple range or your growth rates to achieve consistency.

Exit Multiple Method

The exit multiple method calculates the terminal value by using a multiple at the end of the projection period. You have some flexibility here on which multiple to use. Typically, you use the NTM or LTM EBITDA multiple, but you could also use a revenue multiple. The one constraint is that if you’re performing a DCF analysis on the enterprise value of a company, the multiple should be an enterprise value multiple (so not P/E).

The formula is simple (using LTM EBITDA multiple here):

terminal value = projected LTM EBITDA x exit multiple
PV of terminal value = terminal value / (1 + WACC) ^ 5

Since the terminal value is calculated for period-end, mid-year discounting does not apply to the terminal value. You discount it by the full 5 years.

Check Your Multiple
Selecting an appropriate exit multiple range is key, and it helps to have knowledge of the industry.

  1. Is this a cyclical industry? If current multiples are 12.0x, but the historical average is 8.0x, it is NOT appropriate to select 11.0x - 13.0x as your exit multiple range.
  2. How are you deriving the exit multiple? Are there good comparables?

Implied Perpetuity Growth Rate
Here is where things get tricky.

We know the formula for terminal value using the Perpetuity Growth Method:

Terminal Value = terminal FCF x (1 + g) / (WACC - g)

We need to factor out the g in order to calculate the implied growth rate. Steps below:

TV = (FCF + FCF x g) / (WACC - g)
TV x WACC - TV x g = FCF + FCF x g
TV x WACC - FCF = (FCF + TV) x g
g = (TV x WACC - FCF) / (FCF + TV)

Ok, not so bad.

But wait. Remember from our discussion of the implied exit multiple that terminal values calculated using the PGM and EMM are inconsistent when we apply mid-year discounting: PGM terminal values occur mid-period, and EMM terminal values occur end-of-period.

We need to adjust the terminal values by half a period of discounting - we are taking the EMM terminal value and discounting it to get the implied PGM terminal value, which can then be used to derive the implied growth rate. The revised formula is as follows:

g = ((TV / (1 + WACC) ^ 0.5) x WACC - FCF) / (FCF + (TV / (1 + WACC) ^ 0.5))

Basically the same as before, but we substitute TV / (1 + WACC) ^ 0.5 wherever we had TV previously.

Check Your Work

If you’re rebuilding this template from scratch, or modifying it, check your work.

One efficient way to check the implied exit multiples and implied growth rates is to plug them into the opposing section. I’ll explain what I mean.

Checking Implied Exit Multiples

  1. Copy the row of implied exit multiples (row 65 in the template).
  2. Paste the copied values into the row of LTM Exit multiples (row 78 in the template).
  3. You should see your assumed perpetuity growth rate range in the implied perpetuity growth rate row (row 82 in the template).
  4. Control z to undo the pasted values.

Checking Implied Perpetuity Growth Rates

  1. Copy the row of implied perpetuity growth rates (row 82 in the template).
  2. Paste the copied values into the Perpetuiy Growth Rate row (row 59 in the template).
  3. You should see your assumed exit multiple range in the implied exit multiple row (row 65 in the template).
  4. Control z to undo the pasted values.

If your implied values do not match your assumed values when you perform these checks, there is an error.

Example Outputs

The outputs are actually there! They’re just shifted to the right to avoid messing up the column widths of the other sections.

These are the types of outputs I would show for DCFs - a simple presentation of the build to enterprise value.