In this lesson, we are going to discuss how to complete the discounted cash flow analysis and develop evaluation range. These steps are completed after you have projected out your free cash flow, determined your terminal value, and calculated your weighted average cost of capital. The purpose is to determine the present value of the company or asset you are valuing and involves discounting each year's cash flows and terminal value using the WACC as the discount rate. We use the WACC to calculate a discount factor for each period by employing the following formula. One divided by the sum of one plus WACC to the power of the number of years you are discounting the cash flows. For example, if the WACC was 10 percent and you are discounting cash flows back one year, the discount factor would be 1 divided by 1 plus 0.10 to the first power. This results in a discount factor of 0.91, and this is the number that you would multiply Year 1 free cash flows by to arrive at a present value for them. Now taking this concept to the entirety of the discounted cash flow model, we would use the same approach to present value: Year 1 cash flows, Year 2 cash flows, Year 3 cash flows, Year 4 cash flows, and Year 5 cash flows. For most businesses, the discount factor that we use for each year would be for a period that is one-half less than the end of the year. For Year 2, we would use 1.5, Year 3, we would use 2.5, and so on and so forth. This is because the four-year discount factor assumes that the cash flows all occur at the end of the year when in reality, most businesses generate cash throughout the year. By employing what is known as the mid-year convention, we are effectively assuming ratable cash flow generation each year. In addition, to present valuing the annual cash flows by the discount factor, we would also multiply the terminal value by the discount factor calculated for the end of the projection period. Here we do not use the mid-year convention because we are calculating the value of the company at that point in time. When we sum the present value of free cash flows and the present value of the terminal value, we arrive at enterprise value. This is due to the fact that we are looking at unlevered free cash flows and multiplying EBITDA, which is an enterprise value concept by the LTM EBITDA multiple determined through our comparable company analysis. To calculate equity value, we simply deduct net debt, preferred securities, and non-controlling interest. To arrive at a per-share value, we divide that number by fully diluted shares. This example shows how we do that, arriving at an equity value of $47,297 and a per-share value of $47.30. As I've noted before, the DCF valuation approach, while theoretically very sound is significantly affected by several assumptions, primarily those relating to the WACC, the exit multiple, and the growth rate. Slight changes in each one can have a meaningful outcome on the arrived value. It is for this reason that we always make sure to perform a sensitivity analysis on our model to arrive at a range of valuation outcomes. It is this range that we will use along with the ranges develop from our other methodologies to arrive at our ultimate company evaluation range. This table represents what the sensitivity analysis would look like with a two percentage point spread of WACC and a four multiple points spread of the LTM exit multiple for the exit multiple method and a two percentage point spread of the perpetuity growth rate for the perpetuity growth method. You can see that we develop different ranges of values for each and it is important to use your best judgment to arrive at an ultimate valuation range. That wraps up our review of the discounted cash flow model. Before we move on to another topic, let's review the pros and cons of this methodology. On the pro side, the DCF approach is based on cash flows and is not impacted by non-cash items. It is not explicitly tied to the current market environment, although the current market does come into play when determining the exit multiple for the terminal value and the beta for the WACC and the model is quite flexible. You can run many different cases, scenarios, and employ it for a variety of purposes. The cons side is primarily related to the fact that the DCF model has a number of significant assumptions about things that are going to happen in the future. That inherently is going to be in precise. In addition, the way that the math works, terminal value is typically a very large percentage of the overall outcome. Once again, introducing a high level of subjectivity, given the fact that it has such a long while out into the future. Last, the model assumes that the capital structure of the business stays constant, which is not necessarily reflective of reality. In conclusion, the DCF approach is a very important component of a company valuation. But at the same time, it should not be the only approach used. It is critical that you also apply other approaches and then come up with a valuation range that reflects your best insight into the state of the business and the opportunities that it has in front of it.
