2. Valuation Methodologies (DCF)

Lesson Objectives

By the end of this module, you will be able to:

1. Read and Interpret the Income Statement, Balance Sheet, and Cash Flow Statement.

2. Understand the Story each statement tells about a company's profitability, financial position, and liquidity.

3. Master the Linkages that connect the three statements into a single, dynamic financial picture.

4. Perform Two Key Valuation Methods: Discounted Cash Flow (DCF) for intrinsic value and Comparable Company Analysis (Comps) for relative value.

Part 2: Valuing a Company 

• Now that you know how to read and interpret financial statements, you can use that knowledge to answer the most important question in finance: "What is this company worth?"

Intrinsic Valuation

• Idea: Value is based on the company’s own expected future cash flows.

• Analogy: Like valuing an apartment by the rent it can earn, not by what the one next door sold for.

• Method: Discounted Cash Flow (DCF) analysis.
  
  

Relative Valuation

• Idea: Value is based on what the market pays for similar companies.

• Analogy: Like valuing your house based on similar sales on your street.

• Methods: Comparable Company Analysis (“Comps”) and Precedent Transactions.

Best practice: Use both. If your DCF says $100 but peers trade at $50, you might have found an undervalued opportunity.

Section 2.2: Intrinsic Valuation: The Discounted Cash Flow (DCF) Model 

The DCF estimates value by projecting a company’s future unlevered free cash flows (UFCF) and discounting them back to today using the Weighted Average Cost of Capital (WACC).

IMPORTANT:

Because it's impossible to forecast cash flow forever, we break the future into two parts:

1. The Near Future (Years 1-10). This is the period where we can make a detailed, year-by-year prediction of the cash the company will generate.

   • The cash we predict for each of these years is called Unlevered Free Cash Flow (UFCF).

2. The Distant Future (Everything After Year 10). This period is everything else, from the end of our detailed forecast into the future, forever.

   • This single, lump-sum estimate is called the Terminal Value (TV) (will be explained more later)

Your first job is to calculate the specific UFCF number for each year of the near future (e.g., for the next 10 years). 

Component 1: Unlevered Free Cash Flow (UFCF), this project the cash generated by the core business operations that's available to all capital providers (both debt and equity holders). This is typically done for a 5-10 year period. 

The formula is:

EBIT× (1−Tax Rate) + D&A − Capital Expenditures− Change in Net Working Capital  

Terminology:

• EBIT × (1 - Tax Rate): This is Net Operating Profit After Tax (NOPAT). We use EBIT (Earnings Before Interest and Taxes) because it's a measure of operating profit independent of the capital structure. 

• Then a tax rate is applied to estimate the cash taxes paid on this core profit. The tax benefit of interest expense is not included here: it's captured later in the WACC, which will be explained later.

• + Depreciation & Amortization (D&A): D&A is a non-cash expense that was subtracted to calculate EBIT. Since no cash actually left the company, we must add it back to get to a true cash flow figure. 

• - Capital Expenditures (Capex): This is the actual cash spent on purchasing or maintaining long-term assets like property, plant, and equipment (PP&E). This is a real cash outflow that doesn't appear on the Income Statement.

• - Δ Net Working Capital (ΔNWC): This is the change in Net Working Capital. NWC is the cash tied up in the day-to-day operations of the business. An increase in NWC is a use of cash (and is subtracted from UFCF). For example, if your Accounts Receivable grows faster than your Accounts Payable, you are effectively funding your customers and suppliers, which consumes cash.

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Component 2: The Discount Rate (WACC) 

The Weighted Average Cost of Capital (WACC) is the blended required rate of return for all capital providers, weighted by their proportion in the company's ideal capital structure. It represents the overall risk of the business's cash flows.

The Formula:

WACC= (E/V​×Re​) + ( D/V​ × Rd​× (1−T))

• E/V and D/V: The proportions of Equity (E) and Debt (D) in the total value of the firm (V = E + D).

• Re​ (Cost of Equity): The return shareholders require. It's calculated using the Capital Asset Pricing Model (CAPM).

  • CAPM Formula: Re ​= Rf​ + β × (Rm​−Rf​)

  • Rf​ = Risk-Free Rate: The yield on a long-term government bond (e.g., 10-year U.S. Treasury).

  • β = Beta: A measure of a stock's volatility relative to the overall market. For example, a beta of 1.2 means the stock is 20% more volatile than the market.

  • (Rm​−Rf​) = Equity Risk Premium: The excess return investors expect for investing in the stock market over the risk-free rate.

• Rd​ (Cost of Debt): The current yield to maturity on the company's long-term debt.

• (1−T) (The Tax Shield): Interest payments on debt are tax-deductible. This tax saving effectively reduces the cost of debt to the company.

Future money is worth less than today's money. The WACC is the rate we'll use to "shrink" the future cash flows back to their present value.

• Think of it as a "time travel tax." A higher WACC means the business is riskier, so the tax for bringing its future cash back to today is higher.

Result of Step 2: A single percentage, like 8% or 10%.

Component 3: Terminal Value (TV)

Now, you need to calculate the value for the "forever" period.

The TV captures the value of the company for all the years beyond the explicit forecast period (e.g., beyond year 10). 

• You use a formula (like the Gordon Growth Method) to create one big, lump-sum number that represents the value of all cash flows from Year 11 onwards.

Two Methods:

1. Gordon Growth Method: Assumes the company's UFCF will grow at a stable, slow rate (g) forever.

(Where n is the final forecast year and g is a conservative long-term growth rate, like inflation or GDP growth).

Exit Multiple Method: Assumes the company is sold at the end of the forecast period at a specific valuation multiple (e.g., an EV/EBITDA multiple based on its peer group).