Hi Anonymous,
To answer your questions, I will first describe the theoretical correct valuation approach, and then the simplified approach you can normally apply in consulting interviews.
Full DCF Analysis
From a theoretical point of view, the discount rate is normally approximated with the WACC of the company (Weighted Average Cost of Capital), which can be computed as follows:
WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.
where:
Re= Cost of Equity
Rd= Cost of Debt
E= Equity
D= Debt
V= Total Value (E+D)
Unless you are evaluating something that will not produce any cash flow after some time (eg an oil tank lasting 3 years that will then be destroyed), the time frame should be indefinite, since the common assumption is that a company will last forever.
In valuation, the common approach is to compute the detailed free cash flow for a certain period of time (usually 5 years) and then apply a terminal value formula for the remaining (infinite) years. For example, you may find that free cash flows is the following:
Y1= $18M
Y2= $21M
Y3= $22M
Y4= $23M
Y5= $24M
(As a quick definition of free cash flows: it’s equal to Revenues-Operating Costs-Taxes-Net investment-Change in Working Capital).
The terminal value formula from year 5 to infinite is the one of a perpetuity using the Gordon Model:
TV=Terminal Value = Y5 * (1+Long-Term Cash Flow Growth Rate)/(Discount Rate – Long-Term Cash Flow Growth Rate)
Say Terminal Value ends to be $240M and WACC is 10%. Then the actual Enterprise Value of the company would be:
EV=Y1/(1+i)^1+Y2/(1+i)^2+Y3/(1+i)^3+ Y4/(1+i)^4+Y5/(1+i)^5+ TV/(1+i)^5
That is:
EV=$18M/(1.1)^1+$21M/(1.1)^2+$22M/(1.1)^3+ $23M/(1.1)^4+$24M/(1.1)^5+$240M/(1.1)^5=$230M
Now, let’s see the simplified approach.
Simplified DCF Analysis
Unless you have a financial background, you probably don’t need to go through all the previous details in a consulting interview. In particular, going back to you second question, to simplify things you may ask the interviewer the following questions:
- Can I assume stable cash flow (or: can we assume Y1=Y2=Y3=Y4=Y5=..)?
- Do we have any information on the specific WACC number of the company? If not, could I approximate it to 5% (low-risk company) or 10% (medium-risk company)?
Since an M&A consulting case has far more elements to go through than the formulas above, it is likely they will allow you to do so. You may also ask if you could approximate Free Cash Flow with Net Profit to further simplify the formula.
With these simplifications, you can basically derive the result with a single formula, using the Gordon Model. For a medium risk company, for example, since we assumed no growth in cash flow, the result will be:
EV=Y1/WACC=$18M/0.1=$180M
In the end, in almost all the cases you will not need more than the simplified approach; it would still be good though that you know the theory behind the full theoretical model as a backup.
Hope this helps.
Francesco
