The DCF, part one: from free cash flow to value per share
By the end of this lecture you will be able to
- Derive unlevered and levered free cash flow from EBIT and explain every line
- Build a five-year projection from operating drivers to unlevered free cash flow
- Calculate a terminal value by perpetuity growth and by exit multiple, and cross-check them
- Discount with the mid-year convention and a stub period, read a sensitivity table, and adapt the DCF to a loss-making company
Comparables tell you what the market pays. A discounted cash flow tells you what a business is worth on its own fundamentals. It is the most important model in finance and the one interviewers ask you to walk through more than any other. Today we build one from the first line to a value per share: the cash flows, the terminal value, the discounting and the sensitivities. Next lecture derives the discount rate.
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Interview questions on this lecture
Walk me through a DCF.
Project unlevered free cash flows for five to ten years from assumptions on revenue, margins, taxes, capex and working capital. Estimate a terminal value with a perpetuity growth rate or an exit multiple. Discount the cash flows and the terminal value at the WACC. The sum is enterprise value; subtract net debt and other claims to get equity value and divide by diluted shares.
How do you get from EBITDA to unlevered free cash flow?
Subtract taxes calculated on EBIT, then subtract capital expenditure and the increase in net working capital. Equivalently, start with EBIT times one minus the tax rate, add back D&A, and subtract capex and the change in working capital.