You will be able to explain how a DCF works and what each input does to the answer.
Open your model and put next year's free cash flow beside today's share price. In Marcus's model of Larkspur, a company whose shares are priced in Singapore dollars, free cash flow is about S$32 million next year and about S$44 million in five years, and the shares trade at S$1.60 (invented figures; company figures are in S$ millions unless stated). The model alone can't say whether S$1.60 is cheap, because a forecast of future cash and a share price today are in different units, and you can't compare them directly. A discounted cash flow, or DCF, converts one into the other.
You'd pay less than S$100 today for a promise of S$100 in a year, for two reasons: you could earn safe interest on the money in the meantime, and the promise might not be kept. The more doubtful the promise, the less you'd pay for it. The discount rate reflects both: the time value of money, and the risk that the cash doesn't arrive.
Discounting reduces a future amount to its value today at a given rate. You divide the future amount by (1 + rate) raised to the power of the number of years. At 9% a year (an illustrative rate), S$100 due in one year is worth 100 / 1.09, about S$91.74, today. S$100 due in five years is worth 100 / 1.09^5, about S$65.
A DCF valuation applies this to a business. You forecast the cash the business will produce, discount each year's cash back to today at a rate that reflects its risk, and add the discounted amounts together. The total is what the business is worth to someone who demands that rate of return.
There are two ways to set up a DCF. Analysts most often value the whole firm first, then subtract what's owed to lenders. That approach starts from free cash flow to the firm (FCFF), the cash produced before any payments to lenders or shareholders. It is operating profit after tax, plus depreciation, minus capital spending, minus the increase in working capital.
For Larkspur in FY6, operating profit is about 58.3. After tax at 17%, that is about 48.4. Add depreciation of about 25.9, subtract capital spending of about 34.6 and an increase in working capital of about 7.3, and FCFF is 48.4 + 25.9 - 34.6 - 7.3, about 32.4.
FCFF belongs to everyone who funds the company, so it is discounted at the cost of capital, a blend of what shareholders require and what lenders require. Lesson 8.2, "Cost of capital: equity, debt and a WACC you can defend", builds this rate. The Larkspur base case uses 9%.
The free cash flow you built in Lesson 7.8, "Build the forecast and balance the model", was calculated after interest, so it is slightly different from FCFF. In Marcus's model, FY6 free cash flow after interest is about 29.1, against FCFF of about 32.4 for the same year. The gap between the two is the interest bill after tax.
Discount the five forecast years of FCFF at the cost of capital, then add a value for the years beyond the forecast, which comes from Lesson 8.3. The total is enterprise value, the value of the operating business. Subtract net debt to get equity value, then divide equity value by the number of shares to get value per share. The share count should include the shares that options and awards will add.
Net debt is bank debt plus lease liabilities, minus cash. For Larkspur that is 60 of bank debt plus 20 of lease liabilities minus 60 of cash, which gives 20. Larkspur has 300 million shares. Marcus's model treats leases as debt: new leases count as capital spending, and the lease liability is subtracted along with bank debt. The alternative treats lease payments as an operating cost and leaves the lease liability out. Either approach works. Using both double counts the leases, using neither misses them, and either mistake goes straight into the value.
Your DCF needs five inputs, each with a source in your work:
the free cash flow forecast, from the statement tabs of your model the discount rate, from Lesson 8.2 the value beyond the forecast, from Lesson 8.3 net debt, from the latest balance sheet the number of shares, from the annual report, including shares that options and awards will add
Using Marcus's inputs, the DCF built in Lessons 8.2 and 8.3 gives about S$1.80 a share, with a long-term growth rate of 2%. The shares trade at S$1.60, a gap of S$0.20.
To test the answer, hold every other input fixed and change one at a time. With a discount rate of 8% instead of 9%, the value rises to about S$2.11, up 18% on the unrounded base value (about 17% on the rounded S$1.80). At 10%, it falls to about S$1.56. Long-term growth of 3% instead of 2% gives about S$2.04, and 1% gives about S$1.61. A one-point change in either input moves the answer by about as much as, or more than, the S$0.20 gap between today's price and the base value.
These two inputs dominate because they apply to every year of cash flow, and because most of the value comes from cash that arrives after the forecast ends. This sensitivity can't be fixed. It comes with valuing any long-lived asset, and Lesson 3.3, "Real rates and breakeven inflation from inflation-linked bonds", found distant cash flows sensitive to rates for the same reason.
A DCF does not find the true price of a share, and nobody's model does. It forces every assumption into the open: how fast the business grows, what margin it earns, how much it reinvests, how risky it is and how long it lasts. Anyone who disagrees with your value has to disagree with one specific input, so the argument becomes about evidence rather than opinion. The module spends as much time testing the answer as producing it for this reason. Lesson 8.5, "Reverse DCF: what the market is already pricing in", flips the question round, and Lesson 8.6 replaces a single value with a range.
Before you build the valuation tab, list the five inputs your DCF will need and the cell or document in your model each one will come from.
List the five inputs your DCF needs and where in your model each one will come from.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).