You will be able to explain the logic of a DCF and what each input does to the answer.
Marcus's model now says Larkspur will produce about S$32 million of free cash flow next year and about S$44 million in five years' time. The shares trade at S$1.60. Is that cheap? The model can't say, because a stream of future cash and a price today aren't measured in the same units. A discounted cash flow, or DCF, is the conversion between them.
Figures are made up. Company figures are in S$ millions unless stated.
If someone offers you S$100 in a year, you'd pay less than S$100 for that promise today, for two reasons. You could put the money somewhere safe and earn interest in the meantime. And the promise might not be kept. The more doubtful the promise, the less you'd pay.
Discounting puts a number on that. At a rate of 9% a year, S$100 due in one year is worth 100 divided by 1.09, about S$91.74, today. Due in five years, it's 100 divided by 1.09 to the power of five, about S$65. The rate you use reflects both the time value of money and the risk of the cash not arriving.
A discounted cash flow valuation applies this to a business. Forecast the cash it will produce, discount each year's cash back to today at a rate that reflects its risk, and add them up. That sum is what the business is worth to someone who demands that rate of return.
There are two ways to set it up. Analysts most often value the whole firm first and then subtract what's owed to lenders.
Free cash flow to the firm is the cash the business produces before any payments to lenders or shareholders: operating profit after tax, plus depreciation, minus capital spending, minus the increase in working capital. It belongs to everyone who funds the company, so it's discounted at the cost of capital, a blend of what shareholders and lenders require, which lesson 8.2, Cost of capital: equity, debt and a WACC you can defend, builds.
This differs slightly from the free cash flow in your model from lesson 7.8, Build the forecast and balance the model, which came after interest. For Larkspur's FY6: operating profit of about 58.3, less tax at 17%, gives about 48.4. Add depreciation of about 25.9, subtract capital spending of about 34.6 and the working capital increase of about 7.3, and free cash flow to the firm is about 32.4. The model's figure after interest was about 29.1. The gap is the interest bill after tax.
Discounting five years of these at 9% and adding a value for the years beyond gives an enterprise value: the value of the operating business. Subtract net debt, which for Larkspur is 20, made up of bank debt of 60 plus lease liabilities of 20, minus cash of 60. What's left is the value of the equity. Divide by 300 million shares for a value per share.
One rule on leases. Larkspur's forecast treats leases as debt: new leases count as capital spending and the lease liability is subtracted with the bank debt. The alternative treats lease payments as an operating cost and leaves the liability out. Either works. Using both, or neither, double counts or misses the leases, and the error goes straight into the value.
Strip the method down and you need five things, each with a home in your model.
The free cash flow forecast, from your statement tabs; the discount rate, from lesson 8.2; the value beyond the forecast, from lesson 8.3; net debt, from the latest balance sheet; and the number of shares, from the annual report, including shares that options and awards will add
With Marcus's inputs, the DCF in lessons 8.2 and 8.3 comes to about S$1.80 a share.
The discount rate and the long-term growth rate dominate the answer, because they apply to every year of cash flow, and most of that cash arrives after your forecast ends.
Hold everything else in Marcus's model fixed and change one input at a time. With a discount rate of 8% instead of 9%, value rises from about S$1.80 to about S$2.11, up 18%. At 10% it falls to about S$1.56. Raise long-term growth from 2% to 3% and value goes to about S$2.04. Cut it to 1% and value is about S$1.61. A one-point change in either input moves the answer by more than the gap between today's price and Marcus's base value.
That isn't a flaw you can fix. It's the nature of valuing a long-lived asset, the same reason lesson 3.3, Real rates and breakeven inflation from inflation-linked bonds, found distant cash flows so sensitive to rates.
So a DCF doesn't find the true price of a share. Nobody's model does. What it does is force 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. Someone who disagrees with your value has to disagree with one of those numbers, and then you can argue about evidence rather than opinions.
That's why the rest of this module spends as much time on testing the answer as on producing it. Lesson 8.5, Reverse DCF: what the market is already pricing in, turns the question round, and lesson 8.6 replaces one 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.
Write the five inputs your DCF will need and where each will come from in your model.
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