![]() ![]() ![]() To move from the enterprise value to the equity value, we must subtract net debt and any other non-equity claims such as non-controlling interest to isolate the common equity claims. The unlevered and levered DCF approaches begin to diverge around here, as the unlevered DCF calculates the enterprise value whereas the levered DCF calculates the equity value directly. Step 4 – Move from Enterprise Value → Equity Value In contrast, the cost of equity is estimated using the capital asset pricing model ( CAPM), which is the required rate of return by holders of common equity and is used to discount levered FCFs (FCFE). the required rate of return for all capital providers and the discount rate used for unlevered FCFs (FCFF). The WACC represents the blended discount rate applicable to all stakeholders – i.e. FCFF → Weighted Average Cost of Capital (WACC). ![]() Since the DCF-derived value is based on the present date, both the initial forecast period and terminal value must be discounted to the current period using the appropriate discount rate that matches the free cash flows projected. Step 3 – Discount Stage 1 Cash Flows & Terminal Value Exit Multiple Approach – The average valuation multiple, most frequently EV/EBITDA, of comparable companies in the same industry is used as a proxy for the valuation of the target company in a “mature” state.1% to 3%) is used as a proxy for the company’s future growth prospects into perpetuity. Growth in Perpetuity Approach – A constant growth rate assumption typically based on the rate of GDP or inflation (i.e.The two approaches for estimating the terminal value are as follows: With the Stage 1 forecast done, the value of all the FCFs past the initial forecast period must then be calculated – otherwise known as the “terminal value”. Capital Expenditures and Net Working Capital) Gross Margin, Operating Margin, EBITDA Margin) To project the free cash flows (FCFs) of the company, operating assumptions regarding the company’s expected financial performance must be determined, such as: In practice, the more common approach is the unlevered DCF model, which discounts the cash flows to the firm prior to the impact of leverage. Free Cash Flow to Equity (FCFE) – FCFE is the residual cash flows that flow solely to common equity, as all cash outflows related to debt and preferred equity were deducted.Free Cash Flow to Firm (FCFF) – FCFF pertains to all providers of capital to the company, such as debt, preferred stock, and common equity.The type of free cash flows (FCFs) projected has significant implications on the subsequent steps. Beyond 10 years, the DCF and assumptions gradually lose reliability and the company might be too early in its lifecycle for the DCF to be used. ![]() the Stage 1 cash flows – lasts for around 5 to 10 years. Typically, the explicit forecast period – i.e. The FCFs are projected until the performance of the company reaches a sustainable state where the growth rate has “normalized.” The first step to performing a DCF analysis is to project the company’s free cash flows (FCFs).
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