4th Step: Discounting free cash flows and terminal value

Discounting free cash flows and terminal value

Following are the steps of DCF Valuations;

  1. Forecast Cash Flows
  2. Calculate Discount Rate
  3. Calculate Terminal Value
  4. Calculate PV of Free Cash Flow and Terminal Value
  5. Derive the Equity Value and Share Price

In this article, we are going to discuss the 4th and 5th step of DCF valuation and few related concepts.

Forth step is to derive the PV of cash flows of forecast period and terminal value using the relevant discount rate.

If we are following FCFF model then discount rate will be WACC. FCFF and TV will be discounted to its PV using WACC and we will get Implied Enterprise Value. Enterprise value includes Equity and Non-Equity claims.

Implied Equity Value     =             Implied Enterprise Value – Non Equity Claims

If Non-Equity claims are deducted from Implied Enterprise Value you will get Implied Equity Value.

If we are making FCFE model then the discount rate will Cost of Equity then FCFE and TV will be discounted to PV and we will get Implied Equity Value.

Mid-Year Convention: When you study DCF valuation, it is important to know the concept of Mid Year convention. We use Mid-Year convention to represent the fact that the company’s cash flows don’t come 100% at the end of each year rather they are generated evenly throughout each year.

In a DCF without Mid-Year, the discount period will be 1 for 1st year of cash flows, 2 for 2nd year of cash flow and 3 for 3rd year of cash flows and so on.

With Mid-Year, we will use discount period .5 for 1st year of cash flows, 1.5 for 2nd year of cash, 2.5 for 3rd year of cash and so on.

Mid-Year Convention for Terminal Value:

When you’re discounting the Terminal Value back to its present value, you use different numbers for the discount period depending on whether you’re using the Multiples Method or Gordon Growth Method:

=> Multiples Method: You add 0.5 to the final year discount number to reflect that you’re assuming the company gets sold at the end of the year.

 => Gordon Growth Method: You use the final year discount number as it is, because you’re assuming the free cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end.

 

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