Discounted Cash Flow (DCF) is a common valuation technique in mergers and acquisitions considered by many as the most reliable financial methodology for determining the fair value of a business especially in Precedent Transaction Analysis. Discounted Cash Flow is calculated by summing the present value of a projected stream of income. This can be projected earnings, Free Cash Flow or a similar metric at the discretion of the user and based on the specific circumstance. The projections are made over a significant period of time and discounted the total back to a present value.
Like many valuation methods such as Stand Alone Company valuation, the DCF is only as reliable as its inputs. These inputs may include
- projections of the Income Statement over a appropriate number of years (usually five)
- determining the amount of that income stream in perpetuity
- calculating an assumed sale value of the firm at the end of the analysis period or calculating the value of the income stream into perpetuity, using an assumed growth rate
- developing and applying a discount rate for purposes of calculating the present value of the projected income stream
These inputs depend on numerous assumptions and theoretical constructs such as the methodology for determining an appropriate discount rate. This subjectivity is referred to in the example below. When selecting the discount rate, “Morgan Stanley’s professional judgment and experience” is required.
Discounted Cash Flow Example
The following text is taken from the Form PRER14A Definitive proxy statement relating to merger or acquisition filing with the SEC made by Cincinnati Bell Inc. on March 19, 2020 in relation to the proposed takeover by Red Fiber Parent LLC
Discounted Cash Flow Analysis
Morgan Stanley performed a discounted cash flow analysis, which is designed to provide an implied value of a company by calculating the present value of future unlevered free cash flows and terminal value of that company. The “unlevered free cash flows” refers to a calculation of the future cash flows generated by a company without including in such calculation any debt servicing costs. The present value of a terminal value, representing the value of unlevered free cash flows beyond the end of the forecast period, is added to arrive at a total aggregate value. Outstanding debt and preferred equity is subtracted to arrive at an equity value. For purposes of the DCF analysis, net debt of $1,934 million and preferred equity of $155 million, each as of December 31, 2019, was utilized. The equity value was then divided by the fully diluted share count as of March 6, 2020 in order to arrive at an implied value per Company common share.
Morgan Stanley used estimates from the December Forecasts for purposes of the discounted cash flow analysis, as more fully described below. Morgan Stanley first calculated the estimated unlevered free cash flows, which it defined as Adjusted EBITDA less stock-based compensation and less depreciation and amortization, then subtracting for taxes, plus depreciation and amortization, less capital expenditures, less pension and OPEB payments, less changes in working capital, less restructuring and severance costs, less integration costs. The estimated unlevered free cash flows were then discounted to present values as of December 31, 2019 using a range of discount rates from 7.0% to 7.4%, which range of discount rates were selected, upon the application of Morgan Stanley’s professional judgment and experience, to reflect an estimate of the Company’s weighted average cost of capital (“WACC”). Morgan Stanley then calculated a range of implied terminal values for the Company by applying a range of exit multiples from 5.25x to 6.0x to the Company’s terminal year estimated Adjusted EBITDA.
This analysis reflected a range of implied equity value per Company common share, rounded to the nearest $0.25, of $4.75 to $10.50. In addition, Morgan Stanley conducted an illustrative calculation of the cash flow impact from the Company’s utilization of net operating losses (“NOLs”) for such period, as provided by Company management, discounted at the Company’s estimated WACC. In calculating the cash flow impact of NOLs, Morgan Stanley noted that the value of NOLs was subject to substantial revision based on further input from Company management. At the Company’s direction, Morgan Stanley assumed that NOL usage would be kept constant until the NOL balance was fully depleted. Morgan Stanley noted for the reference of the Board, and not as part of Morgan Stanley’s financial analysis at arriving at its opinion, that the illustrative calculation of NOLs indicated a range of implied equity value per Company common share, rounded to the nearest $0.25, of $4.75 to $13.00.
In this document, the discounted cash flow (DCF) methodology is clearly explained and shown how it forms part of the business valuation analysis. By using a variety of methods to arrive at a fair value for the target firm, the board of directors along with management can state with increased confidence that they have acted in the best interests of their shareholders thus fulfilling their fiduciary duty. Traders and investors employing a merger arbitrage investment strategy can also use this technique to asses to level of acquisition premium and judge the likelihood of a higher offer or a bidding war.
Additional Resources
DCF analysis is a mainstay of many financial education courses and higher education programs. Thus indicating its widespread use in the industry. For this reason, many tools have been developed to help market analysts in applying the technique. Microsoft Excel is a common software program for making these types of calculation. To learn more about the discounted cash flow valuation technique see Lutz Kruschwitz book “Discounted Cash Flow: A Theory of the Valuation of Firms“.
