Discounted Cash Flow Analysis

This method uses the forecasted free cash flow of the target private company (meeting all the liabilities) discounted by the firm’s weighted average cost of capital (the average cost of all the capital used in the business, including debt and equity), plus a risk factor measured by beta. Since risks are not always easy to determine precisely, Beta uses historic data to measure the sensitivity of the private company’s cash flow, for example, through business cycles.

Key Components of DCF
Estimating Beta
Equity Risk Premium
Geographic location
Cost of Equity
Cost of Debt
Cost of Capital
Private Company Cash Flows
Terminal Value
Final Observations on DCF Analysis

Key Components of a DCF

• Free Cash Flow (FCF)- Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business.

• Terminal Value (TV)- Value at the end of the FCF projection period (horizon period).

• Discount Rate- The rate used to discount projected FCFs and terminal value to their present values.
  

Estimating Beta—Beta is a historical measure of a stock’s volatility versus the market. Since private companies do not have equity traded on any exchange, there is no concrete method for determining the beta of a private company’s equity. Therefore the estimation of beta is based on the trading volatility of comparable public companies. It is important to calculate the unlevered betas of the universe of comparable private companies.

βunlevered = βlevered / (1+Debt / Equity) (1-T)

Determine the optimal debt ratio for the private company by either using the existing company capital structure or taking on the industry average capital structure. It is then that you must re-lever the average unlevered beta for the private company using the optimal capital structure.

βlevered = βunlevered / (1+Optimal Debt / Equity) (1-T)


Problems with Equity Risk Premium—Equity risk premium is the return that investors seek to obtain by investing in the stock market. Equity risk premium is the difference between the risk-free rate and the demanded rate of return from the stock market. The equity risk premium for private companies needs to be adjusted to reflect a higher return for a riskier investment.

Estimating Cost of Equity—The cost of equity of a private company is calculated as a function of the risk-free rate, beta, and the market premium.

Cost of Equity = RFR + Beta (MP)

The risk-free rate is often known as the interest rate associated with what is considered a “riskless” security (typically the yield on the highest rated government bonds in the 10-20 year maturity range).

Estimating Cost of Debt—The problem with the cost of debt of private companies is that many private companies rely on bank loans as their primary source of funding. Bank debt does not reflect the current debt cost of capital and is usually offered at a premium to public debt.

Calculating the current cost of debt capital requires analysis of comparable public company cost of debt or the cost of acquiring new funding as of the valuation date.

After-Tax Cost of Debt = Cost of Debt * (1 — Tax Rate)

Estimating Cost of Capital—Percent of debt and equity is obtained from the capital structure.

WACC = (Percent Debt)*(Cost of Debt) + (Percent of Equity)*(Cost of Equity)

Challenges with Private Company Cash Flows—It is important to normalize cash flows to reflect an arm’s-length approach to management. Recasting cash flows for the private company is to determine the true value of the private company based on “real” cash flows.

Challenges with Calculating Terminal Value—The two main ways of calculating the terminal value of a private company is through comparable multiples or perpetuity growth method. Considerations must be made in both methods that appropriate recast cash flows are used and growth rates are inline with potential growth opportunities for the private company based on management discussion and industry analysis.

Since private companies are organized under different corporate structure (LLC, LP or S-Corp), financial statements may not be a reasonable view of the private company’s performance on which an earnings multiple may be used.

Final Observations on DCF Analysis— Valuing a private company using a discounted cash flow analysis requires consideration to be given to recasting financial statements to mirror public counterparts and adjusting components of the WACC to mirror current cost of capital in an illiquid market. It is important to make sure that all adjustments are reasonable and defensible.

The major disadvantage of this method is that the precision of the valuation is not always accurate. The outcome of the valuation is highly dependent on the quality of the assumptions made regarding FCF, TV, and the discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs.