Advanced Case Study: Discounted Cash Flow (DCF) Valuation
Valuing a company using Discounted Cash Flow (DCF) analysis is one of the most fundamental yet complex methods in corporate finance. This case study will take you through a full DCF valuation process, including:
- Building assumptions for revenue growth, costs, and CAPEX
- Estimating free cash flows (FCFs) and terminal value
- Choosing the right discount rate (WACC)
- Performing sensitivity analysis
This case study focuses on valuing TechVision Inc., a high-growth technology company, and challenges you to make key assumptions and model different valuation scenarios.
TechVision Inc. – Case Background
TechVision Inc. is a publicly traded software company providing cloud-based AI analytics. With a consistent annual growth rate of 15%, the company is now being evaluated by a private equity firm for a potential acquisition.
You, as an investment analyst, need to perform a detailed DCF valuation to determine TechVision's intrinsic value and compare it to its current market price.
Financial Data and Assumptions
Historical Data (Last 3 Years)
| Financials ($M) | 2021 | 2022 | 2023 |
|---|---|---|---|
| Revenue | 500 | 575 | 661 |
| EBIT (Operating Profit) | 100 | 120 | 145 |
| Depreciation & Amortization | 20 | 25 | 30 |
| Capital Expenditures (CAPEX) | (30) | (35) | (40) |
| Change in Net Working Capital (NWC) | (5) | (10) | (15) |
| Free Cash Flow (FCF) | 85 | 100 | 120 |
- Revenue Growth: 12% per year
- EBIT Margin: 22%
- Depreciation as % of Revenue: 4%
- CAPEX Growth: 8% per year
- NWC Investment: Increasing by $5M per year
- Tax Rate: 25%
- Risk-Free Rate: 3.5%
- Equity Risk Premium: 6%
- Beta: 1.3
- Cost of Debt: 5.5%
- Debt Tax Shield: 25% Tax Rate
- Perpetual growth rate (g): 3%
- Assuming TechVision's capital structure consists of 70% equity and 30% debt
1. Forecasting Free Cash Flow
Task: Using the assumptions below, project Free Cash Flow (FCF) for the next five years.
Show Formula for Free Cash Flow (FCF)
FCF = EBIT × (1 - Tax Rate) + Depreciation - CAPEX - Change in NWC
2. Calculating Discount Rate (WACC)
Task: Compute TechVision’s Weighted Average Cost of Capital (WACC) using the provided inputs.
Show CAPM Formula for Cost of Equity
Re = Risk-Free Rate + Beta × Market Risk Premium
Show After-Tax Cost of Debt Formula
Rd = Cost of Debt × (1 - Tax Rate)
Show WACC Formula
WACC = (E / (E + D) × Re) + (D / (E + D) × Rd)
3. Terminal Value Calculation
Task: Calculate the Terminal Value (TV):
Show Terminal Value Formula
TV = (FCFfinal year * (1 + g)) / (WACC - g)
4. Discounting Cash Flows to Present Value
Task: Discount the forecasted Free Cash Flows and Terminal Value to present value using WACC.
Show Discounting Formula
PV = FCFt / (1 + WACC)t
5. Sensitivity Analysis
Task: Perform a sensitivity analysis by adjusting WACC and Terminal Growth Rate.
| WACC (%) | 2.0% Growth | 2.5% Growth | 3.0% Growth |
|---|---|---|---|
| 8.0% | $85 | $90 | $95 |
| 9.0% | $80 | $85 | $90 |
| 10.0% | $75 | $80 | $85 |
Solution
The Discounted Cash Flow (DCF) valuation method is a fundamental approach to estimating a company's intrinsic value based on its expected future cash flows. This guide provides a detailed step-by-step solution to the TechVision Inc. valuation case study, ensuring even beginners can understand the concepts of cash flow forecasting, discounting, and financial modeling.
1. Understanding Free Cash Flow (FCF) Projections
Free Cash Flow (FCF) represents the amount of cash available to a company’s investors after covering operating expenses and capital expenditures (CAPEX). The standard formula for FCF is:
Show Free Cash Flow Formula
FCF = EBIT × (1 - Tax Rate) + Depreciation - CAPEX - Change in Net Working Capital
Using the assumptions from the case study, let's calculate TechVision Inc.'s projected FCF for the next five years:
| Year | Revenue ($M) | EBIT ($M) | Depreciation ($M) | CAPEX ($M) | Change in NWC ($M) | FCF ($M) |
|---|---|---|---|---|---|---|
| 2024 | 740 | 163 | 30 | (43) | (20) | 110 |
| 2025 | 829 | 182 | 33 | (47) | (25) | 120 |
| 2026 | 928 | 204 | 37 | (51) | (30) | 130 |
| 2027 | 1039 | 229 | 41 | (56) | (35) | 140 |
| 2028 | 1164 | 257 | 47 | (61) | (40) | 150 |
Each year, the free cash flow grows as revenues increase and TechVision efficiently manages costs.
2. Calculating the Discount Rate (WACC)
The Weighted Average Cost of Capital (WACC) represents the required return from both debt and equity investors. It accounts for the company’s **cost of equity and cost of debt**, weighted by the proportion of financing sources.
Show WACC Formula
WACC = (E / (E + D) × Re) + (D / (E + D) × Rd × (1 - Tax Rate))
Where:
- Re (Cost of Equity): Calculated using the Capital Asset Pricing Model (CAPM).
- Rd (Cost of Debt): The company's interest rate on debt.
- E: Market value of equity.
- D: Market value of debt.
Show CAPM Formula for Cost of Equity
Re = Risk-Free Rate + Beta × Market Risk Premium
Plugging in the case study values:
- Risk-Free Rate: 3.5%
- Equity Risk Premium: 6%
- Beta: 1.3
Re = 3.5% + (1.3 × 6%) = 11.3%
Assuming TechVision's capital structure consists of 70% equity and 30% debt with a pre-tax cost of debt of 5.5%, WACC is:
WACC = (0.7 × 11.3%) + (0.3 × 5.5% × (1 - 25%)) = 9.2%
3. Calculating Terminal Value
Beyond the forecast period, we estimate TechVision’s value using the Gordon Growth Model:
Show Terminal Value Formula
TV = (FCFfinal year * (1 + g))/ (WACC - g)
Assuming:
- Perpetual Growth Rate (g): 3%
TV = (140.03 * (1 + 3%)) / (9.2% - 3%) = $2.34622 billion
4. Discounting Cash Flows to Present Value
To determine TechVision’s intrinsic value, we discount all projected cash flows to their present value:
Show Present Value Formula
PV = FCFt / (1 + WACC)t
Discounted TV = 2346.22 / (1 + 9.15%) = $1.51461 billion
Summing the discounted values, we calculate:
- Present Value of FCFs: $425.89M
- Present Value of Terminal Value: $1.51461 billion
Enterprise Value (EV) = $1.9405 billion
5. Sensitivity Analysis
coming soon
Conclusion
This detailed DCF analysis provides insights into how future cash flows drive intrinsic valuation. By adjusting growth rates, discount rates, and WACC assumptions, investors can refine their estimates and improve decision-making.