What is DCF Modeling?
A discounted cash flow model (“DCF model”) is a specific type of financial model for valuing a business. It values a company by forecasting its’ cash flows. But also by discounting the cash flows to arrive at current, present value. Valuing companies using the DCF is a core skill for investment bankers, private equity, equity research analysts, and investors.
How to calculate Equity Value per share?
Eventually, here are the steps you need to take to build a DCF financial model from scratch and calculate the Equity Value per share:
Step 1. Derive historical information from financial statements.
Step 2. Calculate historical value drivers.
Step 3. Make assumptions for the projected value drivers.
Step 4. Calculate projected line items for the model.
Step 5. Calculate Equity Value per share.
You can find the details of how to build the first four steps in our article “5 steps to building a DCF financial model”.
In this article, we’ll tell you how to build the final fifth step.
What is WACC?
WACC (weighted average cost of capital) is the rate that a company should pay on average to all its security holders to finance its assets. The WACC commonly refers to as the firm’s cost of capital. Moreover, it is the external market and not the management that dictates that.
Here’s the formula to calculate WACC:
WACC = (Cost of equity * Equity as a % of total capital) + (Post-tax cost of debt * Debt as a % of total capital)
In our sample model, we found through research that WACC is 8.8%.
What is the Terminal growth rate?
The terminal growth rate is a percentage that represents the expected growth rate of a firm’s free cash flow. The terminal growth rate = GDP growth rate in two cases. First, it’s if your industry is in the mature state (not growth, not decline). Second, your company’s market share will remain stable.
In our sample model, we found through research that the terminal growth rate is 6%.
What is Unlevered Free Cash Flow?
Unlevered Free Cash Flow is the gross free cash flow that a company generates. Leverage is another name for debt, and if one levers the cash flows, that means they are net of interest payments. The formula for UFCF is:
Unlevered FCF = EBITDA – CapEx – Working Capital – Tax Expense
Unlevered FCF = Net Income + D&A – Capex – Working Capital.
We have calculated UFCF in step 4. Therefore, we will use it in our final calculation for step 5.
1. Calculate Net Present Value of Unlevered Free Cash Flow
First thing we would need to do in step 5 is to calculate the NPV of UFCF.
Net present value (NPV) is the calculation for finding today’s value of a future stream of cash flows. It accounts for the time value of money. The concept that money available at the present time is worth more than the identical sum in the due to it.
Therefore, we need to use Excel function NPV here.
=NPV (rate, value1, [value2], …), where:
rate – Discount rate over one period.
value1,2 – Values representing cash flows.
You can find the calculation of the NPV of Unlevered free cash flow for our model in the screenshot below:
2. Calculate Terminal Value of the company
Terminal value (TV) is the value of a business or project beyond the forecast period when future cash flows can be estimated. Terminal value assumes the business will grow at a set growth forever after the forecast period.
Here’s the formula to calculate terminal value:
Terminal Value = (Unlevered FCF for the last projected year* ( 1 + Growth Rate ))/ ( WACC – Growth Rate)
You can find the calculation of Terminal Value for our sample model in the screenshot below:
3. Calculate Present Value of the Terminal Value
Present Value (PV) of Terminal Value (TV) brings calculated Terminal Value into today’s dollar amount.
We need to use the Excel function PV here.
=PV (rate, nper, pmt, fv)
rate – The interest rate per period (WACC)
nper – The total number of payment periods (5 years for our model)
pmt – The payment made each period (0 in our case)
fv – Future Value (Terminal Value
You can find the calculation of the present value of terminal value for our sample model in the screenshot below:
4. Calculate Enterprise Value of the company
Enterprise Value (EV) is the measure of a company’s total value. It looks at the entire market value rather than just the equity value. So, all ownership interests and asset claims from both debt and equity are included.
Here’s the formula to calculate enterprise value for financial models:
Enterprise Value = NPV of Unlevered FCF + PV of Terminal Value
You can find the calculation of enterprise value for our sample model in the screenshot below:
5. Equity Value calculation
Equity Value is the value of a company available to owners or shareholders. It is the enterprise value plus all cash and cash equivalents, short and long-term investments. Then, we subtract all short-term debt, long-term debt, and minority interests.
Here’s the formula to calculate equity value:
Equity Value =Enterprise value – Debt + Cash
You can find the calculation of equity value for our sample model in the screenshot below:
6. Equity Value per Share
The final step of our DCF Financial Model is to calculate the Equity Value per share.
Here’s the formula to calculate equity value per share:
Equity Value per share = Equity Value/ Number of Shares Outstanding
You can find the calculation of equity value per share for our sample model in the screenshot below:
What to remember about Equity Value per share in DCF models?
Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.
To remember the logic of building DCF or any other financial model think of four quadrants. You need to build them one after another. Take the historical data from financial statements then, historical value drivers. The next step is to take the projected value drivers and, finally, the projected line items). Then build necessary calculations on top of that.
Have a look at the steps to calculate equity value per share. We make these calculations after the first four steps of the model (four quadrants):
- Net Present Value of Unlevered Free Cash Flow
- Terminal Value of the company
- Present Value of the Terminal Value
- Enterprise Value of the company
- Equity Value calculation
- Equity Value per Share
To follow the logic and learn how to build financial model hands on step by step, play KeySkillset educational game Financial Modeling.