Discounted Cash Flow Valuation: Step by Step.
Step 1. Determine our forecast period. 5 years will be about as far out as we want to go. The further out we project, the less accurate the projections will be.
Step 2. It’s important to find the free cash flows of the firm we are looking into. We will want to make a realistic projection going 5 years into the future. To find our free cash flow, we need to use the following equation: FCF = EBIT (1 - tax rate) + Depreciation – CAPX – Working Capital.
Step 3. We will also need to find our WACC to get our present value. We can do this by following this equation. WACC = (Equity / Total Capital) * Cost of Equity + (Debt / Total Capital) * Cost of Debt * (1 - Tax Rate). The weights represent the ratios of debt and equity to the total amount of capital. The cost of capital will tell us what it will cost to access the funds.
Step 4. Find CAPM. This is done with a formula that takes into account the beta value of the stock, the general market, and the risk free rate. Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate). By finding the rate of return the market is trading at, the beta, which shows us the risk level involved with a particular stock in comparison with the rest of the market (the higher the beta the more volatile the stock, where as a lower beta suggests a more stable risk) we can effectively estimate the cost of shareholder equity.
Step 5. Determine the terminal value to find the value of our company at maturity. This can be found by using the following formula: Stock value = expected dividend per share 1 year from now / (required rate of return for investor – growth rate in dividends).
Step 6. Calculate our firms enterprise value with the following written formula: Enterprise Value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.
Step 7. Subtract the company’s net debt from the enterprise value to get our fair value. We can divide our fair value by our company’s outstanding shares to find our estimated value per share and company’s worth.
Market Multiples: Step by Step.
Step 1. This method is used more to help us understand if our other methods such as DCF are on course. The first step of this valuation process involves finding comparable companies with similar business operations as our target company. We need to know how our target company creates value, who are its customers and suppliers, and what drives its financial performance. To protect against bias in this selection process, we should make sure we use a systematic selection process before the selections begin. The screening process should progressively narrow down the field of companies from an entire range of relevant companies. The early screening is all inclusive and can be done through Bloomberg’s or Standard & Poor’s Compustat using 3 digit SIC codes. The next step in the screening process will attempt to exclude companies based on criteria such as geography, size, or having a 4 digit SIC code. Once we have the companies narrowed down to a manageable size, we can begin analyzing their financials, SEC filings, life cycle stages, and varying customer bases. Market multiples can be used to calculate the company’s equity value rather than its enterprise value. These multiples…