CONFIDENTIAL

Training Material Investment Banking Valuation

April 2004

DELIVERING PROCESS INNOVATION

DCF Analysis: Overview

The DCF analysis is based on the premise that ownership is essentially a claim on the cash flows generated by a firm's assets. The method entails estimating the unlevered free cash flows (FCF) available to all investors and discounting these cash flows back to the present using an appropriate cost of capital to arrive at a present value for the assets (Enterprise Value). The assets may be financed in a multitude of different ways but because the returns generated by these assets are available to all providers of capital, and to avoid distortions caused by a particular capital structure, the cash flows should be considered on an unlevered basis, i.e., free from financing considerations. The company's operations value (prior to adjustments for non-operating assets) can be broken down into 2 components:
PV of free cash flows up to a cut point for terminal value calculation PV of terminal value
Company value = PV(FCF) =
n

FCFt (1+r)t

TV (1+r)n

t=1

The discount rate r is the Weighted Average Cost of Capital (WACC) which reflects the required returns by both debt and equity investors for investments with the same risk profile Summary Bullet
1

DCF Analysis: Overview

Discounted cash flow (DCF) analysis is a theoretical valuation technique which values a company as the discounted sum of its:
Unlevered (before financial costs) free cash flows (this is not operating cash flow) over some

forecast period (usually 5 years), and

Terminal value at the end of the forecast period (Year 5)

Terminal Value
Terminal value is the projected value of the company at the end of the forecast period. Terminal

values are most often derived by assuming the business is sold for some multiple of earnings or cash flow. Alternatively, terminal values can be calculated based on the ongoing perpetual value of the companys cash flows beyond the forecast period

Terminal values may be calculated in one of several ways:

Comparable company multiples of Year 5 cash flow, operating income, net income, etc. Comparable acquisition multiples of Year 5 cash flow, operating income, etc. Perpetual value of cash flows after Year 5 f Perpetual value = (final year free cash flow x growth rate)/(discount rate - growth rate)

The cash flow stream and terminal value are discounted at the companys appropriate weighted average cost of capital Discount rates are generally based on the weighted average cost of capital of companies in similar businesses to reflect the relative riskiness (i.e. variability) of the projected cash flows
2

DCF Analysis: The Process

Step 1

Projections

Project the operating results and free cash flows of a business over the forecast period.

Step 2

Terminal Value Estimate the terminal value of the business, often by using exit multiples, at the end of the forecast period.
Step 3

Discount Rate

Use the weighted average cost of capital to determine the appropriate discount rate range. Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present. Adjust your valuation for all assets and liabilities not accounted for in cash flow projections.

Step 4

Present Value

Step 5

Adjustments

Step 1: Projections
The free cash flows from a business can be projected using information about the industry in which a business operates and information specific to the business.
DCF analysis is an attempt to look at the companys pure operating results free and clear of

financial leverage, extraordinary items, discontinued operations, etc.

f It is also extremely important to look at the historical performance of a company or business

to understand how future cash flows relate to past performance.

A companys discounted free cash flows represent the cash generating ability of a particular

company, regardless of its capital structure. As a result, free cash flows are projected on an unlevered basis before subtracting interest and financing expense.
DCF projections should be based on: f Historical performance f Company projections f Equity research analyst estimates f Industry data f Common sense

Step 1: Projections
Components of Unlevered Free Cash Flow
Unlevered Free Cash Flow is the unlevered after-tax cash flow generated by the Company (including the impact

of any reinvestment). Free Cash Flow is available to all providers of the Companys capital, both creditors and shareholders
Unlevered free cash flow is best determined by considering sources and uses of cash f It is free from financing considerations, i.e., it assumes that company is 100% equity financed

Calculation of Unlevered Free Cash Flow EBIT + Taxes on EBIT Depreciation and Amortization Capex Increase / (Decrease) in net working Capital Any other change in the companys financials which cause the company to spend cash or to be a source of cash Unlevered free Cash Flow = + + + -

Calculation of Unlevered Free Cash Flow Net Income After-Tax Interest Expense Deferred Tax Expense Depreciation and Amortization Capex Increase / (Decrease) in net working Capital Any other change in the companys financials which cause the company to spend cash or to be a source of cash Unlevered free Cash Flow

Step 1: Projections Sanity Checks on FCF

Confront sales growth assumptions with underlying market industry dynamics
Does the increase in sales reflect a constant market share in an expanding market? If so, why

is the market expanding? Does that assumption agree with industry projections? If it is an expanding market, why will the company be able to maintain a constant market share? Or does the increase reflect a rising market share in a stagnant market? If yes, why? Are some firms leaving the industry? Why? etc. Check reasonableness of Gross and EBIT margins
Avoid hockey sticks. Be clear on the required actions which will cause improvement in

margins (or reasons for decrease in margins). Are the margin levels consistent with structure of competition? Any risk of new entrants/substitute products that will drive margins down? etc. Capital Expenditures
Watch out for step-up of production capacity required as sales increase. Is CAPEX level

sufficient for increase in sales? Factor in impact of industry trends on CAPEX (i.e., increased environmental expenditures, technology changes, etc.)

Step 1: Projections Sanity Checks on FCF

Working Capital
Are inventory and other working capital forecasts consistent with the sales increase? What is the pattern in receivable collection period? How is it practically achieved? Assess bargaining power of customers (receivable terms) and suppliers (account payables) Are your assumptions in line with industry standards? etc.

Be Critical About Buyer and Seller's Projections

Use due diligence/access to seller's management to gain in-depth understanding of company's

assumptions and challenge them, (if appropriate) on the basis of your analyses
Compare also for instance company's past record of actual versus budgeted results. Add value/ manage client's expectations (both on buy and sell sides) by thorough

understanding of the company's market dynamics and competitive positioning. Be Realistic About Synergies
When developing a business case, avoid general optimistic statements about synergies. Be as

specific as possible about nature and level of cost savings.

Take into account time to implement cost cuttings/achieve synergies Consider also costs related to merger such as severance pay, plant shutdown costs that can

diminish synergy benefits.

Step 2: Determination of Terminal Value

Terminal Value Calculation
Since DCF analysis is based on a limited forecast period, a terminal value must be used to

capture the value of the company at the end of the period. The terminal value is added to the cash flow in the final year of the projections and then discounted to the present.
A company value, based on expected FCF, can be separated into two components:

Company Company Value Value

PV PV of of FCF FCF during during explicit explicit forecast forecast period period

PV PV of of FCF FCF after after explicit explicit forecast forecast period period

The second component is the continuing or terminal value. The ideal DCF analysis forecasts free cash flows far enough into the future (e.g., 20 years or

more) so that the present value of the terminal value does not constitute a large percentage (e.g., over 40%) of firm value
Terminal value can be estimated using exit multiples, cash flow approaches (perpetuity formula)

or other approaches such as liquidation or break-up value, replacement cost, etc.

Step 2: Determination of Terminal Value

Comparable Multiples Method Use multiples that produce an enterprise value.
Litmus test: Has interest been subtracted before I arrived at this figure? f If yes: the multiple gives EQUITY value (for instance, BV) f If no: the multiple gives an ENTERPRISE value (Sales, EBITDA, EBIT) Exit strategy in final forecast year drives the selection of multiples f IPO assumption: Comparable company trading multiples f Sale assumption: Comparable acquisition multiples Typically final years EBITDA is used

Commonly used method because conceptually easy to implement and to explain. Be aware of circular reasoning (I am putting a value on what I am trying to value!) and theoretical difficulties in predicting multiples at the end of the forecast period. Provide a range of multiples (i.e., implied valuation for say 6.0x, 7.0x and 8.0x EBITDA) to increase reasonableness of results.

Step 2: Determination of Terminal Value

FCF Perpetuity - Growth Rate Method
Perpetuity formula based calculations implicitly assume that you will own the company and be

entitled to the FCF to perpetuity (theoretically more correct than multiple approach).
Assuming that Cash Flow after explicit forecast period grow at a constant rate, the value of the

terminal value is given by the growing FCF perpetuity formula: FCFn: r-g r: g: n: Discount rate Perpetual growth rate of FCF Forecast horizon (terminal year) consumption growth for the industry's products plus inflation (starting point could be forecasted nominal GNP growth).
Cross check the reasonableness of your terminal value calculation by linking the multiple and

Free Cash Flow in year n

TVn = FCFn*(1 + g)

Perpetual growth rate must be realistic. It can be estimated as the expected long-term rate of

perpetuity methods (i.e., calculate implied perpetual growth rate for a range of EBITDA multiples or conversely check how the perpetual growth rate translates into EBITDA multiples) at different discount rates.

10

Step 3: Determination of Discount Rate

The discount rate is a function of the risk inherent in any business and industry, the degree of uncertainty regarding the projected cash flows, and the assumed capital structure.
In general, discount rates vary across different businesses and industries. The greater the uncertainty about the projected cash flow stream, the higher the appropriate

discount rate.
Providers of capital (both debt and equity investors) in any given industry require returns

commensurate with the perceived riskiness of their investment. The best measure of the riskiness of projected cash flows and the best way to determine the correct range of discount rates is the weighted average cost of capital (WACC) of similar businesses.
WACC should be thought of as the opportunity cost of capital, the return an investor expects to

earn in an alternative investment of equivalent risk.

The WACC to be used in a DCF analysis is specific to the asset being valued, and should

depend neither on how the asset will be financed nor on the potential buyers or sellers cost of capital. The relative weights applied to the costs of equity and debt used in computing WACC for an asset represent the optimal capital structure for that asset

11

Step 3: Weighted Average Cost of Capital (WACC)

Mathematical Expression of WACC
WACC(1) = Cost of = Equity(2) Levered = Beta
(3) After-tax Cost of Debt

x +

Proportion of Debt in Capital Structure

Cost of Equity

Proportion of Equity in Capital Structure

Risk-Free Rate

Levered Beta

Equity Market Risk Premium

Unlevered Beta

1 + (1 - Tax Rate) x (Debt/Equity Ratio)

Intuitively, we have to pay our equity holders their required rate of return and we have to pay our

debt holders their required rate of return.

f Because dividends the theoretical absolute return to an equity holder are not tax-

deductible, our true cash cost of equity is reflected as a pre-tax result. reflected as an after-tax result.

f Because interest the return to a debt holder is tax-deductible, our true cash cost of debt is To determine the WACC of a company, one must ascertain for a target capital structure, the

costs of the various sources of capital for the company.

(1)Assumes capital structure is only debt and equity. Other sources of capital (i.e. preferred stock) would need to be included if present. (2)Cost of Equity calculated using the Capital Asset Pricing Model (CAPM). (3)Assumes beta of debt is zero. Correct formula is: BetaUNLEV EQ = BetaDEBT x (D x [1 t]) / [E + D x (1 t)] + Beta LEV EQ x E / [E+ D x (1-t)].

12

Step 3: WACC Target Capital Structure

Prior to calculating the cost of equity and debt for the company you are valuing, you need to define a target capital structure based on the appropriate market value weights (i.e., D/D+E and E/(D+E)) for the WACC calculation. The target capital structure should reflect the debt to equity ratio that is expected to prevail over the life of the business. You can use a combination of the following three approaches:
Estimate the current market value based capital structure of the company. f Estimate the market values of the debt and equity components of the capital structure and review how they

have changed over time. If a company's common stock is publicly traded and its other source of financing is traded corporate bonds, just multiply the number of each type of outstanding security by its respective market price. If the debt is not traded, estimate the market value by comparing with publicly traded similar debt. If the company is not traded, use the other two approaches.
Review the structures of comparable companies. f Assess the average market capital structure prevailing in the company's sector, which provides a good

indication of a capital structure for your company.

Review the management's financing philosophy. f When possible, discuss with the management their financing policy and their explicit or implicit target capital

structure on a normalized basis. If you don't have access to management, look for any statements in press, research reports, annual report, etc. that give hints on the company's medium to long term financing objectives.

13

Step 3: WACC Conceptual Issues

Various challenges exist in calculating a cost of capital that is entirely consistent with finance theory. In reality most practitioners use judgment and approximations. Some of the issues one comes across often:
The Risk Free Rate f Theory recommends using a true risk-free rate that has the same term as the cash flows

projected.

f Since long bond rates have intrinsic interest rate risk factored in, theorists suggest making a

liquidity adjustment to the long bond rate representing the term premium implicit in those rates. This is, however, rarely done in practice by Wall Street.

The equity risk premium f The equity risk premium must be consistent with the risk-free rate. For example, if your risk

free rate is the 20-year bond, the risk premium must represent return in the equity market relative to the 20-year bond.

f Ibbotson, the most commonly referred-to source, uses actual annual stock market returns

since 1926 to compute the equity risk premium. Some argue that use of this period overestimates the premium, and that data over a more recent period would suggest a lower premium. Goldman Sachs Equity Research: 3.5% CSFB Equity Research (April 1999): 4.3% Ibbotson (long-term, from 19261998): 8.0%

f Equity premia from as low as 3.5% to 8.0% are used on the Street.

14

Step 3: WACC Conceptual Issues

Various challenges exist in calculating a cost of capital that is entirely consistent with finance theory. In reality most practitioners use judgment and approximations. Some of the issues one comes across often:
Beta f Beta represents a measure of the systematic (as opposed to unique or diversifiable) risk that

exists in an asset, and is central to the CAPM.

f Beta = COV[Rasset, Rmarket] / VAR[Rmarket], or equivalently

= CORR[Rasset, Rmarket] x STDasset / STDmarket

f Historical betas of publicly traded equity securities can be calculated based on an analysis of

the actual returns on the security vs. the actual market returns.

f Unfortunately, historical betas can be poor predictors of expected beta, which is what we

need in our analysis. public companies.

f BARRA, a financial research firm to which CSFB subscribes, computes predicted betas for f There are many sources for beta: BARRA, Bloomberg, Value Line. Levering / Unlevering Beta f Observed betas of companies are by definition levered (to the extent the companies have

debt). Unlevering is required to arrive at the beta of the assets (as opposed to the equity) of the company.

f Increasing leverage will, according to theory, increase the beta of a firms equity and hence

its cost of equity. Theorists differ on the most appropriate adjustments to make for the effects of leverage.
15

Step 3: WACC Unlevering Beta

The formula presented previously is the one we use at CSFB and is perhaps the most widely recognized (and also the simplest). unlevered = U =

comp

comp 1 + (1 - ) * D comp E

Where:

is the tax rate

Dcomp the market value for the debt and Ecomp the market value of the equity

The comp is based on market returns, not book returns. That is why you should unlever this using the

market value of equity and debt for the comparable.

If the market value of debt is not easily calculated, use the book value of debt. Once you have the u for the company, you have to relever it with the debt to equity ratio you have chosen for

your company or asset:

f levered=u* (1+(1- ) * D/E) f where D/E is our target debt to equity ratio

16

The Recommended Way

In practice we make the following assumptions:
Risk Free Rate f 30 year US Treasury coupon bond yield for US WACC calculation. WACC calculation for

international assets, particularly emerging market assets, is harder and has to be considered on a case-by-case basis.

Tax Rate f Marginal tax rate (usually 35%). Cost of Debt f Risk free rate + current corporate spread over treasury for comparable credits. Optimal Debt/Equity f Average of ratio of debt and equity market capitalization of selected comparable companies. Beta f Simple average of unlevered predicted betas of comparable companies as derived from

BARRA levered predicted betas (available on-line).

Equity Market Premium f Ibbotson equity market premium (approx 8.0%), calculated based on historical return of

equity market relative to 30 year treasury bond.

In general, WACC calculation is not a science; there are no exact answers, judgment and reality checks are essential

17

Step 3: Example WACC Analysis

Assumptions Risk Free Rate Assumptions: US Treasury Bond Rate: Country Risk Spread Risk Free Rate: Corporate Credit Premium: Estimated Pre-tax Cost of Debt: Industry Statistics Comparable Companies ANADARKO PETROLEUM APACHE CORP BURLINGTON RESOURCES ENRON OIL & GAS KERR MCGEE NOBLE AFFILIATES UNION PACIFIC RESOURCES UNION TEXAS PETROLEUM UNOCAL VASTAR RESOURCES Average Cost of Capital Levered Beta (5) 0.63 0.61 0.55 0.53 0.61 0.56 0.45 0.64 0.59 0.53 0.57 Debt 1,109.7 1,405.1 1,800.0 824.8 713.2 695.0 5,058.7 891.3 2,949.0 715.7 Market Debt/Market Levering Unlevered Cap.(6) Cap. Ratio Factor (7) Beta (8) 4,021.0 3,105.8 7,570.9 3,136.0 2,756.4 2,146.4 4,487.7 2,505.2 8,885.4 4,291.8 27.6% 45.2% 23.8% 26.3% 25.9% 32.4% 112.7% 35.6% 33.2% 16.7% 37.9% 3.6% 2.3% -2.1% Debt/ Capital 0.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0% 1.18 1.29 1.15 1.17 1.17 1.21 1.73 1.23 1.22 1.11 4.1% 2.6% -1.6% 0.54 0.47 0.47 0.46 0.52 0.46 0.26 0.52 0.48 0.47 0.47 4.6% 3.0% -1.1% 5.1% 3.3% -0.6% 5.6% 3.6% -0.1% 6.1% 3.9% 0.4% 6.6% 4.3% 0.9% 7.1% 4.6% 1.4% 7.6% 4.9% 1.9% 8.1% 5.2% 2.4% 5.67% (1) 0.00% (3) 5.67% 0.40% (4) 6.07% Equity Risk Premium: Tax Rate (Foreign): Tax Rate (U.S.): 7.40% (2) 33.00% 35.00%

Pre-tax Cost of Debt After-tax Cost of Debt Corp. Credit Spread Debt/ Equity 0.0% 25.0% 33.3% 42.9% 53.8% 66.7% 81.8% 100.0% 122.2% 150.0% 185.7% 233.3% Average Unlev'd Beta 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 Levering Factor 1.00 1.17 1.22 1.29 1.36 1.45 1.55 1.67 1.82 2.01 2.24 2.56 Levered Beta (9) 0.47 0.54 0.57 0.60 0.63 0.67 0.72 0.78 0.85 0.93 1.05 1.19 Cost of Equity (10) 9.1% 9.7% 9.9% 10.1% 10.4% 10.7% 11.0% 11.4% 11.9% 12.6% 13.4% 14.5%

Debt/ Capital 0.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0%

9.1% 8.2% 8.0% 7.8% 7.5% 7.3% 7.1% 6.9% 6.6% 6.4% 6.2% 6.0%

9.1% 8.3% 8.1% 7.9% 7.7% 7.5% 7.2% 7.0% 6.8% 6.6% 6.4% 6.2%

9.1% 8.4% 8.2% 8.0% 7.8% 7.6% 7.4% 7.2% 7.0% 6.8% 6.6% 6.4%

WEIGHTED AVERAGE COST OF CAPITAL (11) 9.1% 9.1% 9.1% 9.1% 9.1% 8.4% 8.5% 8.5% 8.6% 8.7% 8.2% 8.3% 8.4% 8.5% 8.6% 8.1% 8.2% 8.3% 8.4% 8.5% 7.9% 8.0% 8.1% 8.2% 8.3% 7.7% 7.8% 8.0% 8.1% 8.2% 7.5% 7.7% 7.8% 8.0% 8.1% 7.4% 7.5% 7.7% 7.8% 8.0% 7.2% 7.4% 7.5% 7.7% 7.9% 7.0% 7.2% 7.4% 7.6% 7.8% 6.8% 7.0% 7.3% 7.5% 7.7% 6.7% 6.9% 7.1% 7.3% 7.6% (7) (8) (9) (10)

9.1% 8.7% 8.6% 8.6% 8.5% 8.4% 8.3% 8.2% 8.1% 8.0% 7.9% 7.8%

9.1% 8.8% 8.7% 8.6% 8.6% 8.5% 8.4% 8.3% 8.3% 8.2% 8.1% 8.0%

(1) 30-year US Treasury Bonds as of June 22, 1998. (2) Average historic spread, based on the arithmetic mean, between common stock returns and long-term US Gov't bonds (Ibbotson Associates, 1/96). (3) Credit Suisse First Boston Estimate. (4) Based on average Spread to 10-year Treasury for AAA and A rated industrials. (5) July 1997, Barra US Equity Beta Book predictions. (6) Stock prices as of June 26, 1998.

Levering Factor: 1 + [( 1 - tax rate ) * (Debt / Equity Market Value Ratio Unlevered Beta: ( Beta / Levering Factor ). Levered Beta: ( Beta * Levering Factor ). Cost of Equity (Re): Re = Rf + Beta * (Rm - Rf), or the risk free rate plus beta times the eq (11) WACC: Rd = Return on Debt Re = Return on Equity WACC = [ Rd * (1 - tax rate ) * ( D / ( D + E ) ] + [ Re * ( E / ( E + D ) ]

18

Step 4: Present Value

Mechanics of Discounting
Time Value of Money A dollar today is worth more than a dollar tomorrow. Discounting The process of finding the present value of a future sum Very Simple Example (Assume the WACC is 10%.)
Year 1 2 3 4 5

Cash Flow Discount Rate Discount Factor Disconted Value NPV

$10.0 10% 0.909 $9.09 $71.53

$15.0

$20.0

$24.0

$30.0

0.826 $12.40

0.751 $15.03

0.683 $16.39

0.621 $18.63

The total NPV is the sum of the present values of the individual cash flows. The NPV calculation assumes that cash flows occur at the end of the period.

Mid-Year Convention

Assuming that cash flows are received at mid year (i.e., spread evenly over the

year) comes down to moving all cash flows by half a period

This amounts mathematically to multiplying by (1+WACC) the NPV calculation.

19

Step 5: Corporate Adjustments

DCF analysis calculates the Enterprise Value (Adjusted Market Value) of a company.

Value of the Company

The Equity Value (Market Value) of a company is the Enterprise Value less Corporate Adjustments.
Corporate Adjustments include the companys net debt plus other obligations, less other

assets not included in the DCF + + + + + + Long Term Debt (including current portion) Short Term debt Minority Interest Preferred Stock Capitalized Leases Contingent Liabilities Cash Cash Equivalents Investments in Affiliates Value of other assets not in DCF

The Equity Value per diluted share is the Equity Value divided by the number of fully-diluted shares.
Number of diluted shares = Basic shares + shares underlying in the money exercisable

options / warrants + shares from the conversion of in the money convertible debt and convertible preferred stock
Incremental common-equivalent shares are typically calculated using the treasury stock

method.

20

Conclusions
The commonly used DCF method consists in estimating the after tax free cash flows available

to all investors and discount them back to the present at the Weighted Average Cost of Capital (WACC)
The DCF analysis is as good as the projections used. You should step back from the numbers

by doing repetitively sanity checks and thinking through the implications of your assumptions
Produce a set of sensitivity analysis on the key model variables to bound the company's

(intrinsic) value
Particular care should be given to the last year of the explicit forecast period and the calculation

to the terminal value as it often represents a significant portion of the total value of the company. Terminal value can be calculated using exit multiples and perpetuity approaches. Ideally, you should develop the two approaches independently and compare the results obtained
The WACC reflects the opportunity cost for each type of investors, i.e., the respective rates of

return these investors could expect to earn on other investments of equivalent risk. The Capital Asset Pricing Model (CAPM) establishes a simple relationship between risk and return which allow to estimate the cost of equity of a project/company for a given risk level
The value obtained by discounting the free cash flow and the terminal value should be adjusted

for non-operating assets or liabilities to yield the firm's asset value. The equity value is then derived by deducting all non working capital debt and obligations

21