DCF AAPL Course Manual PDF

WALL STREET PREP CORE MODELING COURSE
Discounted
Cash Flow (DCF)
Modeling
CASE STUDY: APPLE
v W W W. WA L L S T R E E T P R E P. C O M
Usage & Terms
Usage
• This is a supplementary document to be used with a Wall
Street Prep boot camp or online course.
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2
Licensed to Norman Berube. Email address: nberube@email.com
Table of Contents
Chapter 1: Overview............................................................4
Chapter 2: DCF Mechanics ...............................................14
Chapter 3: DCF Modeling..................................................48
Chapter 4: Diluted Shares Outstanding............................78
Chapter 5: WACC.............................................................111
Chapter 6: Finishing Touches.........................................140
Chapter 7: Bells and Whistles……………...........................156
Chapter 8: Appendix, Cash in Valuation.........................165
Chapter 9: Appendix, Value Drivers................................169
3
DCF Modeling
Overview
Overview
Introduction
• Valuation
• Fundamentals of a DCF
• Valuing a real company using the DCF
• Advanced DCF valuation issues
5
Overview
Valuation perspectives
• You buy a house (investment property)
• What do you most care about?
• Equity value or total value?
• Original price (book value) or current value?
• To determine current value, do you look at comps or
discount future cash flows?
• The same questions apply to businesses
6
Overview
Valuation
• I decide to start a hot dog business
• Before I can sell hot dogs, I secure
financing - $500k with debt and $450k
with equity
Liabilities
Debt $500k
Assets
Cash: $950k I incorporated my company and
Equity
$450k arbitrarily issued myself 90k
shares. Since my equity value is
$450k, I record the value of
each share as $5.
7
Overview
Equity value vs. Enterprise value

• I use some of the cash to purchase inventories /
equipment
• $20k of the equipment purchased was not paid for with
cash; instead, it was invoiced.
• This put a $20k A/P liability on my B/S
Liabilities
Assets A/P $20k
Cash: $50k Debt $500k
Inventory: $500k
PP&E: $420k Equity
$450k
8
Overview

• Enterprise value: value of the operating business
(operating assets minus operating liabilities)
• Operating assets: Usually all assets except for cash &
other investment assets
• Operating liabilities: Usually all liabilities except for
debt & debt-like liabilities
• Rather than treating cash as an operating asset, it is
netted against debt (net debt)
9
Overview
Using the B/S below, answer the following:

Total assets 970 Enterprise
value
Total liabilities 520 Net debt
Equity value 450 Equity value
Liabilities
Assets A/P $20k
Cash: $50k Debt $500k
Inventory: $500k
PP&E: $420k Equity
$450k
10
Overview

• Enterprise value – net debt = Equity
value is just a slight re-formulation
of the basic accounting equation
Assets -liabilities = Equity
Enterprise value ≠ the
value of the entire
business
• This is a common way to discuss It measures only the
value, so make sure you are value of the core
operations, whereas
comfortable with the basic intuition equity value measures
the portion of the entire
business that belongs
to equity
11
Overview
Book value vs. Market value

• Does our hot dog stand really have equity of $450 and an
enterprise value of $900?
• Most businesses are worth more than their book values
• What tools do we have to determine the value of the
business?
• For a publicly traded company, the equity market value is
readily observable via the company’s share price x shares
outstanding (market capitalization), but how do investors
determine the right price?
12
Overview
Book value vs. Market value
Book value vs. market value

• Google has an equity book value of $104b per the
company’s 2014 10K
• Google shares trade at $500
• With 680m shares outstanding, this implies an equity
market value (market cap) of $340 billion
• Google has $60b in cash, $5b in debt per the company’s
2014 10K, implying (market) enterprise value of $340b +
($5b-$60b) = $285b
13
DCF Modeling
DCF Mechanics
DCF Mechanics
Intrinsic value (DCF) vs. Relative value (Comps)

• Two frameworks for valuation: Most common valuation
approaches
Intrinsic valuation (DCF) is
derived from the fundamental
Relative
analysis of the company’s cash Intrinsic (DCF)
(Comps)
flow generation potential
• Relative valuation (“comps”) is derived by comparing a
company to its comparable peers.
• DCF and comps seem quite different but they’re actually
very related – in theory a DCF should yield the same value
as comps (but rarely does)
15
DCF Mechanics
DCF valuation
• DCF values a business as the sum of all the cash flows it
will generate, discounted to the PV at a rate that reflects
the riskiness of the cash flows
• Cash flows = Operating cash flows – cash reinvestment
• Discount rate: The required rate of return for the investors
and is a function of the riskiness of the cash flows
௧ୀ௡
‫ݓ݋݈݂ ݄ݏܽܥ‬௧
ܸ݈ܽ‫ = ݁ݑ‬෍ ௧
1 + ݀݅‫݁ݐܽݎ ݐ݊ݑ݋ܿݏ‬
௧ୀଵ
16
DCF Mechanics
DCF valuation
Effect on value
(higher/lower?)
Increase cash flows
Increase in discount rate
17
DCF Mechanics
DCF valuation
Effect on value
(higher/lower?)
Increase cash flows Higher
Increase in discount rate Lower
18
DCF Mechanics
DCF mechanics
• It is January 1, 2015. Your hot dog stand is
expected to generate $10,500 in 2015, and
cash flows are expected to grow 5% each
subsequent year
• Assuming a discount rate (r) of 10%, and
that all cash flows are generated at the end
of the period, what is the present value of
cash flows generated in the first 5 years?
19
DCF Mechanics
DCF mechanics
Cash flow /
Year Cash flow (1+r)t
2015 $10,500.0 $9,545.5
2016 11,025.0 9,111.6
2017 11,576.3 8,697.4
2018 12,155.1 8,302.1
2019 12,762.8 7,924.7
Sum: $43,581.21
20
DCF Mechanics
DCF mechanics
• How do you value a business with
perpetual cash flows?
• We use a well-established perpetuity
formula in mathematics:
‫ݓ݋݈݂ ݄ݏܽܥ‬௧ାଵ
ܸ݈ܽ‫݁ݑ‬௧ =
݀݅‫ ݎ ݁ݐܽݎ ݐ݊ݑ݋ܿݏ‬െ ݃‫)݃(݁ݐܽݎ݄ݐݓ݋ݎ‬
• Note the growth rate cannot be larger than discount rate
21
DCF Mechanics
DCF mechanics
• It is January 1, 2015. Your hot dog stand is
expected to generate $10,500 in 2015,
and cash flows are expected to grow 5%
each subsequent year, in perpetuity
• Assuming a discount rate (r) of 10%, and
that all cash flows are generated at the end
of the period, what is the present value of
cash flows generated in perpetuity?
22
DCF Mechanics
DCF mechanics
$10,500
Value2015 = = $210,000
(10% - 5%)
23
DCF Mechanics
DCF mechanics
• In practice, you will often have Cash
Year flow
explicit forecasts for a few
2015 10,500
years, and then you’ll have to 2016 13,000
make simplifying assumptions 2017 15,000
beyond this period. 2018 17,500
2019 20,500
• Based on the forecasts on the
Perpetual % growth
right and assuming all cash thereafter 5%
flows are generated at the end Discount rate 10%
of the period, what is the
present value of the hot dog
stand?
24
DCF Mechanics
DCF mechanics
Hot dog stand: DCF analysis

Comments
Discount rate 10%
Perpetual growth rate 5%
Year 2015 2016 2017 2018 2019

Period 1 2 3 4 5
Cash flow $10,500 $13,000 $15,000 $17,500 $20,500
Present value (PV) of cash flow 9,545.5 10,743.8 11,269.7 11,952.7 12,728.9 Cash flow/(1+discount rate)period
2020 cash flow 21,525.0 2019 cash flow * (1+perpetual growth rate)
Perpetuity value in 2019 430,500.0 2020 cash flow / (discount rate - perpetual growth rate)
PV of perpetuity value 267,306.6 Perpetuity value / (1+discount rate)5
DCF value (PV of all cash flows) 323,547.2 PV of perpetuity value + sum of 2015-2019 PV of cash flows
25
DCF Mechanics
DCF in contrast to comps

• We valued our business at $323,547 based on a DCF
valuation approach. We could have valued the hot dog
stand by looking at the value of comparable businesses:
• In comps, values are typically compared relative to a
measure of the firm’s profitability (EV/EBITDA, P/E, P/B):
• These ratios are called multiples; which facilitate
comparisons for companies of different size, leverage and
other characteristics
26
DCF Mechanics

• Assume three nearly identical hot dog stands were sold:
• Comp 1: Sold for $260,000, 2015 cash flows of $10,000
• Value your hot dog stand using a comps approach
27
DCF Mechanics

Hot dog stand: Comps
Cash flow Sales price Multiple
Comp 1 10,000.0 260,000.0 26.0x
Comp 2 14,000.0 380,000.0 27.1x
Comp 3 6,000.0 150,000.0 25.0x
Peer group mean 26.0x
Our hot dog stand 10,500.0

Comps-derived multiple 26.0x
Implied value 273,500.0
• Which approach is best? Pros/cons?

• DCF valuation should equal relative valuation in theory
• Theoretically, market should value at intrinsic value (but
often doesn’t)
28
DCF Mechanics
DCF advantages in contrast to comps

• Widely used in practice and respected
academically
• Theoretically, very sound method of
valuation
• Can value individual pieces of
business / synergies
• Not influenced by current market pricing
• Counter-argument: isn’t the market best way to value
business?
29
DCF Mechanics
DCF implementation challenges

• No real consensus on implementation –
estimating cost of equity is controversial
• Requires detailed company financials
• Very sensitive to changes in operating,
terminal value, and cost of capital assumptions
• Garbage in = garbage out
30
DCF Mechanics
Levered vs. unlevered DCF

• Before starting user must choose between two DCF
approaches:
1. Directly value equity (levered DCF)
2. Directly value enterprise (unlevered DCF)
• Depending on approach, FCFs, cost of capital (r), and cash
flow growth rate (g) must consistently match the value
they are determining
31
DCF Mechanics
Matching cash flows to value
Value of the operations (enterprise value)

+ Cash & other investments
- Debt & other financial obligations
Value of the equity (equity value)
32
DCF Mechanics

DCF Approach Unlevered DCF Levered DCF
Means you are trying to find the value of the Means you are trying to find the value of the
operations to all providers of capital business to equity owners
Free Cash Flows
Unlevered FCF Levered FCF
(FCF)
• FCFs that "belong" to both debt and
• FCFs that "belong" to equity owners
equity providers
• FCF before subtracting out dividends or
• FCF before subtracting out interest and
share buybacks (but after subtracting out
debt payments, dividends or share
interest and debt payments
buybacks
Weighted average
Discount rate (r) Cost of equity (CoE)
cost of capital (WACC)
Should incorporate the costs of capital to Should incorporate the costs of capital to
debt and equity investors equity investors
Output Enterprise value Equity value
Subtract net debt to arrive at equity value Add net debt to arrive at enterprise value
Relevant
Most industries Banks
industries
33
DCF Mechanics
Levered DCF
• Forecast levered free cash flows (LFCF): Cash flows
that trickle down to equity owners after all non-equity
related expenses are removed
• LFCF = CFO – capex – debt principal payment
• LFCF takes out operating expenses, capex and debt
related payments (interest expense & principal)
• The appropriate discount rate is the cost of equity,
which captures risk and expected returns to equity only
34
DCF Mechanics
Unlevered DCF
• Forecast unlevered free cash flows (UFCF): Cash flows that
trickle down to both debt and equity providers of capital
• UFCF = EBIAT + D&A/noncash items +/- WC changes –
capex
• UFCF takes out operating expenses, capex but not debt
related payments (interest expense & principal)
• The appropriate discount rate on unlevered FCFs is the
weighted average cost of capital (WACC), which captures
risks and expected returns to both debt and equity
providers
35
DCF Mechanics
Getting from equity value to enterprise value

• In a levered DCF, the resulting PV of LFCF is the equity
value; you can easily get to enterprise value by adding net
debt
• Conversely, in an unlevered DCF, the resulting PV of UFCF
is enterprise value but you just subtract net debt to get to
equity value
• For the same company, both approaches should yield
exactly the same equity value and enterprise value
36
DCF Mechanics

• Circle the appropriate metric
Unlevered DCF Levered DCF

Cash flows UFCF / LFCF UFCF / LFCF
Discount rate WACC / Cost of equity WACC / Cost of equity
Value directly Enterprise value / Enterprise value / Equity
derived Equity value value
Which FCF is higher? UFCF / LFCF UFCF / LFCF
37
DCF Mechanics
DCF Implementation
• The prevalent form of the DCF model in practice is the
two-stage unlevered DCF model (our focus)
• Multi-stage DCFs (3-stage, high-low models) are possible
but less used in practice
Stage #1: Stage #2:
Projecting Calculating
UFCFs the TV
Forecast period is Estimate the value of = Enterprise value
typically 5-10 years the company at the
end of stage 1 then Value of the operations
discount to present
Discount using WACC
38
DCF Mechanics
DCF Implementation
Nonoperating Nonequity
assets (cash) financial claims
(Debt)
Net debt
Enterprise Equity value

value Divide by dil.
Value of the shares out.
operations to get equity
value per
share
39
DCF Mechanics
DCF Implementation
• Stage 1: Unlevered free cash flow projections (5-10 years)
• Annual cash flow freely Stage 1
available (but necessarily ‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ = ෍
௧ୀ௡
‫ܨܥܨ‬௧
distributed) to all providers 1+‫ݎ‬ ௧

௧ୀଵ
of capital in the business,

after accounting for all
necessary reinvestments
• Linking from an integrated FSM is optimal
40
DCF Mechanics
DCF Implementation
• Stage 2: Terminal value (TV) Stage 2
‫ܨܥܨ‬௧ାଵ
• Beyond stage 1, assume a ‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ =
‫ݎ‬െ݃
constant growth rate and use
the perpetuity formula to
estimate a TV that represents
the PV of all the FCFs generated after stage 1
• Alternatively, analysts use ‘exit multiple’ approach
(more on this later)
• TV is present value at end of stage 1, so needs to be
discounted yet again to beginning of stage 1 (PV of TV)
41
DCF Mechanics
Calculating unlevered FCF
Unlevered FCF
EBIT (Operating income)
Less: Taxes
Do not use actual taxes, rather calculate as EBIT (1 – tax rate); avoids double
counting the interest expense tax shield captured in the cost of debt part of WACC
Equals: EBIAT (also called unlevered net income, tax-effected EBIT, NOPAT)
Plus: Depreciation and amortization
Less: Increases in working capital assets
Plus: Increases in working capital liabilities
Less: Capital expenditures
Less: Other required investments
Equals: Unlevered FCF
42
DCF Mechanics
Understanding unlevered FCF conceptually

• UFCF are cash flows from the operating performance of
the business, before any effects of leverage or non-
operating assets are factored in
• UFCF are a company’s cash flows AS IF it was an all-
equity financed company with no non-operating assets
• That’s why we start with EBIAT, which completely
ignores interest expense and the resulting tax shield
43
DCF Mechanics
Understanding unlevered FCF conceptually

So how are the effects of leverage and non-operating assets
factored in?
• The debt related outflows (like interest payments) and
non-operating assets (like cash) are factored into the
model in the calculation of net debt but not in the UFCF
What about the interest tax shield? You ignored that benefit
in the UFCF
• True - the interest tax shield is factored in the discount
rate but not in the UFCF
44
DCF Mechanics
Weighted average cost of capital

• While this will be discussed in greater detail later, below
is the basic WACC formula. Since most firms’ capital
structure includes a combination of debt and equity to
fund their operation, the overall cost of capital is the
market-based weighted average of the cost of debt and
equity. The formula for WACC is:
‫ݐܾ݁ܦ‬ ‫ݕݐ݅ݑݍܧ‬
ܹ‫ݎ = ܥܥܣ‬ௗ௘௕௧ ‫( כ‬1 െ ‫כ )݁ݐܽݎ ݔܽݐ‬ + ‫ݎ‬௘௤௨௜௧௬ ‫כ‬
‫ ݐܾ݁ܦ‬+ ‫ݕݐ݅ݑݍܧ‬ ‫ ݐܾ݁ܦ‬+ ‫ݕݐ݅ݑݍܧ‬
• Debt = market value of debt
• Equity = market value of equity
• rdebt = cost of debt
• requity = cost of equity
45
DCF Mechanics
DCF Output: Sensitivity analysis

• DCF valuation is highly sensitive to future free cash flows,
terminal value, and discount rate assumptions
• Therefore, DCF output should be represented in ranges
• Key assumptions to sensitize include the discount rate,
revenue and operating margin assumptions, and terminal
value assumptions
46
DCF Mechanics
It’s time to build a real DCF!

• We are going to continue to use Apple (AAPL:NASDAQ) as
our case study, and rely on the FSM that we built in our
prior course to provide us with all necessary forecasts
• As with the FSM course, assume
date of analysis is May 19, 2014
47
DCF Modeling
DCF Modeling
DCF Modeling
Let’s Model
The following modeling steps cover:
• Forecasting free cash flows (FCFs)
Open the following files to begin:

• 1_FCF_Empty
• AAPL Q2 2014
49
DCF Modeling
Did you get this error when opening the file?
• Click OK and then enable iterative calculations
• Excel 2013, 2010 & 2007: Excel Options | Formulas | Enable Iterative Calculation
• Excel 2003: Tools |Options | Calculation | Select Iteration
• Mac Excel: Excel | Preferences (ႛ + ,) | Calculation | Select Iteration
Why did I get this message?

It’s because the DCF model template includes the full financial statement model (FSM) that
we built for Apple, and as you’ll recall it has an intentional circularity. Excel detected the
circularity in the file and wants you to tell it how to deal with it.
50
DCF Modeling
This is a row header that

pulls the company name
from the FSM tab using
concatenation
Date headers are

being referenced
from the FSM tab
Notice there are two tabs in the DCF model

• The first is the financial statement model that you built in the prior course
• The second tab (pictured here) is where we will build the DCF model.
51
DCF Modeling
Input general assumptions as illustrated

• Share price, share date and latest basic share count can all be found in the FSM tab
• Format references from other tabs green to show that they are indeed coming from another tab
• We will calculate Apple’s true WACC later on, for now just hard code 10% as a placeholder
Linking cells from other sheets without the mouse

1. Go to the cell you want to bring data into
2. Hit ‘=’ to get “inside” the cell
3. Holding down Ctrl, hit PageUp to go to tabs on
the left, PageDown to go to tabs on the right
4. Once you’re in the desired tab, let go of Ctrl and
use the arrow keys to find the desired cell
5. Hit Enter when done
The FSM is an annual model

so the latest share count is
actually a little stale, we’ll
update it to most recent share
count as of 5/19/14 shortly.
52
DCF Modeling
Calculate EBIAT
• EBITDA, EBIT and tax rate for each year can all be found in the FSM tab
• EBIAT should be calculated as illustrated
Tip: Complete all of 2011 and then fill to the right1 to avoid extra work
1Regular right fill: Highlight origin cells and desired range and hit Ctrl r
Power Fill Right: Highlight origin cells and hit Ctrl r (Boost Excel add-in must be installed)
53
DCF Modeling
Adjust EBIAT for noncash items and working capital items to arrive at unlevered CFO
• Use the cash flow statement in the FSM to find the required adjustments
• Notice that this is an identical set of adjustments to the adjustments from net income to CFO in the FSM; we
have now calculated CFO on an unlevered basis
54
DCF Modeling
Complete the unlevered FCF by subtracting capex and purchases of intangible assets
• Use the cash flow statement in the FSM to find the required adjustments
• Calculate an annual % growth in unlevered FCF to serve as a sanity check
• Large year over year variances in FCFs, if any, should be investigated
55
DCF Modeling
Discount each year’s FCF to the present

• Discount factor: Number of periods FCFs are discounted by to get to their PV (i.e. 36% = 0.36 periods)
• Calculate PV of FCFs: PV of FCF = Unlevered FCF / (1+wacc)^discount factor
Understanding discounting
For the time being, we assume
that FCFs are generated at the
very end of each period. For each
period we should discount back
by the number of periods we are
away from the valuation date
using the YEARFRAC excel
function as illustrated.
Of course, it is unlikely that a

company’s entire FCFs are
generated at the end of the
period. We will relax this
assumption later on.
9 Check your work with 1_FCF-Done.xlsx 56

DCF Modeling
Terminal value (TV)

• Apple is expected to generate cash flows beyond 2018,
but we cannot project FCFs forever (with any degree of
accuracy). So how do we estimate the value of Apple
beyond 2018? There are two prevailing approaches:
• Growth in perpetuity: Assumes Apple will grow at some
constant growth rate assumption from 2018 to… forever
• EBITDA multiple method: Values Apple at 2018 using a
assumed multiple of its 2018 assumed EBITDA
• Since TV often represents a significant % of the value
contribution in a DCF, the assumptions used are important
57
DCF Modeling
TV - growth in perpetuity
• Analysts calculate the Calculating terminal value using
perpetuity approach
PV of all the FCFs
generated after stage 1 ܸܶଶ଴ଵ଼ =
‫ܨܥܨ‬ଶ଴ଵଽ
‫ ܿܿܽݓ‬െ ݃
by assuming cash flows
will grow at a perpetual ܸܶ௏௔௟௨௔௧௜௢௡ ௗ௔௧௘ =
ܸܶଶ଴ଵ଼
1 + ‫ ܿܿܽݓ‬ଶ଴ଵ଼ ௗ௜௦௖௢௨௡௧ ௙௔௖௧௢௥
& constant growth rate
• The perpetuity formula yields Apple’s value at end of
stage 1, we need to discount it (further) to the valuation
date to get the PV of the TV
58
DCF Modeling
What is the right long term growth rate ‘g’?

• No business can be expected to grow forever at rates
above the economy, so ‘g’ should be a sustainable rate
• In practice a 2-5% range is most frequently used
• Companies in high growth / early stage with high growth
rates during stage 1 tend to be valued with a higher LT g
than companies with lower growth rates in stage 1
• ‘Fuzziness’ of this is an often-criticized part of the DCF
• DCF outputs are frequently presented using a range of
growth rate assumptions
59
DCF Modeling
Calculating FCF in the terminal year

• Recall that the perpetuity formula requires using a FCF
that is one year beyond the projection period
• The most common and simple way to deal with this is to
take FCF in the last year of the projection period (t) and
grow it one more year (t+1) at the long term growth rate.
In Apple’s case: FCF 2019 = FCF2018 * (1+g)
Online Lesson: Normalized free cash flows

A more rigorous approach is to calculate a “normalized” terminal year FCF by adjusting working capital and
capex assumptions to match them more realistically to the long term growth rate. See DCF online lessons 40-
41 for this.
60
DCF Modeling
Exit multiple method

• Instead of using the growth in perpetuity equation, TV is
often calculated by simply multiplying an LTM EBITDA
multiple x EBITDA in the last forecast year
• The LTM EBITDA multiple is usually derived from a
trading comps or transaction comps analysis, depending
on the purpose of the DCF (standalone valuation or for
acquisition analysis)
• Used because it requires fewer explicit assumptions about
future cash flows, growth, and more ‘realistic’
61
DCF Modeling
TV: Exit multiple method vs. perpetuity

• Today’s company multiple provides a more ‘realistic’
valuation than the generic growth input in the perpetuity
formula (i.e. “all companies get the same g”)
• On the other hand, the multiple itself incorporates
implicitly all the assumptions about growth, discount
rate, and FCFs the perpetuity formula incorporates
explicitly
• The multiple selected is derived from market-based comps
analysis, which in turn, is used to determine DCF value.
(“What if the market today is wrong?”)
62
DCF Modeling
Implementation caveats
• EV/EBITDA is most common multiple but can use any
enterprise value multiple in unlevered DCF (EV/Rev,
EV/EBIT, etc.)
• P/E and P/B is most common in levered DCF
• Just like with perpetuity approach, terminal value needs
to be discounted to present using the WACC
63
DCF Modeling
Let’s Model
• Terminal value

• 2_TV_Empty
• AAPL comps set.pdf
64
DCF Modeling
Estimate Apple’s EV using the perpetuity approach

1. Reference 2018 FCF
2. Input a 3% long term growth rate assumption (we’ll sensitize this for a range later)
3. Estimate 2019 FCF by growing 2018 FCF by 3%
4. Calculate TV in 2018 using the perpetuity formula
5. Discount TV to its PV using the 2018 discount factor and WACC
6. Reference the sum of all stage 1 FCFs
7. Calculate Apple’s enterprise value as: PV of TV + PV of stage 1 FCFs
65
DCF Modeling
Locate the comps-derived average EBITDA multiple for Apple (Data provided by Factset1)
By using this multiple as the TV multiple, we’re saying that this is the multiple we expect for Apple in 20182
1 Use average EBITDA (as opposed to median) in this case because the peer group is so small (3 companies). For larger peer
groups, use the median. We used Factset comps for this course. Both Factset and Capital IQ are widely used data services by
analysts to calculate comps. However, in practice, you are often required to spread your own comps rather than relying on a data
provider. This process is an important part of the analyst skill set and is the subject of WSP’s comps modeling course.
2 If you have reason to believe the comps-derived multiple today is inappropriate for 2018 then it should be adjusted accordingly.
However keep in mind that assuming multiple expansion (higher future multiple than current multiple) is aggressive and implicitly
assumes that a company’s fundamental drivers like returns on capital, risk and reinvestment rates will improve. This is usually not
consistent with the rest of the analysis and thus unjustifiable (more on this later).
66
DCF Modeling
Estimate Apple’s EV using the exit EBITDA multiple approach

1. Reference 2018 EBITDA
2. Input the comps-derived average EBITDA multiple
3. Calculate terminal value in 2018 as 2018 EBITDA x EBITDA multiple
4. Discount to the present using the 2018 discount factor and WACC
5. Reference the sum of all stage 1 FCFs
6. Calculate Apple’s enterprise value as: PV of TV + PV of stage 1 FCFs
9 Check your work with 2_TV-Done.xlsx 67

DCF Modeling
Net debt
• Now that we calculated enterprise value, we must subtract
net debt from enterprise value to arrive at equity value
• Use the book values of these items as of the latest filing as
proxies for the market value unless instructed otherwise
Net Debt
Debt & equivalents Net Debt
1. Debt / Capital Leases
2. Non-controlling interests Enterprise
3. Preferred Stock Equity Value
Less: Non operating assets Value
1. Cash & equivalents
2. Other non op. assets
68
DCF Modeling
Debt
• Use the latest book value of debt (latest 10Q or 10K)
• Long term debt (incl. current portion), short term debt
• Capital leases
• Convertible debt should be tested;
• If conversion assumed for purpose of calculating
shares do not include in net debt (double counting)
• If conversion not assumed include in net debt
• We’ll review this test shortly
69
DCF Modeling
Preferred stock
• Preferred stock that isn’t convertible to common should be
included in net debt
• Use the latest book value (latest 10K/10Q)
• Convertible preferred stock should be tested;
• If conversion assumed for purpose of calculating shares
do not include in net debt (double counting)
• If conversion not assumed include in net debt
• We’ll review this test shortly
70
DCF Modeling
Non-controlling interests (NCI)

• The value of the business that belongs to NCIs should be
included in net debt
• Use the latest book value (latest 10K/10Q)
• NCI expense should be excluded from the calculation of
UFCF (if you start the UFCF calculation with EBIT no
adjustment necessary since EBIT is before NCI expense).
71
DCF Modeling
Non-operating assets
• The cash flows related to non-operating assets (i.e.
interest income) were not reflected in our FCF calculation
• We recognized the value of operating assets by
forecasting unlevered FCF, we haven’t recognized the
value of idle cash & investments anywhere yet
• The book value of idle cash & investments (latest 10-
K/10-Q) is used (assumes BV of cash = MV of cash)
72
DCF Modeling
Let’s Model
• Net debt

• 3_Net_Debt_Empty
• AAPL 2013 10K
• AAPL Q2 2014
73
DCF Modeling
Calculate Apple’s latest net debt using the latest 10Q (Q2 2014)
Negative net debt: Because Apple has so much more cash than debt, it has negative net debt. This means that
the equity value is greater than enterprise value (the value of Apple’s core business) because owners benefit
not only from owning the operating business, but having all that cash on the balance sheet.
74
DCF Modeling
Apple’s trapped cash:

As you may have heard, a lot of Apple’s cash is “trapped” abroad to avoid US taxes. According to page 64 of
Apple’s 2013 10K (no disclosure is made in the more recent 10Q):
U.S. income taxes have not been provided on a cumulative total of $54.4 billion of earnings.
The amount of unrecognized deferred tax liability related to these temporary differences is
estimated to be approximately $18.4 billion.
Impact on Apple’s valuation

That means that if Apple ever sought to bring that cash back to the US, it would have to pay tax on it in the
amount of $18.4b. From a valuation standpoint, we need to remove this from today’s cash balance if it is not
really available to shareholders.
• Some argue that Apple would likely take advantage of something like
a tax repatriation holiday (circa 2004) that enabled companies to
bring over cash at lower rates. In that case, a lower adjustment would
be merited
• Also, what about future trapped cash? Recall that in the DCF forecast,
we assumed a 26% tax rate rather than the 35% US statutory tax rate
(due to lower Ireland tax rates)
• However, if we believe that Apple will repatriate and actually paying
the incremental tax, the FCFs used in calculating enterprise value
itself might be inflated by as much as 9% (35%-26%)
• Bottom line: The valuation impact of trapped cash is unclear. We’ll adjust net debt for existing trapped cash
but make no adjustments for future trapped cash
75
DCF Modeling
Adjust Apple’s net debt for trapped cash
76
DCF Modeling
Calculate equity value

for both TV approaches
9 Check your work with 3_Net_Debt_Done.xlsx 77

DCF Modeling
Diluted Shares
Outstanding
Diluted Shares Outstanding
Diluted shares outstanding

If you decided a pizza is worth $16, the
• Front cover of latest value of each slice depends on knowing
how many slices there are…
10Q/10K will disclose latest $4 $2
actual share count (basic)
• But we need diluted
shares (basic shares +
dilutive securities)
…If you get the number of slices wrong,
• Dilutive securities include
you’ll get the price of each slice wrong.
options, restricted stock and other securities that can

become common stock
79
Types of dilutive securities

• Stock options are issued to pay and Warrants are identical
mechanically to options but
motivate employees. Gives employees are issued to debt holders as
opposed to employees.
the option to purchase common stock Note that the debt remains
at a given price over an extended after warrants are exercised.
period of time.
• Restricted stock is the other prevalent form of stock based
compensation. Employees get shares (or the right to
shares) subject to vesting. Unlike options, there is no
exercise price and employees receive the stock free and
clear upon vesting.
80
Types of dilutive securities

• Convertible bonds can be converted into common shares
upon a certain strike price. Conversion gives investors
benefit of defined interest payments and upside of equity.
• Convertible preferred is similar to convertible debt.
Provides all the benefits of preferred stock (dividends,
priority of payments) with a conversion feature that
provides upside of equity.
81
Calculating shares outstanding

A business with an equity value of $500m has 100m basic shares outstanding
What would you expect this company’s share price would be? ___________________________
Now assume option-holders hold 25m exercisable options (assume a $0 exercise price)
Now assume that in addition to the options, convertible preferred shareholders hold 15m shares, each
convertible into 5 shares of common stock (assume no dividends and no liquidation value).
82
Calculating dilution from options & warrants

• Each option has an exercise
(strike) price, which the In-the-money: Strike price < current stock price
At-the-money: Strike price = current stock price
owner must pay to the Out-of-the-money: Strike price > current stock price
company to exercise the option

• Only include “in the money” options in the share count
because these are the options that have potential to dilute
the company’s shareholder base.
83
Options outstanding vs. exercisable

• To keep employees around, companies impose vesting
restrictions on options; so a 10,000 option grant might
vest evenly over 3 years
• Use only options exercisable in a standalone DCF
• However, If you’re building a DCF to value a target
company in an M&A analysis, use outstanding or “vested
and expected to vest” options instead of exercisable
because unvested options often vest upon a change of
control
84
Treasury stock method

• If we count exercisable in-the-$ options in share count, we
must account for the implicit option proceeds
• The prevalent approach uses assumed proceeds from
exercised options to repurchase shares at current share
price.
85
Options disclosures
• Options disclosure level Finding the options footnote
Search for the terms “exercisable”, “options
vary across companies outstanding” to quickly find the footnote
• Ideally, you get a tranche-by-tranche breakout of

exercisable options and their corresponding exercise price
• You may find such data in the latest 10Q, but you may
have to go back to 10K; sometimes tranche-by-tranche
data is not available at all (Apple)
Apple discloses aggregate option data in 10Qs (p.18)
86
Options disclosures
Apple’s 10K disclosure is not much better, so might as well use fresher 10Q data
87
Options disclosures
Here’s an example of a more typical, complete disclosure usually found in 10Ks (EXTR)
88
Restricted stock in the calculation of diluted shares

• Vested restricted shares: They are already in the actual
share count, so no additional adjustments required
• Unvested shares: Like options, unvested restricted stock is
usually not included in the diluted share count1.
Apple discloses restricted stock data in the 10Q (p.18)
1 Not including any unvested restricted stock or options in the share count (the prevailing practice in a standalone DCF valuation)
can lead to an overestimation of company’s fair value per share. An alternative approach (rarely used but more conceptually
rigorous) is to apply an illiquidity discount to unvested restricted shares and to include this in the diluted share count. In the M&A
context, analysts generally include unvested and RSUs in the diluted share count.
89
Convertible preferred stock in the DCF

• Analysts must determine whether to assume conversion
for the purposes of calculating diluted shares and net debt
• If conversion is assumed include the shares in the share
count and remove preferred stock from net debt
• Assume conversion if the following 2 conditions are met:
1. Are the convertibles in-the-$ /out-of-the-$?
2. Is conversion dilutive or anti-dilutive
• The next 2 slides describe these conditions
90
Condition 1: In the $?
• If the market share price is > conversion price, the
convertible preferred stock is in-the-$.
Liquidation (redemption value) of preferred shares
‫= ݁ܿ݅ݎ݌ ݊݋݅ݏݎ݁ݒ݊݋ܥ‬
(‫( ݔ )݋݅ݐܽݎ ݊݋݅ݏݎ݁ݒ݊݋ܥ‬# ‫݂݁ݎ݌ ݂݋‬. ‫ݐݑ݋ ݏ݁ݎ݄ܽݏ‬. )
• Liquidation value = What the company must pay to

eliminate the obligation in the event of liquidation or sale
(usually the book value of the preferred stock on the B/S).
• The conversion ratio = # of common shares each
convertible share can receive upon conversion
91
Condition 2: dilutive or anti-dilutive?

• Preferred stock usually get preferred dividends.
• If the dividends are sufficiently high, their elimination due
to conversion will actually be antidilutive. In this case, we
don’t assume conversion, since preferreds get a larger
fraction of profits as preferreds rather than as common
Scenario 1 Scenario 2 Scenario 3
Net income 100.0 100.0 100.0
Preferred dividends 15.0 10.0 20.0
Net income to common 85.0 90.0 80.0
Basic shares 170.0 170.0 170.0
Basic EPS $0.500 $0.529 $0.471
Pref. stock dividend yield 15.0% 10.0% 20.0%
Diluted net income $100.00 $100.00 $100.00

Dilutive impact of converted shares 30.0 30.0 30.0
Diluted EPS $0.500 $0.500 $0.500
As-converted pref. shares as % of total 15.0% 15.0% 15.0%
Dilutive or antidilultive?
92
Real world exercise: Colgate’s convertible preferred

• Convertible securities disclosures can usually be found on
the B/S and in footnotes of a company’s 10K /10Qs.
Exercise: Testing Colgate’s convertible preferred stock in 2010
Using the disclosures on the next two slides and the assumptions
below answer the following:
1. Does Colgate’s convertible preferred stock meet conversion tests in 2010?
2. At what redemption price does the “in the money” test (Test 1) fail?
3. At what conversion ratio would the conversion become antidilutive?
Assumptions
In 2010, Colgate had:
• 2,405,192 convertible preferred shares outstanding
• 487,800,000 weighted average basic shares outstanding
• CL share price as of time of the analysis of $66.84
• Calculate Basic & Diluted EPS using the information provided here and in the disclosures
in the next two slides, do not use the company’s reported EPS.
93
94
95

Exercise: Testing Colgate’s convertible preferred stock in 2010
Does Colgate’s convertible preferred stock meet conversion tests in 2010?
Yes
Test 1
• Conversion price = $65 redemption value per share / 8:1 conversion ratio = $8.13
• Conversion price ($8.13) < Share price ($66.84)
Test 2
• Basic EPS $4.44 > Diluted EPS $4.34
At what redemption price does the “in the money” test (Test 1) fail?
8 x $66.84 = $534.72
At what conversion ratio would the conversion become antidilutive?
3.66
96
Convertible debt in the DCF

• Same mechanics as preferred stock. If we assume
conversion, exclude convertible debt from net debt and
include converted shares in the diluted share count
Book value of debt
‫= ݁ܿ݅ݎ݌ ݊݋݅ݏݎ݁ݒ݊݋ܥ‬
‫݋ݐ݊݅ ݈ܾ݁݅ݐݎ݁ݒ݊݋ܿ ݏ݅ ݐܾ݁݀ ݏ݁ݎ݄ܽݏ ݊݋݉݉݋ܥ‬
• The same 2 conversion tests are employed:

1. In-the-$? If the market share price is > conversion
price, the convertible debt is in-the-$.
2. Dilutive or antidilutive? If interest on debt is high such
that elimination due to conversion will actually be
antidilutive, do not assume conversion
97
Stock splits
• In stock splits, all common stock and dilutive securities
are adjusted to reflect the split.
• Always confirm that no split has taken place subsequent
to the latest financial report.
• Easiest way to check is to select ‘CACS’ on the Bloomberg
terminal to review recent corporate actions, otherwise
news runs.
98
Stock splits
• In fact, stock splits are an issue in our model
• Apple announced a 7::1 stock split on April 23, 2014
• Stock split took affect June 9, 2014, with the share price
immediately going from $645 to $92 per share
• Since the date of our analysis is May 19, 2014, we just
missed the split and no adjustments are necessary
99
Dual classes
• Sometimes companies issue 2 or more classes of common
stock (A and B), where one class has more voting rights.
• The rationale is to allow management, families, and other

insiders to retain voting control without a 1-for-1 stake in
equity.
• Count both classes equally in the share base and include a
footnote.
100
Let’s Model
• Shares outstanding

• 4_Shares_Empty
• AAPL 2013 10K
• AAPL Q2 2014
101
Input Apple’s latest share count from front cover of Q2 2014 10Q
102
Reference share count into the dilutive securities section as illustrated
103
Locate Apple’s options data in its latest 10Q and input into the model as illustrated
Qs when modeling options

1. Under what circumstances
would it have been preferable
to go to the 10K for this data?
When the 10K provides a
tranche by tranche breakout
2. Why do we use exercisable
options instead of
outstanding? Because at the
moment of the analysis, un-
exercisable options literally
cannot be exercised.
3. Under what circumstances
might it make sense to use
outstanding? When valuing a
company to understand its
value in the context of being
acquired, since unvested
options often vest in an
acquisition, considering all
outstanding options instead of
just exercisable is appropriate.
104
Insert a formula to determine if the options are in-the-$ as illustrated
105
Calculate the net dilutive impact of options using the treasury stock method
1. Insert a formula to calculate total assumed proceeds
2. Calculate how many shares can be bought back at the current price with those proceeds
3. Net dilutive impact of options = In-the-$ options – shares repurchased
106
Check the balance sheet and footnotes to see if there are any other dilutive securities
1. Warrants?
2. Convertible bonds?
3. Convertible preferred stock?
Restricted stock
Apple does have unvested
RSUs but recall that for
better or worse, analysts
generally ignore these from
the share count because
they are unvested (while
vested RSUs are already in
the actual share count)
107
Complete the net diluted shares outstanding schedule

• There is no dilutive impact from any securities other than options
108
Complete the fair value per share section

• Link diluted shares
• Calculate fair value per share
• Calculate the market premium (discount) to fair value
This is it!
The DCF is telling us that based on all of our
assumptions Apple is significantly undervalued.
Of course, we still have to look at the WACC more

carefully. That’s next…
9 Check your work with 4_Shares_Done.xlsx 109

If you were building this model right after Apple’s 7 for 1 stock split on June 9, 2014, it’s pretty simple to
make the required adjustments:
• Adjust share price and date
• Adjust the latest share count and dilutive securities data
As you’d expect, the DCF fair

value per share drops to reflect
the split and continues to show
Apple as undervalued
110
DCF Modeling
WACC
WACC
Weighted average cost of capital (WACC)

• Both debt and equity investors contributes capital to
businesses with the expectation that the risks they take
will be offset by an appropriate return
• Quantifying the cost of capital is different for both debt
and equity
• Cost of debt: Relatively straight-forward
• Cost of equity: Quite challenging
112
WACC
Weighted average cost of capital (WACC)

• In unlevered DCF, WACC is the appropriate discount rate
because we are discounting free cash flows that belong to
all providers of capital
• Debt = market value of debt
• Equity = market value of equity
• rdebt = cost of debt
• requity = cost of equity
113
WACC
Capital structure assumptions in WACC

• DCF assumes a constant WACC throughout

• As a result, an implicit assumption in the DCF is that the
company being valued maintain a stable capital structure
• Otherwise, users would need to adjust their WACC
assumptions for each projection period (both weights and
cost of debt and equity), making models such as the
adjusted present value more appropriate
114
WACC
The equity weight

Public companies
• Use the market value of the equity (dil. shares x market
share price) to calculate the WACC
Private companies
• Use the DCF-derived equity value
• Creates a circularity because WACC is used to derive that
very equity value so be sure that iterations selected in
Excel, and insert a circuit breaker
115
WACC
The debt weight

• Most of the time: Use the book value of debt as an
approximation for market value of debt
• More rarely: If interest rates have changed substantially
since debt issuance, don’t use book value, instead use the
market price of the company’s debt if it is actively traded
116
WACC
Cost of debt
• Public debt: The cost of debt is directly observable in the
market as current yield-to-maturity on the company’s
long-term debt (Bloomberg good source)
• Analysts instead frequently use the weighted average
coupon rate (incorrect if coupon is significantly different
from yields
• For private companies: Use yield of debt with similar
credit rating
• Use credit agencies such as Moody’s and S&P which
provide yield spreads over US treasuries by credit rating
117
WACC
Cost of debt
Impact of capital structure on cost of debt
• The cost of debt will increase with the level of debt as a
percentage of the capital structure because a more
highly levered business has a higher default risk
118
WACC
Interest expense – tax shield

• Until now, we have ignored the tax Tax shield: Imagine a
benefits that debt provides via the $10m loan at a 10%
interest rate. At a 40%
tax deductibility of interest tax rate, the cost of debt
payments is not 10% but is 6%.
This is because the $1
• The true cost of debt is the after-tax interest expense reduces
earnings by $1 x (1 -
rate due to the ability of interest marginal tax rate)
because of the tax
expense to shield taxes. deductibility of interest
expense.
• Analysts should use the marginal
tax rate, such that the true cost of
debt = ‫ݎ‬ௗ௘௕௧ ‫( כ‬1 െ ‫)݁ݐܽݎ ݔܽݐ‬
119
WACC
Cost of equity
• Not directly observed in the market
so difficult to estimate
• Represents the expected rate of return
for equity investors
• Expected return correlated with risk
but how is this quantified?
• Start with a risk free rate and
quantify a premium specific to the
company being valued.
120
WACC
Cost of equity
• Multiple models exist for estimating the cost of equity
• Fama-French, Arbitrary pricing theory (APT), Capital Asset
Pricing Model (CAPM)
• CAPM - widely used & often criticized. Divides risk into:
1. Unsystematic (company-specific) risk: Risk that can
be diversified away so ignore this risk
2. Systematic risk: The company’s sensitivity to market
risk can’t be diversified away so investors will
demand returns for assuming this risk
121
WACC
Cost of equity – the CAPM

ܿ‫݁ݐܽݎ ݁݁ݎ݂ ݇ݏ݅ݎ = ݕݐ݅ݑݍ݁ ݂݋ ݐݏ݋‬+Ⱦ x ERP
• Ⱦ (“beta”) = A company’s sensitivity to systematic risk
• ERP (“Equity risk premium”) = The incremental risk of
investing in equities over risk free securities
122
WACC
Risk-free rate
• Should theoretically
reflect YTM of a default-free
government bonds of
equivalent maturity to the
duration of each cash flows
being discounted
• Current yield on U.S. 10-year bond is the preferred proxy
for the risk-free rate for U.S. companies
• German 10-year for European companies
• Japan 10-year for Asian companies
123
WACC
The equity risk premium (ERP)

• ERP represents how much extra return investors seek for
investing in equities as a class
• Prevalent approach compares Sources for ERP
historical spreads between Ibbotson (SBBI)

Duff & Phelps
S&P 500 returns and the yield Damodaran
on 10-yr treasuries
• Still, period used, averaging technique & other issues
lead to debate around ERP calculation
• A generally acceptable range of ERPs is 4-8%
124
WACC
Small-cap premium (SCP)

• In practice, an additional premium Premium above ERP
is added to the ERP when analyzing Mid cap ($800m-4b) 0.5%

Small cap ($200m-800m) 1.0%
small companies and companies Micro-cap (<$200m) 2.5%
operating in higher-risk countries Source: Ibbotson
• ܿ‫ ݁ݐܽݎ ݁݁ݎ݂ ݇ݏ݅ݎ = ݕݐ݅ݑݍ݁ ݂݋ ݐݏ݋‬+ SCP +Ⱦ x ERP
125
WACC
Country risk premium (CRP)

• In practice, an additional Country Risk Premiums, July 2013
premium is added to the ERP United States 0.0%

United Kingdom 0.5%
when analyzing small Germany 0.0%
companies and companies Australia 0.0%

France 0.5%
operating in higher-risk China 1.1%
countries India 3.4%
Middle East 1.4%
• ܿ‫݁ݐܽݎ ݁݁ݎ݂ ݇ݏ݅ݎ = ݕݐ݅ݑݍ݁ ݂݋ ݐݏ݋‬ Eastern Europe 3.1%

Brazil 3.0%
+ CRP +Ⱦ x ERP Africa 5.9%
Source: Damodaran
126
WACC
Interpreting Beta (Ⱦ)

• A company whose equity has a Ⱦ of 1 has on average seen
returns in line with the overall stock market (S&P 500 is
the proxy)
• Company with a Ⱦ of 2 has on average seen returns rise
twice as fast or drop twice as fast as the overall market
• Higher Ⱦ = Higher cost of equity because the increased risk
investors take (via higher sensitivity to market
fluctuations) should be compensated via a higher return
• Ⱦ is the only company specific variable in the CAPM
127
WACC

What asset would you expect to carry a Ⱦ of 0?
What asset would you expect to carry a negative Ⱦ?
What assets would you expect to carry a very low Ⱦ?
What type of company would you expect to carry a very high ɴ?
128
WACC

What asset would you expect to carry a ɴ of 0? US treasuries and cash
What asset would you expect to carry a negative ɴ? Gold and insurance
What assets would you expect to carry a very low ɴ? Consumer staples
What assets would you expect to carry a very high ɴ? Highly discretionary items like luxury watches
129
WACC
Exercise: Calculate Home Depot’s WACC

• Home Depot trades at $50 per share
• 1.5b diluted shares outstanding
• $7.6 billion in debt outstanding (no cash)
• Current yield on Home Depot debt is 6%
• Home Depot’s marginal tax rate is 35%
• Ⱦ = 0.80, MRP = 6%, Risk free rate = 2%
• Calculate Home Depot’s WACC
130
WACC
Home Depot WACC

Shares outstanding 1,500.0
Share price $50.00
Debt 7,600.0
Cost of debt 6.0%
Marginal tax rate 35.0%
Beta 0.8
Market risk premium 6.0%
Risk free rate 2.0%
Debt weight 9.2%

Equity weight 90.8%
WACC 6.5%
ࢃ࡭࡯࡯ = ‫ݎ‬ௗ௘௕௧ ‫( כ‬1 െ ‫כ )݁ݐܽݎ ݔܽݐ‬ + ‫ݎ‬௘௤௨௜௧௬ ‫כ‬
ࢉ࢕࢙࢚ ࢕ࢌ ࢋ࢛ࢗ࢏࢚࢟ = ‫ ݁ݐܽݎ ݁݁ݎ݂ ݇ݏ݅ݎ‬+ Ⱦ x market risk premium
131

WACC
Calculating Ⱦ
Online Lesson: Industry (bottom up ɴ)
• For a public company, finding

The problem with the observed
(regression-derived) ɴ is that there are
often high standard errors with this
Ⱦ is easy: Barra and other approach (company specific events
reduce the quality of the correlation)
services such as Bloomberg and
The other problem is that for private
S&P provide it companies there is no observed ɴ.
In these cases, the preferred solution is

• All of these services calculate industry ɴs (see lessons 42-44 to learn
how to model an industry beta)
Ⱦ based on the company’s
historical share price sensitivity to the S&P 500, usually,
by regressing the returns of both over a 60 month period
132
WACC
Let’s Model
• WACC

• 5_WACC_Empty
• AAPL 2013 10K
133
WACC
Input WACC assumptions as illustrated
Apple’s debt disclosure enables us to calculate a weighted average % interest
134
WACC
Complete the following calculations

• Link the tax rate to tax affect the cost of debt from 20181
• Calculate after tax cost of debt
• Calculate cost of equity
1 Practitioners
usually calculate the same tax rate for all years in the forecast. However, when the model assumes that the effective
tax rate grows to the statutory tax rate by the terminal year, we should use an average tax rate when calculating WACC.
135
WACC
Complete the cost of capital section

• Calculate market value of equity as current share price x diluted shares outstanding1
• Link net debt from the net debt section
• Calculate % of total capital (total capital = equity + net debt)
Understanding the impact of large

cash reserves on WACC
Apple’s large cash balances reduces
investor risk. Thus, the observed ɴ is
lower (and lower cost of equity) than
had Apple had no cash balances.
BUT when discounting unlevered

FCFs, we do not want the large cash
reserves distorting the discount rate.
So… at first glance it may appear that

we have a problem. However, we do
not because this distortion is removed
by the high equity capital weight (>1)
and negative debt weight, which raise
the total cost of capital2.
1 Fora private company where there’s no market price, you can apply a peer-derived valuation multiple. An alternative is to use the
company’s model-derived fair value, but this creates a circularity.
2 See appendix 1 for a detailed discussion on dealing with capital weights for companies with large cash reserves.
136
WACC
Remove the hard-coded placeholder in C8 with the new WACC calculation
9 Check your work with 5_WACC_Done.xlsx 137

WACC
How did adding the “correct”1 WACC affect our valuation?

Now that we inputted a more rigorous discount rate assumption, our valuation is much closer to Apple’s actual
share price (though still higher)
1 Because the estimation of inputs that go into WACC (like ɴ and the market risk premium) are so hotly debated it’s hard to call a
single WACC calculation truly “correct.” This is why WACCs are almost always a sensitized variable in a valuation matrix (as we’ll
see shortly).
138
WACC
How would you do if you listened to your DCF and bought Apple?
Recall that the analysis was pre stock split; a
current share price of $128.74 is $901 / share
on a pre-split basis. You would have done
quite well. Apple’s up almost 50%!
Remember – this valuation lives and dies by

the assumptions we made about Apple’s
future operating performance. Recall that
we relied quite heavily on analyst research
for those. Of course, it also relies on all the
terminal value and WACC assumptions we
have made in this course.
139
DCF Modeling
DCF Model
Finishing Touches
DCF Model Finishing Touches
Let’s Model
• Adjusting stub year FCFs

• Implied growth rates
• Sensitivity analysis
• LTM summary calculations
• Football Field valuation chart Open the following files to begin:
• 6_Finishing_Touces_Empty
• Apple Q2 2014 10Q
141
Before we continue…let’s adjust stub year FCF
Adjusting stub year FCFs Online Lesson: Timing of FCFs

Recall that up to now we have assumed all cash flows occur at the end of Assuming cash flows occur
the period and have thus included a full annualized FCF in the stub year. evenly, also opens up other less
Let’s now assume that cash flows occur evenly throughout the year and significant but more complicated
thus reduce first year FCFs by the FCFs that have already presumably discounting problems. Go to
been occurred as of the valuation date. lesson 39 & 45 of the online
course to see how to model
We format the cell a different color to make sure that subsequent users do those.
not copy and past the formula to all future FCF forecasts.
142
Let’s compare the impact of the stub year adjustment on valuation
Before the stub year adjustment…
After the stub year adjustment…
143
TV: Exit multiple method vs. perpetuity

When using the EBITDA multiple to calculate the TV, you
can calculate the implied growth rate by using the following
formula:
‫ݐܨܥܨ‬
‫ ܿܿܽݓ‬െ
݅݉‫= ݃ ݈ܽ݊݅݉ݎ݁ݐ ݈݀݁݅݌‬ ܸܶ
‫ݐܨܥܨ‬
1+
ܸܶ
When using the midyear adjustment, adjust formula as follows:

‫ ݐ ܨܥܨ‬1 + ‫ ܿܿܽݓ‬଴.ହ
‫ ܿܿܽݓ‬െ ܸܶ
݅݉‫= ݃ ݈ܽ݊݅݉ݎ݁ݐ ݈݀݁݅݌‬
‫ ܨܥܨ‬1 + ‫ ܿܿܽݓ‬଴.ହ
‫ݐ‬
1+
ܸܶ
144
We added an implied growth rate and to the EBITDA multiple approach section
Discussion
If the EBITDA approach implies a high terminal
growth rate, does that challenge the validity of
the EBITDA multiple?
145
We also added an implied EBITDA multiple to the perpetuity section
Discussion
Perpetuity approach implies an exit EBITDA multiple much lower than the actual EBITDA multiple we’re using.
146
Build a data table that will show a range of Apple fair values per share based on the following ranges:
• Model-derived WACC +/-2%
• Our growth rate assumption +/-1% (increments of 0.5%) in the top data table
• Exit EBITDA multiple assumption +/- 2.0x in the bottom data table
Data tables rules to live by

1. The output variable should be linked in into the
top left corner of the table directly from the cell
in the model that you are attempting to
sensitize
2. Don’t link input variables from the model! For
example, do not link WACC or the EBITDA
multiple directly from the model, hard-code the
values instead
3. Highlight the data table before launching the
data table dialog box (Alt d t)
4. “Row input cell” is the cell that contains the
assumption in the model that you want to
replace with the assumptions in the row of the
data table (same logic with “column input cell”)
5. After running the data table, hit F9 to
calculate!
147
Build a third data table that will show a range of Apple fair values per share based on the following ranges:
• 2018 EBITDAs at various ranges (do not link EBITDA directly from the model, hard-code the value instead)
• Exit EBITDA multiple range of 7.25-10.25x in the row
148
Review the output
149
Add conditional formatting (alt o d) to all data tables to show outputs that are below the current market
value as illustrated
150
Add a last twelve month ( aka LTM/TTM) section to show Apple’s LTM EV/EBITDA multiple
• Operating income: Use the model’s annual forecasts and the 10Q to calculate the stub year results (2013 +
last 6 months – prior year 6 months)
• D&A and SBC: Link 2013 data from the FSM and use the 10Qs for the last 6 months and prior year’s 6 months
151
Review the raw data required for a football field valuation chart
• The football field chart is a common way to present valuation conclusions
• We’ll include the DCF valuation ranges using both the perpetuity and EBITDA multiple approach and contrast
that to Apple’s 52 week high and low (we have included the raw data for Apple’s 52 week high and low in a
separate tab in the template
• Other valuation models (comps and LBO) are often added to the football field as well
Dynamic row headers
Link from data tables
Calculation
Link from 52 wk HL tab
152
How do we make a football field chart?

The football field looks like a “floating” bar chart but its simply a stacked column (or stacked row) chart, where the
color of the bottom and top stack has been changed to “no fill”
Axis: The chart looks better

if you make the y-intercept
close to the minimum value
of the stock. To do this,
right click on the y-axis
after making the chart and
input the y-axis min and
max as illustrated
153
Review the football field output
9 Check your work with 6_Finishing_Touches_Done.xlsx 154

Congratulations!
To delve deeper, go online to learn the following:
• Online Lesson 39: Midyear adjustments in DCFs
• Online Lesson 40-41: Normalizing terminal year FCFs
• Online Lesson 42-44: Modeling industry beta
• Online Lesson 45: Making a stub year adjustment
155
DCF Modeling
DCF Bells
& Whistles
DCF Bells & Whistles
Normalizing terminal free cash flow

• The final year of stage 1 should reflect sustainable long
term growth and reinvestment rates (i.e. normalized)
• Since most real world DCF models are 2-stage models,
where stage 1 is only 5 years, the final year of stage 1 is
sometimes not normalized:
• Imagine a high growth company that is still showing
double digit operating profit growth by the end of stage
1, with significantly higher than normalized
reinvestment rates (i.e. capex > depreciation). Is this
sustainable indefinitely?

Normalizing terminal free cash flow

• Other issues that persist at the end of stage 1 include:
• Significant cash inflows/outflows from working capital
changes or DTL/DTAs.
• Theoretically the solution to this should be to extend the
stage 1 forecast period or create a 3 stage model,
• In practice practitioners simply adjust the FCF used for
calculating the TV to a “normalized” FCF by converging
the capex/depreciation ratio to 1, and removing any major
working capital and DTL/DTA inflows/outflows.

Calculating Ⱦ
• Despite various vendor algorithms to mitigate the problem
(Bloomberg’s forward / adjusted Ⱦ), this limits the
usefulness of historical Ⱦ as a predictor
• In addition, for private companies, no Ⱦ is available
because there are no observable share prices

Industry Ⱦ
• For private companies and for when public company Ⱦs
have a high standard error, one solution is to use an
industry Ⱦ.
• By looking at historical Ⱦs of a company’s peer group with
similar sensitivity to market fluctuations, a private
company’s Ⱦ can be derived, and a public company Ⱦ with
high standard error can be improved as the impact of
uncorrelated company-specific events that raise the
standard error will cancel each other out the more peers
are added

Delevering and relevering Ⱦs of industry peers

• Industry peers can still have different capital structures
• We must undo the distorting impact of different capital
structures on Ⱦ as, all else equal, more highly leveraged
companies will have higher observed Ⱦs
• Cash flows to equity holders are more volatile due to the
higher fixed interest payments
• To eliminate this distortion, we de-lever Ⱦs of comparable
companies and re-lever them at the target company’s
target capital structure

Delevering Ⱦs
Ⱦ(observed)
Ⱦ ݈݀݁݁‫= ݀݁ݎ݁ݒ‬
ܰ݁‫ݐܾ݁ܦ ݐ‬
1 + 1 െ ‫݁ݐܽݎ ݔܽݐ‬
‫ݕݐ݅ݑݍܧ‬
Re-levering Ⱦ
• Once you have derived the unlevered Ⱦ, you need to
relever it at the target capital structure using the reverse of
the formula:
ܰ݁‫ݐܾ݁ܦ ݐ‬
Ⱦ ݈݁‫ = ݀݁ݎ݁ݒ‬Ⱦ ݈݀݁݁‫( כ ݀݁ݎ݁ݒ‬1 + 1 െ ‫݁ݐܽݎ ݔܽݐ‬ )
‫ݕݐ݅ݑݍܧ‬

Exercise
• Determine Ⱦ for a private drug store
given the following information:
Private Co. WAG CVS RAD
ɴ 1.21 0.93 1.71
Share price $30 71.76 77.04 7.09
Diluted shares outstanding (mm) 400.0 956.6 1,170.0 963.3
Market cap 12,000.0 68,642.7 90,136.8 6,830.0
Cash (mm) 100.0 2,130.0 2,850.0 166.0
Gross debt (mm) 5,000.0 4,550.0 13,410.0 5,700.0
Tax rate 35% 37.0% 39.0% 0.0%

Solution
Private Co. WAG CVS RAD
ɴ 1.21 0.93 1.71
Share price $30 71.76 77.04 7.09
Diluted shares outstanding (mm) 400.0 956.6 1,170.0 963.3
Market cap 12,000.0 68,642.7 90,136.8 6,830.0
Cash (mm) 100.0 2,130.0 2,850.0 166.0
Gross debt (mm) 5,000.0 4,550.0 13,410.0 5,700.0
Tax rate 35% 37.0% 39.0% 0.0%
Delevered ɴ 1.18 0.87 0.94

Industry average ɴ 1.00
Private co. ɴ 1.26

DCF Modeling
Appendix 1:
Cash in Valuation
Appendix 1: Cash in Valuation
Large cash (negative net debt) weirdness in valuation

• Negative net debt in valuation creates a weird (but not
incorrect) outcome: the equity capital weight is > 1 and
the debt capital weight is < 0
166
Negative net debt quirks in valuation

• All else equal, the more cash a company the lower the
observed Ⱦ, leading to a lower cost of equity
• This is an underestimation of the true cost of equity of the
unlevered FCFs, but is resolved by the >1 equity capital
weight and <0 debt capital weight which bring up the cost
of capital
• There is an alternative which avoids the weirdness by
using gross debt, but then the Ⱦ needs to be adjusted to
remove the impact of cash (see next slide)
167
Large cash (negative net debt) weirdness in valuation
The cost of equity is higher but

cost of capital is almost the same
(the minor difference arises from
the tax deductibility of debt)
168
DCF Modeling
Appendix 2: Value
Drivers in the DCF
Appendix 2: Value Drivers in the DCF
Value drivers
• Let’s revisit the perpetuity formula
• Recall that it defines value using three value drivers:
‫ܨܥܨ‬௧ାଵ
‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ =
‫ݎ‬െ݃
• But how do companies generate the growth used in the

equation? How does a company’s reinvestment decision
and returns on capital affect value?
170
Value drivers
• FCF can be thought of as operating profit – reinvestment
• Reinvestments are made to generate returns and along
with the returns on those reinvestments, ultimately
determine a company’s growth rate
Example: CRT Systems
CRT Systems, a small maker of auto-parts, earned $5m in operating profits this
year. The company expects operating profit of $5.25m next year (5% growth).
This growth is expected to be driven be $250k in incremental sales from new

merchandise made using a new machine the company purchased this year for
$1m.
Below we identify key terms and relationships associated with the activities above:
Reinvestment rate (rr) = reinvestment/profit = $1m/$5m = 20%
Reinvestment = profit x rr
Return on invested capital (ROIC) = return/reinvestment = return/(profit x rr) = 250k/$1m = 25%
The growth rate (g) = return /operating profit = rr x ROIC = $0.25m/5 = 5%
171
Value drivers
• The perpetuity formula can be re-expressed as:
‫ܨܥܨ‬௧ାଵ ܱ‫ݐ݂݅݋ݎ݌ ݃݊݅ݐܽݎ݁݌‬௧ାଵ × 1 െ ‫ݎݎ‬
‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ = =
‫ݎ‬െ݃ ‫ ݎ‬െ (‫)ܥܫܱܴ ݔ ݎݎ‬
Exercise
• You forecast operating profits of $100m. Assuming a
reinvestment rate of 25%, ROIC of 20% and WACC of 10%,
calculate the value of this company
̈́ͳͲͲ݉ × 1 െ 25% ̈́͹ͷ݉
‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ = = = $1,ͷͲͲ݉
10% െ (20% ‫ ݔ‬25%) 5%
172
Value drivers
• Revisiting our hot dog stand, recall we forecast FCF of
$10,500, with g of 5% and discount rate of 10%.
• Now assume the FCF is comprised of $15,000 operating
profit less $4,500 in reinvestment.
• Calculate value, ROIC and the rr
• If we raise the rr to 40%, what is the impact on value?
• Can we draw a broad conclusion on the impact of rr on
value? Would the conclusion change if ROIC was lower
than the discount rate? How does ROIC affect value?
173
Calculating multiples intrinsically

• The very same things that drive intrinsic value should be
driving multiples.
ܱ‫ݐ݂݅݋ݎ݌ ݃݊݅ݐܽݎ݁݌‬௧ାଵ × 1 െ ‫ݎݎ‬

‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ =
‫ ݎ‬െ (‫)ܥܫܱܴ ݔ ݎݎ‬
• Dividing both sides by operating profit, we get:

‫݁ݑ݈ܽݒ ݁ݏ݅ݎ݌ݎ݁ݐ݊ܧ‬௧ ܱ‫݌‬. ‫ݐ݂݅݋ݎ݌‬௧ାଵ × 1 െ ‫ݎݎ‬ 1
= ‫(ݔ‬ )
ܱ‫݌‬. ‫ݐ݂݅݋ݎ݌‬௧ ‫ ݎ‬െ ‫ܥܫܱܴ ݔ ݎݎ‬ ܱ‫݌‬. ‫ݐ݂݅݋ݎ݌‬௧ାଵ
• Observed market multiples implicitly say what an intrinsic

valuation explicitly says
174
Calculating multiples intrinsically

• So what does it mean when the DCF-derived multiple ്
comps-derived multiple?
• Suggests there are differences between the implicit
ROIC, rr and discount rate assumptions baked into the
comps analysis and those baked into the DCF analysis.
• Had the hot dog stands we used earlier in the course as
comps truly been comparable in growth, ROIC, and
discount rate characteristics, the derived multiple
should have been identical to our stand’s multiple.
175

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WALL STREET PREP CORE MODELING COURSE

Equity value vs. Enterprise value

Equity value vs. Enterprise value

Equity value vs. Enterprise value

Using the B/S below, answer the following:

Equity value vs. Enterprise value

Book value vs. Market value

Book value vs. Market value

Book value vs. market value

Intrinsic value (DCF) vs. Relative value (Comps)

• Note the growth rate cannot be larger than discount rate

Hot dog stand: DCF analysis

Year 2015 2016 2017 2018 2019

DCF in contrast to comps

DCF in contrast to comps

DCF in contrast to comps

Our hot dog stand 10,500.0

• Which approach is best? Pros/cons?

DCF advantages in contrast to comps

DCF implementation challenges

Levered vs. unlevered DCF

Matching cash flows to value

Value of the operations (enterprise value)

Value of the equity (equity value)

Levered vs. unlevered DCF

Getting from equity value to enterprise value

Levered vs. unlevered DCF

Unlevered DCF Levered DCF

Discount using WACC

Enterprise Equity value

distributed) to all providers 1+‫ݎ‬ ௧

of capital in the business,

Calculating unlevered FCF

Understanding unlevered FCF conceptually

Understanding unlevered FCF conceptually

Weighted average cost of capital

DCF Output: Sensitivity analysis

It’s time to build a real DCF!

• Forecasting free cash flows (FCFs)

Open the following files to begin:

Did you get this error when opening the file?

• Click OK and then enable iterative calculations

• Excel 2003: Tools |Options | Calculation | Select Iteration

• Mac Excel: Excel | Preferences (ႛ + ,) | Calculation | Select Iteration

Why did I get this message?

This is a row header that

Date headers are

Notice there are two tabs in the DCF model

Input general assumptions as illustrated

Linking cells from other sheets without the mouse

The FSM is an annual model

Discount each year’s FCF to the present

Of course, it is unlikely that a

9 Check your work with 1_FCF-Done.xlsx 56

Terminal value (TV)

What is the right long term growth rate ‘g’?

Calculating FCF in the terminal year

Online Lesson: Normalized free cash flows

Exit multiple method

TV: Exit multiple method vs. perpetuity

Open the following files to begin:

Estimate Apple’s EV using the perpetuity approach

Estimate Apple’s EV using the exit EBITDA multiple approach