DCF and comps mechanics

At superday level, "walk me through a DCF" is followed by questions that test the mechanics: how you get from EBIT to free cash flow, where the discount rate comes from, why you might use one terminal value method over another, and how a comps table is put together. This lesson goes through each step with numbers.

Unlevered free cash flow

Unlevered free cash flow is the cash the operations generate for all capital providers. It is before interest, so it is not affected by how the company is financed.

Tax is calculated on EBIT, not on profit before tax, because the interest tax shield belongs in the discount rate. Stock-based compensation is often added back in company-reported figures, but many analysts treat it as a real cost and leave it in.

IFRS 16 needs a consistent choice. If your EBITDA and EBIT exclude lease costs, the lease payments are not in free cash flow, so subtract lease liabilities in the bridge from enterprise value to equity value. Alternatively, deduct lease payments in free cash flow and leave lease liabilities out of net debt. Mixing the two double counts or ignores the leases.

The discount rate

• Risk-free rate: for a sterling valuation, a long-dated gilt yield
• Beta: how much the share moves with the market, often taken from peers and adjusted for their leverage
• Equity risk premium: the extra return investors demand for owning shares over gilts, typically assumed at around 5% to 6%
• Cost of debt: the rate the company would pay to borrow today, which is taken after tax because interest is deductible
• Weights: target debt and equity at market values, not book values

Terminal value, discounting and the bridge

With perpetuity growth, terminal value = final-year free cash flow × (1 + g) ÷ (WACC − g). With an exit multiple, terminal value = final-year EBITDA × an EV/EBITDA multiple from comps. Good practice is to calculate both and check that each implies something sensible about the other: the growth rate implied by your exit multiple should look reasonable, and the multiple implied by your growth rate should sit near today's trading range.

Discount each year's cash flow by (1 + WACC)^n. Many banks use the mid-year convention, discounting each year's cash flow by half a year less, because cash arrives through the year rather than on the last day. The terminal value is discounted at the same point as the final year's cash flow if you use perpetuity growth, or at the end of the final year with an exit multiple.

Sum the present values to get enterprise value, then subtract net debt, lease liabilities if consistent with your free cash flow, non-controlling interests and preference shares, and add non-operating assets. Divide equity value by diluted shares, using the treasury stock method, to get value per share. Because diluted shares depend on the share price, some models iterate, but a single pass is fine in an interview.

Trading comparables

• Pick peers on business model first, then size, growth, margins and geography
• Pull the latest share price, diluted shares, net debt and other bridge items for each peer
• Take LTM figures from the latest annual and interim reports, and forecasts from broker consensus
• Adjust for one-off items, such as restructuring costs or gains on disposals
• Calendarise figures so every company covers the same period
• Work out the multiples and show the median and interquartile range

Calendarising matters because UK companies have a wide range of year ends. A retailer with a February year end and a manufacturer with a December year end are not reporting the same twelve months.

Putting it together

Bankers rarely rely on one method. A football field chart shows the value ranges from trading comps, precedent transactions, a DCF and sometimes an LBO side by side. Precedent transactions usually give the highest values, because they include control premiums. If a DCF gives a value far above the others, the most likely causes are an aggressive growth rate, a low WACC or an exit multiple taken from a peak market.