1. Numerator and Denominator Consistency
When discounting cash flows back to present value, the key thing here is
to remember our discussion around numerator denominator consistency,
recall that enterprise value is an unlevered metric, that is it is not
impacted by capital structure. Since unlevered free cash flows are also
not impacted by capital structure, hence the name unlevered,
then it makes sense that if we discount unlevered free cash flows back
to the present value, you will derive enterprise value.
Of course, that brings us back to the appropriate discount rate,
since we are using unlevered cash flows and these cash flows are available
to all providers of capital, debt inequity, then our discount rate must
reflect the risk to all of those investors.
The weighted average cost of capital, WACC, is the appropriate discount
rate here, because it factors in the risk for both debt and equity
investors. We will discuss the specific WACC calculation a little later
in the course. Before we get into more granular details, a few words
on performing a DCF valuation, a DCF is easiest to use on a
company that has positive and fairly predictable cash flows. A DCF becomes
more difficult for early stage startup companies and companies that are
in financial distress or bankruptcy. Additionally, while a private company
can be valued using a DCF, assuming you have access to its financials,
of course, the hard part is estimating a discount rate for that private
company.
2. Let's practice!