DCF Analysis: Coming Up with a Fair Value

In the previous chapter, we calculated the discount rate for ACME Corp. Now we’ll do the final calculations to generate a fair value for the company’s equity.

Calculate the Terminal Value

Now that we’ve estimated the free cash flow generated over the five-year forecast period, we need to estimate the value of ACME Corp.’s cash flows after that period (if we don’t include this, we would have to assume that ACME Corp. stopped operating at the end of the five-year forecast period). To do so, we’ll determine the company’s terminal value.

Gordon Growth Model

A widely-used method of estimate the terminal value of cash flows is the Gordon Growth Model, which uses the following formula:

In Forecasting Free Cash Flows, we estimated free cash flow of $21.3M for ACME Corp. in Year 5, the final or “terminal” year of our company projections. We also calculated the company’s discount rate as 11% in Calculating the Discount Rate. We’ll also assume that cash flows will grow in perpetuity by 4% per year. Now we can calculate the terminal value of ACME Corp. using the Gordon Growth Model:

Calculating Total Enterprise Value

We now have the following free cash flow projection for ACME Corp.:

To determine a total company value, or enterprise value (EV), we take the present value of the cash flows, divide each by the discount rate (11%) and then add the results:

EV = ($18.5M/1.11) + ($21.3M/(1.11)²) + ($24.1M/(1.11)³) + ($19.9M/(1.11)⁴) + ($21.3M/(1.11)⁵) + $316.9M/(1.11)⁵)

EV = $265.3M

Calculating the Fair Value of Equity

We have one more step. ACME Corp.’s $265.3M enterprise value includes the company’s debt. Because investors are more interested in the value of the company’s shares alone, we’ll deduct net debt from this value to arrive at a fair value of the company’s equity.

For our example, we’ll assume that ACME Corp. has $50M in net debt on its balance sheet, so we’ll subtract that from the company’s enterprise value to get the equity value:

Fair Value = Enterprise Value – Debt

Fair Value of ACME Corp. = $265.3M - $50M = $215.3M

And that it’s, our DCF valuation is complete. ACME Corp. has a fair value of $215.3 million. We can divide the fair value by the number of ACME Corp. shares outstanding to get a fair value per share. If shares are trading at a lower value, it could represent a buying opportunity for investors; conversely, if they’re trading at a higher value, it could represent a selling opportunity.