Discounted Cash Flow (DCF) valuation is one of the fundamental models in value investing. The model is used to calculate the present value of a firm by discounting the expected returns to their present value by using the weighted average cost of capital (WACC).
How to perform a DCF valuation
There are certain steps in performing a DCF valuation. These are:
- Calculate the WACC
The weighted average cost of capital is fundamental to the capital asset pricing model (CAPM). The WACC is calculated as the weighted average of a firm’s cost of debt and cost of equity.
Assuming that you have invested in Novartis (NYSE: NVS), the steps for the calculation of WACC are the following:
The cost of debt is derived as follows:
The company’s total debt is $16.33 billion and the interest expenses are $655.0 million. The interest expenses will save Novartis $655 x 30% (tax rate) = $196.50 million. So, the after-tax cost of debt Rd = ($655.0 – $196.5) / $16.33 = 2.81%
The cost of equity is calculated using the formula Rs = RRF + (RPM * b), where,
- RRF: the risk-free rate
- RPM: the return that the market expects
- b: the stock’s beta (systemic risk)
Therefore, for a risk-free rate of 5.00%, an expected market return of 5.10% and a b=0.75, the cost of equity is:
Rs = RRF + (RPM * b) = 5.00% + (5.10% x 0.75) = 8.83%
b) The second step is to calculate the weights of debt and equity
First, you need to find the Market value added (MVA) of the company, which represents the difference between the current market value of a firm and its book value. Novartis is currently trading at $75.21 and the number of shares outstanding is 2.37 billion. Therefore, the company’s market value is $75.21 x 2.37 = $178.25 billion. Given the company’s book value per share (BVPS) of $31.57, its book value is $31.57 x 2.37 = $74.82 billion. Therefore, the market value added is market value – book value = $178.25 – $74.82 = $103.43 billion.
Now that you know the MVA and the total debt, you added them to derive the weights of debt and equity. Therefore:
The book value of debt + MVA of equity = $16.33 + $103.43 = $119.76. Therefore, the weight of debt Wd = $16.33 / $119.76 = 13.63% and the weight of equity We = $103.43 / $119.76 = 86.37%.
c) The final step is to calculate the WACC
The formula for WACC is (Rd*Wd) + (Rs*We). Therefore:
WACC = (2.81% x 13.63%) + (8.83% x 86.37%) = 0.38% + 7.62% = 8.00%.