Part 2 – Lesson 8

Building off the previous lessons on cost of capital and present value, below is a DCF analysis of Verizon, which you can download in Excel (Part 2 Excel Download).  The easiest way to learn to build a DCF is to go through the Excel file cell by cell to understand how the valuation flows together and then try building your own DCF.

Below is the full DCF valuation of Verizon: We will list below the steps we took to build out the DCF:

1. Cost of Equity – Calculate the cost of equity by identifying the beta of Verizon (we have used 0.95), multiply the beta by the equity risk premium, and then add the risk-free rate. We have used 2.80% as this is the current yield on the 10-year treasury as of July 2018.  We calculate the cost of equity for Verizon as 8.1%.  For a mature, steady-state business, a cost of equity of 8.1% seems reasonable.  Notice that the 10-year treasury yield going up would increase the cost of equity.  This shows why valuations are very sensitive to the overall interest rates in the economy.

2. Cost of Debt – In 2017, Verizon issued debt at a 4.95% coupon and 5.25% coupon. We used 6.00% as our pre-tax cost of debt, which appears appropriately conservative given recent debt issuances.  This information can be found in Verizon’s debt schedule, which is in the notes section of the 2017 10-K.  Please refer to Part 1, Lesson 13 for instructions on how to navigate the notes to the financial statements.  We have used a 25% tax rate, which is lower than recent historical rates due to the reduction in corporate tax rate to 21% instituted by Congress in 2018.  Lower tax rates are generally positive for valuations since it lowers the discount rate used in the valuation and increase the after-tax projected cash flow.

3. WACC – We calculated the current market cap of Verizon (refer to Part 2, Lesson 4 for details on calculating market cap) as \$201Bn. We pulled the current debt outstanding from the most recent balance sheet available on sec.gov.  This results in an equity weighting of 64% and debt weighting of 36%.  Using these relative weightings, we calculated the WACC of 6.78%.  Remember that the WACC is our blended cost of capital that we will use to discount unlevered cash flows.  Unlevered cash flows are the cash flows available to both debt and equity investors (in other words, it is before the deduction of interest expense).

4. Perpetual Growth Rate – We have assumed Verizon’s cash flows will grow at 0.5% in perpetuity. Remember that the perpetual growth rate will be used in calculating the terminal value of Verizon through the use of a growing perpetuity formula (Part 2, Lesson 6).  A 0.5% perpetual growth rate is conservative since the rate of inflation has historically been around 2%.

5. Financial Projections – We have pulled financial projections (revenue, EBITDA, etc) for Verizon from Wall Street research we have access to. As an individual investor, this information may be harder to come by.  We will discuss in later sections how to build financial projections on your own.

6. Calculating Unlevered Free Cash Flow – You may refer to Part 1, Lesson 12 for a more detailed discussion on calculating levered and unlevered cash flow. In this DCF, we are using unlevered cash flows.  We arrive at unlevered cash flow by calculating Net Income as if there was no interest expense, then add back Depreciation and Amortization, and subtract out any increases in working capital.  This gives us our unlevered operating cash flows.  We then subtract capital expenditures to calculate unlevered cash flow.

7. Terminal Value – In the final year of the DCF (2023), we calculate the terminal value of Verizon. Remember that the growing perpetuity formula = year 1 cash flow / (discount rate – perpetual growth rate).  We want to use the 2024 cash flow in this formula to get our “timing” of the year 1 cash flow correct.  If we applied the growing perpetuity formula to the 2023 cash flow number in the model, then, this value will be as of the beginning of 2023.  However, the Net Present Value formula in Excel assumes that all cash flows arrive at the end of the period.  Therefore, we want to calculate the growing perpetuity value as of the end of 2023.  To do that, we need to use the cash flow from 2024 as the year 1 cash flow in the growing perpetuity formula.  For the discount rate, we will use the WACC.

8. Net Present Value – We will then use the =NPV(rate, cash flows) formula in Excel to calculate the present value of all Verizon cash flows (including all yearly cash flows and the 2023 terminal value). The result from this formula is the enterprise value of Verizon.  The enterprise value is the total value of Verizon’s business.  This total value includes both the value of the equity and the value of the debt.  Remember – we discounted unlevered cash flows with an unlevered discount rate (WACC).

9. Equity Value – Since the enterprise value (NPV of all cash flows) includes the value of debt, we must subtract the current debt outstanding of \$119Bn to arrive at the equity value of \$252 Bn. This is the DCF estimate of the value of the market capitalization of Verizon.

10. Equity Value per Share – Ultimately, this is the answer that we are solving for in a DCF analysis. We are calculating our view of what Verizon’s stock is worth based on our financial projections discounted by an appropriate discount rate.  Dividing the present value of the equity by the current shares outstanding yields a stock value of \$61, which is approximately 19% higher than Verizon’s stock price as of July 2018.

### What are the important drivers of value in a DCF?

Let’s look at various factors and how they impact the value calculated by a DCF:

1. Higher Cost of Equity or Debt = Lower DCF Value

2. Lower Cost of Equity or Debt = Higher DCF Value

3. Higher Risk-Free Rate = Higher WACC = Lower DCF Value

4. Higher Financial Projections = Higher DCF Value

5. Lower Financial Projections = Lower DCF Value

6. Higher Share Count = Lower DCF Value

7. Lower Share Count = Higher DCF Value

8. Higher perpetual growth rate = Higher DCF Value

9. Lower Perpetual Growth Rate = Lower DCF Value

10. Lower Tax Rate = Higher DCF Value

11. Higher Tax Rate = Lower DCF Value

Most of these items are intuitive, but it is worth mentioning that a DCF analysis is only as good as the quality and accuracy of the inputs that go into it.  A common saying in finance is “garbage in, garbage out.”  Any investor can massage a DCF to fit their investment thesis by using a discount rate that is too low or using financial projections that are too high.  To be a prudent investor, it is important to be intellectually honest when choosing assumptions that will go into a valuation.

### Can a DCF be performed using levered cash flows instead of unlevered cash flows?

Yes.  If we want to build a DCF off levered cash flow (meaning after deducting interest expense), then, we must discount these cash flows using a levered discount rate (the cost of equity).

Unlevered cash flows are cash flows that can go to both equity and debt holders.  The WACC is a discount rate that incorporates both the cost of equity and the cost of debt.  Therefore, the WACC should only be used to discount unlevered cash flows.

Levered cash flows are cash flows that can only go to equity holders since it is after interest expense has been deducted.  We should only use the cost of equity to discount cash flows that are going to equity holders.  Additionally, the terminal value should be calculated using the cost of equity rather than the WACC.  When we discount all our levered cash flows with the cost of equity, the resulting answer is the present value of the equity of the business (not the enterprise value).  From here, we’ll need to divide this by the share count to arrive at the value per share.

Below, we have re-worked the DCF of Verizon using levered cash flows as our projections: The DCF valuation using levered cash flows results in a value of \$64 for Verizon stock vs. \$61 using unlevered cash flows.  Why is there a difference?

First, it is important to note that DCF valuations are very sensitive to changes in the underlying assumptions.  By moving from an unlevered valuation to a levered valuation, we are inevitably going to end up knowingly or unknowingly changing a few of the inputs that go into the valuation.

In this example, one of the reasons that the levered cash flow valuation results in a higher value is because it is implicitly assuming a lower cost of debt than what was assumed in the unlevered valuation.  In the unlevered valuation, we used a 6.0% pre-tax cost of debt.  However, the interest expense projections used in the levered valuation of \$4.8Bn implies an interest cost closer to 4% (\$4.8 Bn interest / \$119 Bn debt outstanding).