Conducting a discounted cash flow (DCF) analysis requires investors and equity research analysts to adhere to the highest standards of professional excellence. Rigorous due diligence is essential to accurately determine a company’s intrinsic value.
To help investors and professional analysts in their jobs we draw up a must-follow guide that thoroughly covers every crucial aspect of due diligence required for companies’ valaution using the DCF method.
For every phase of the analysis, we listed the primary sources useful for gathering data and information.
Summary:
- Phase 1. Business Model Analysis
- Phase 2. Industry Overview & Growth Forecasts
- Phase 3. Projecting Free Cash Flows
- Phase 4. Valuation
- Phase 5. Market Sentiment & Analyst Coverage
Company Valuation Due Diligence
Phase 1. Business Model Analysis
Main sources: 10K, 10Q, Investors Day report, earnings call transcript, company’s website, financial data providers (TIKR terminal, Seeking Alpha)
Analyse Financial Statements
Segment Analysis: Break down revenue by segment, geography, and product or service. Understand which segment is growing or shrinking.
Quality of Revenue: Assess the sustainability and quality of revenues. How sensitive are they to economic cycles?
Customer Dependency: Look for any customer concentration risks and understand the customer retention rates.
Supplier Risks: Evaluate the company’s dependency on key suppliers and the risks associated with supply chain disruptions.
Assess Profitability Metrics
Margin Analysis: Examine gross, operating, and net margins over time. Compare them to industry peers.
COGS Analysis: Examine COGS over time. Have they increased/decreased abnormally from year to year? Have they increased/decreased more than revenues?
Operating Expenses Analysis: Examine operating expenses over time. Have they increased/decreased abnormally from year to year? Have they increased/decreased more than revenues? What type of expense is predominant?
Operating Income: Examine operating income over time. Look for non-recurring items, accounting adjustments, or red flags that might suggest quality issues.
Evaluate Moat
Competitive Advantages: Identify and assess the company’s unique strengths, brand power, patents, market share, cost advantages, network effects, etc.
Durability of Moat: Consider how long the company can sustain its competitive edge. Look at historical data, industry trends, and potential disruptors.
Forecast Margins: Project operating margins into the future. Are margins likely to be in line/improve/deteriorate compared to historical/industry values?
Reinvestment Needs
Investment in Growth: Look at how much is being reinvested into the business for future growth (CapEx, R&D, and Acquisitions) versus returned to shareholders (dividend & buybacks).
Free Cash Flows Analysis
Free Cash Flows to Firm: Examine FCFF over time. Have FCFF been volatile/stable through the years?
Efficiency Ratios Analysis
Sales to Invested Capital Ratio: Calculate how effectively the company turns invested capital into revenue.
Return on Invested Capital: Calculate and interpret ROIC to understand how well the company is using its capital.
Improvement Trends: Identify trends in efficiency ratios and the reasons behind changes.
Assess Financial Health
Debt Structure and Liquidity: Assess the company’s debt maturity profile, interest coverage, and liquidity ratios.
Off-Balance Sheet Items: Identify and understand the implications of any off-balance sheet financing or liabilities.
Phase 2. Industry Overview & Growth Forecasts
Main sources: BlackNote Investment, financial data providers (TIKR terminal, Seeking Alpha), generalist news providers, Investors Day report, independant industry report
Market Share and Competitors Analysis
Market Position: Determine the company’s position and market share within the industry.
Competitive Landscape: Identify and study major competitors, their strategies, strengths, and weaknesses.
Benchmarking: Benchmark key financial and operational metrics against peers to identify strengths and weaknesses.
Consider Industry Dynamics
Industry Trends: Look at technological advancements, regulatory changes, consumer preferences, and other macro trends affecting the industry.
Economic Cycles: Understand how different economic cycles affect the industry and company. Use economic indicators (Industrial Production Index, Manufacturing Purchasing Managers Index, CPI, PPI) to assess the current state of the economy.
Risk Assessment
Litigation Risks: Identify any ongoing or potential litigations and their possible impact on the company.
Regulatory Compliance: Ensure the company complies with relevant regulations and understand the impact of any regulatory changes.
Geopolitical Risks: Consider the impact of political instability, trade policies, or changes in government regulation.
Estimate Growth
Growth Rate: Examine past and projected industry growth rates based on reinvestments and efficiency industry ratios. (For additional info check out this detailed post including a step-by-step guide to forecasting industry future revenues)
Forecast Market Share: Examine past and projected company’s market share. Identify the driving factors behind these rates and forecast future revenues. (For additional info check out this detailed post including a step-by-step guide to forecasting future company revenues)
Phase 3. Projecting Free Cash Flows
Main sources: 10K, 10Q, equivalent company report, BlackNote Investment, financial data providers (TIKR terminal, Seeking Alpha)
Project Reinvestment Needs
Reinvestment margin: Estimate future capital needs for maintaining and growing the business.
Project Efficiency Ratios
Sales to Invested Capital Ratio: Project sales to IC ratio into the future. Are Sales to IC ratios likely to be in line/improve/deteriorate compared to historical/industry values?
Return on Invested Capital: Project ROIC ratio into the future. Are ROIC ratios likely to be in line/improve/deteriorate compared to historical/industry values?
Forecast Cash Flows
Sensitivity Analysis: Understand how key assumptions (growth rates, margins, capital reinvestments) affect free cash flows.
Phase 4. Valuation
Main sources: Aswath Damodaran, BlackNote Investment
Discount Rate Calculation
Discount Rate: Estimate the right discount rate in normal/stable growth by assessing the required capital mix, beta, and default spread once the company enters the steady state.
Internal Rate of Return: Assess the implied IRR to justify current prices.
Quantified Risk/Reward: Clearly quantify the risk/reward asymmetry in the valuation context.
Market Mispricing and Catalysts: Explain any market mispricing in the valuation and identify catalysts that could narrow the mispricing.
Probabilistic Models: Consider using probabilistic models to account for the range of possible outcomes in your valuation.
Phase 5. Market Sentiment & Analyst Coverage
Main sources: financial data providers (TIKR terminal, Seeking Alpha), generalist news providers
Analyst Expectations: Compare your valuation to the consensus estimates and understand the reasons for any significant discrepancies.
Market Sentiment: Gauge the market sentiment and understand how it might affect the company’s stock price.
Social Media Sentiment Analysis: Consider using data analytics to gauge customer and market sentiment towards the company from social media and news outlets.
We believe following these thorough due diligience guidlines allows investors and professional analysts to deliver professional excellence and assess better investment opportunities in the long run.
If you are looking for financial data to support your valuations, on BlackNote Investment you can find the expected growth rate for 37 different industries used to forecast companies’ future revenues.
Additionally, the site offers useful data such as equity risk premiums for 39 different countries, used for calculating discount rates, as well as expected earnings growth rates for those countries based on analysts’ expectations.
Detailed industry and sector reports are also available, containing data like total revenues, total free cash flows, median operating margins, return on capital, as well as beta and financial ratios used to assess companies’ risk.
Feel free to use them in your analysis.