5 steps to building a DCF:
⦁ Forecast the Free Cash Flow
⦁ Calculate the Weighted Average Cost of Capital
⦁ Calculate the Terminal Value
⦁ Discount the Free Cash Flow and Terminal Value
⦁ Calculate the implied share price

Free Cash Flow Formula:
FCF = EBIT*(1-tax rate)
+ (Depreciation and Amortization)
– (Capital Expenditures)
– (Increase in non-cash working capital)

Example:

Weighted Average Cost of Capital Formula

The weighted average cost of capital or WACC calculates the cost of deploying capital. It is the average rate that a company expects to pay to finance its assets. This is based on their cost of debt, equity, and the current tax rate. 

E = Equity

D = Debt

T = Tax Rate

R_E = Cost of Equity (CAPM)

R_D = Cost of Debt 

Example:

Terminal Value

Terminal value is the predicted value of an investment beyond its estimated cash flow period. This can be calculated using the perpetuity growth method or the exit multiple method. 

Perpetuity Growth Method assumes that the cash flows will grow at a constant rate forever.

Exit Multiple Method assumes that the company sold using a multiple metric in this case enterprise value divided by earnings before income tax depreciation and amortization.

Example:

Discounting Cash Flows

This is done by taking the free cash flow for each year, dividing it by one plus the discount rate raised to the power of each period and then summing all discounted cash flows together to get the present value of future cash flows. Then by adding it to the terminal value you get the current enterprise value. 

To simplify, to find the current value of an investment one must add up all of the future cash flows generated by the venture discounted by an average rate of cost of capital and then add a predicted future value which goes beyond the cash flow period based on perpetual growth.

Enterprise Value to Equity Value

Once enterprise value is calculated we can determine the equity value based on the DCF analysis. This is done by subtracting debt from the enterprise value and then adding cash. This can be further broken down into equity value being equal to enterprise value minus debt and debt equivalents minus non-controlling interest minus preferred stock plus cash and cash equivalents. But in the most basic terms we are simply subtracting debt and adding cash and liquid assets. 

By dividing equity value by the shares outstanding we are able to determine the share price

Primary Market

Before delving into the secondary market, the primary market should be covered first because a company gets established during this phase. A Primary market has many multifunctional components, but it is ultimately the market where securities first get created. Whether a corporation is private or public, it will issue stock and undergo underwriting (a middleman who purchases shares for an IPO or a private placement offering).

Private companies have their own regulations and can only be purchased by accredited investors or venture capital funds. Private companies aim to become public at a point in the future due to losing footing in research and development or a shortage in capital. Public companies have investors take a share in the company; in return, the business has more money to work with, creating enriched opportunities.

When a company is going public and issuing shares as a form of equity to an investor, it must register with the SEC and get an S-1 statement approval. When the S-1 is approved, the company ready to go public can look for institutional investors or venture capital firms to buy up stock from the underwriter.

 The Secondary Market 

Once the first pair of investors, giant corporations, or professional investors are found, the company can be listed on an exchange like the New York Stock Exchange. Then, friends, family, employees, etc., can invest in the public company. In the secondary market, derivatives like futures and options can be traded, contracts that allow investors to trade with each other, or an exchange, to predict a price of an underlying stock in the future. The contract’s winner pockets the difference, and the loser loses money.

Other instruments traded on the secondary market or an exchange consist of ETFs, bonds, short-term debt, mortgage-backed securities, collateralized investments, dividend payments, and more. Although each investment class has its own vital rules and unique characteristics, investors will pick the option they see fit in the current market economy.

The Third Market

The over-the-counter market, also known as the third market, is a marketplace that houses securities or debt that do not trade on a regular exchange. Instead of trading on an exchange, all trades are decentralized and exchanged on a peer-to-peer base. Penny stocks are traded on the third market because they didn’t meet the requirements to be traded on a large exchange. Other investments, like most bonds, are traded on the third market between large broker-dealers and lenders like investment banks or pension funds. The third market is often overlooked, but it’s typically the marketplace where some of the most significant trades occur.

Other investment options that trade on the third market are the foreign exchange market and foreign stocks listed outside of the United States. An essential characteristic of the third market is the privacy that the traders receive. For example, massive institutions can trade in what’s known as a dark pool, a private trade between two investors in an off-exchange venue. In a dark pool, giant corporations will not know who they’re trading with, and everything will stay anonymous, including the transaction itself, which isn’t available to the public. This way of trading lets corporations trade large blocks of stock without the public seeing these trades and reacting by making the underlying security price more volatile.

Fourth Market

These markets are secretive and, for the most part, are only traded with the largest corporations. Unlike a dark pool, where the investors don’t know who they’re trading with, fourth markets let two corporations trade with each other privately. As a result, there is little known to the public on how fourth markets operate except that they trade amongst corporate institutions.