Download DCF Tutorial Part 1

Discounted Cash Flow (DCF)
Tutorial
Wednesday, January 31st, 2007
Tutorial Objectives
• Basic Underlying Principles
– Time Value of Money
– Present/Future Value
– Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
– Compostion
– Computation
– Forecasting
Present Value
• Time Value of Money: A dollar today is worth more
than a dollar tomorrow.
– A dollar today can be invested to earn a rate of return or
interest.
• What is today’s dollar worth tomorrow (future value)?
FV
PV
(1i)N
• What is tomorrow’s dollar worth today (present value)?
PV
FV
/(
1

i)
N
Time Value: Example
• You are given $5,000 and decide to invest it in the
stock market for 10 years and expect an average
annual rate of return of 10%. What is that $5,000
worth 10 years from now?
FV

$
5
,
000
*
(
1

10
%)
FV
$12
,969
10
years
• Likewise…
PV

$
12
,
969
/(
1

10
%)
PV$5,000
10
yea
What is a Business Worth?
• A business is worth the present value of the
expected future cash flows of the business.
• A company's stock price is a reflection of the
market's concensus expectation regarding the
value of the equity in the business.
Ex. Target Corp (TGT):
$60 Share Price
x 858.89 Shares Outstanding (mm)
= $51,533 Market Capitalization or Market Value of Equity
• Is the market always right?
Capital Budgeting
• The process of determining how a firm should allocate scarce
resources to available long term investment opportunities
• Decisions whether a company should undertake a given project
• Goal: Increase (Maximize) shareholder wealth
• One capital Budgeting tool is NPV
Y
ear 0
($30,000)
D
iscount R
ate:
N
et Present Value
Y
ear 1
$3,000
10%
($225.39)
Y
ear 2
$10,000
Y
ear 3
$25,000
Discount Rate
• The interest rate at which you discount
expected future cash flows to the present
• Efficient Markets Hypothesis (EMH)
– Finance theory which states that all stock market
prices at any given time reflect the accurate present
value of the future cash flows of a business
– Assumes market as a whole has rational
expectations and is always right
– Uses Capital Assets Pricing Model (CAPM) to
establish the theoretical 'cost' of equity
Discount Rate
• EMH uses Beta as a measure of risk by
quantifying the stock's volatility (up and down
movements) relative to the market.
– Since the stock price reflects the PV of future cash
flows, the more volatile the stock price, the more
uncertain the future performance of the business.
– This 'extra risk' is reflected in a higher Cost of
Equity. (Risk/Return)
Cost of Equity = Rf + B * (Mkt – Rf)
Discount Rate
"I'd be a bum on the street with a tin cup if the
markets were always efficient" – Warren Buffett
• The Opportunity Cost of Money –
– Also known as the Hurdle Rate
• The expected rate of return available on
alternative investment opportunities
– Historically, the stock market has generated an
average annual return of about 10%.
Discounted Cash Flow Analysis
• Same Concept as capital budgeting: Is a $60 per
share ‘initial investment’ in Target Corp. worth the
projected future cash flows of this business given a
discount rate of 10%?
• Instead of a CFO conducting Capital Budgeting
analyses to evaluate the projected cash flows of
projects for his/her company to invest in, we are a
fund conducting DCF analyses to evaluate the
projected cash flows of whole companies.
Free Cash Flow – Equity (FCFE)
• Net Income adjusted for all non-cash sources
of revenue and expense, less capital
expenditures
– Ex. Subtract all revenue paid for on credit, and add
all expenses paid for on credit
– Add back depreciation – largest non-cash expense
• The cash that is left for shareholders after debtholders have been paid and necessary
reinvestment has been made
• FCFE is what we care about!
Free Cash Flow – Equity (FCFE)
Net Income
Add: Depreciation
Less: Capital Expenditures (CAPEX)
= Free Cash Flow to Equity
DCF Example
Lemonade Stand Business
Year 0
Initial Cost
(50,000)
Operating Income
Taxes (34%)
Income
Plus: Depreciation
Minus: CapEx
Free Cash Flow
Discount Rate
($50,000)
Year 2
Year 3
75,000
(25,500)
$49,500
84,000
(28,560)
$55,440
100,000
(34,000)
$66,000
3,750
4,500
4,200
5,040
5,000
6,000
$48,750
$54,600
$65,000
$44,318
$45,123
$48,835
10%
Discounted Values ($50,000)
Present Value
Year 1
$88,277
Terminal Cash Flow
• Going Concern Assumption: The business will
operate and generate cash flows indefinatley.
– Zero Growth: CF / i
• $48,835/0.10 = $488,350
– 5% Growth: CF*(1+g) / (i-g)
• $48,835*(1.05)/(.05) = $1,025,535
• Liquidation: Sell off remaining assets in
liquidation.
– PV of Fixed Assets: $52,590/(1+10%)^3
=$39,511
Forecasting Cash Flows
• Historical performance is not important in terms
of business value, but is important in terms of
predicting future performance.
• The trickiest part of business valuation
– Future performance is unknowable
• Things to consider when predicting the future:
– Every projection should be backed by a rational
argument
– The strongest arguments will include both
quantitative and qualitative support
– Mean Reversion
Forecasting Cash Flows
• Historical Simple/Weighted Averages
– Primarily used when there is no discernable trend,
or current trend is not expected to continue
Net Income Growth
Year 1
7%
Year 2
12%
Simple Average
Weighted Average
Year 3
8%
6.60%
Weight
Growth
33.3%
5%
26.7%
1%
20.0%
8%
13.3%
12%
6.7%
7%
100.0%
1.7%
0.3%
1.6%
1.6%
0.5%
5.6%
Year 4
1%
Year 5
5%
Forecasting Cash Flows
• Historical Trend Exrapolation
Net Income Margin
Year 1
4%
Year 2
4%
Year 3
4%
Year 4
5%
Year 5
6%
Estimated NI Margin
Year 6
6%
Year 7
7%
Year 8
8%
Year 9
8%
Year 10
8%
What We've Covered
• Basic Underlying Priciples
– Time Value of Money
– Present/Future Value
– Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
– Compostion
– Computation
– Forecasting