Introduction to Discounted Cash Flow Analysis
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Transcript Introduction to Discounted Cash Flow Analysis
Introduction to
Discounted Cash Flow Analysis
CHRIS DELL’AMORE
COLGATE FINANCE CLUB
2/12/11
What is a DCF?
Value can be derived from the present value of its
projected free cash flows
Intrinsic Value ≠ Market Value
Assumptions:
Growth rates (i.e. sales)
Profit margins
CAPEX
Net Working Capital requirements
When do we use a DCF?
No “true” comparable companies
Times of economic turmoil
Flexibility in assumptions
Fundamental approach
Process of a DCF
Analyze Target and Determine Drivers
2. Project the Free Cash Flow (FCFs)
3. Calculate Weighted Average Cost of Capital (WACC)
1.
•
Capital Asset Pricing Model (CAPM)
4. Calculate Terminal Value (TV)
5. Calculate Present Value (PV)
Disclosure: This presentation will go over the basics of each step and will not analytically delve into the development of each calculation.
Target Analysis (Step 1)
Public
SEC filings, earnings call transcripts, analyst research and
Management Discussion and Analysis portion of the 10-K and
10-Q
Private:
Confidential Information Memorandum (CIM), analyst research,
trade journals and SEC filings
Business model
Financial profile
End markets
Competitors
Driver Analysis (Step 1)
Sales Growth
Internal: new facilities, new products, capital efficiency
improvements, costumer contract expansion
External: acquisitions, end market trends, regulatory changes
consumer buying patterns
Profitability
Management, brand, customer base, marketing, technology
Free Cash Flow Generation
CAPEX (i.e. owning vs. leasing)
Projecting Free Cash Flows (Step 2)
Historical Performance
Projection Period Length (~5-10 years)
Best Case, Base Case, Worst Case
Projections:
Sales, COGS and SG&A, EBITDA, EBIT, Tax, D&A, CAPEX,
NWC
EBIAT /NOPAT= EBIT – Marginal tax rate (~35-40%)
NWC = Current Assets – Current Liabilities
FCF= EBIAT + D&A - CAPEX - ΔNWC
Calculating WACC (Step 3)
Represents the weighted average of the required return
on the invested capital
Debt and Equity have different risk and tax benefits/detriments
Determine target capital structure
Debt-to-total capitalization [D/(D+E)]
Equity-to-total capitalization [E/(D+E)]
Calculating WACC (Step 3)
(Cost of Equity)
(Cost of Debt)
Calculating WACC (Step 3)
Estimate Cost of Debt (rd)
Credit Profile at target capital structure
Bonds: current yield on all outstanding issues
Credit Facilities: analyzed by DCM team internally
Tax-effect your cost of debt by marginal tax rate
Estimate Cost of Equity (re) – CAPM
Annual rate of return that equity investors expect to receive
Use CAPM to find this rate
re = rf + βL * (rm - rf )
Disclosure: Did not discuss process of unlevering and relevering beta for sake of simplicity
Calculating WACC (Step 3)
WACC
=
(
E
(D+E)
)
(re) +
(
D
(D+E)
)
(1-t)(rd)
D = market value of debt
E = market value of equity
rD = discount rate for longterm debt
re= discount rate for equity (from CAPM)
Calculating Terminal Value (Step 4)
Captures the value beyond the projected period
Steady state; accounts for ~75% of valuation
Exit Multiple Method (EMM)
Based on the current LTM trading multiples of comps
Must normalize to account for peaks and troughs in industry
TV = EBITDAn * Exit Multiple
Perpetuity Growth Method (PGM)
Treats company’s terminal year FCF as a perpetuity growing at an
assumed rate. (Must be cautious when choosing growth rate)
TV =
FCFn * (1 + g)
(re -g)
Calculating Present Value (Step 5)
Time value of money
Discount Rate:
Fractional value representing the present value of a dollar
received at a future date given an assumed discount rate
(WACC)
Discount Factor =
1
(1 + WACC)n
PV of FCFn = FCFn *Discount Factor
Final Valuation
Enterprise Value
Discount and sum the present values of the FCF for each
period and the TV
Equity Value
Implied Equity Value = Enterprise Value – (Net Debt + Preferred Stock +
Non-controlling Interest)
Share Price
Implied
Share Price =
Implied Equity Value
Fully Diluted Shares Outstanding
Works Cited
Pearl, Joshua, and Joshua Rosenbaum. Investment
Banking Valuation, Leveraged Buyouts and
Mergers & Acquisitions. Hoboken: John Wiley &
Sons, 2009. Print.