Discounted Cash Flow (DCF) Analysis Tutorial

This presentation is to be used ONLY as a template for DCF Analysis presentations. In no way should it reflect a finished work.

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 – Composition – – 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)?

 1

i

)

N

• What is tomorrow’s dollar worth today (present value)?

 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

$ , 969  %) $ 5 , 000

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 consensus 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 ($30,000) $3,000 10%

($225.39)

$10,000 $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

• 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%.

– Weighted Actual Cost of Capital (WACC)

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

•

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 debt holders have been paid and necessary reinvestment has been made

Free Cash Flow – Equity

Net Income

Add: Depreciation Less: Capital Expenditures (CAPEX) ------------------------------------

Free Cash Flow to Equity

DCF Example

Lemonade Stand Business Year 0 Year 1 Year 2 Year 3

Initial Cost (50,000) Operating Income 75,000 84,000 100,000 Taxes (34%) (25,500) (28,560) (34,000)

Income $49,500 $55,440 $66,000

Plus: Depreciation 3,750 4,200 5,000 Minus: CapEx 4,500 5,040 6,000

Free Cash Flow ($50,000) $48,750 $54,600 $65,000

Discount Rate 10% Discounted Values ($50,000) $44,318 $45,123 $48,835

Present Value $88,277

Terminal Cash Flow

•

Going Concern Assumption

– –

Zero Growth: CF / i

• • $48,835/0.10 = $488,350

5% Growth: CF*(1+g) / (i-g)

: The business will operate and generate cash flows indefinitely.

$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 • 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 discernible trend, or current trend is not expected to continue

Net Income Growth Year 1

7%

Year 2

12%

Year 3

8%

Year 4

1%

Year 5

5%

Simple Average 6.60% Weighted Average Weight

33.3% 26.7% 20.0% 13.3% 6.7% 100.0%

Growth

5% 1% 8% 12% 7% 1.7% 0.3% 1.6% 1.6% 0.5%

5.6%

Forecasting Cash Flows

• Historical Trend Exrapolation

Net Income Margin Year 1

4%

Year 2 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%