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)?

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

NiPVFV )1(

NiFVPV )1/(

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?

• Likewise…

yearsFV 10%)101(*000,5$

969,12$FVyearsPV 10%)101/(969,12$

000,5$PV

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

Year 0 Year 1 Year 2 Year 3

($30,000) $3,000 $10,000 $25,000

Discount Rate: 10%

Net Present Value ($225.39)

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 debt-holders 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 Year 1 Year 2 Year 3

Initial Cost (50,000)

Taxes (34%) (25,500) (28,560) (34,000)

Operating Income 75,000 84,000 100,000

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: 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 Year 1 Year 2 Year 3 Year 4 Year 5

Net Income Growth 7% 12% 8% 1% 5%

Simple Average 6.60%

Weighted Average Weight Growth

33.3% 5% 1.7%

26.7% 1% 0.3%

20.0% 8% 1.6%

13.3% 12% 1.6%

6.7% 7% 0.5%

100.0% 5.6%

Forecasting Cash Flows

• Historical Trend Exrapolation

Year 1 Year 2 Year 3 Year 4 Year 5

Net Income Margin 4% 4% 4% 5% 6%

Year 6 Year 7 Year 8 Year 9 Year 10

Estimated NI Margin 6% 7% 8% 8% 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