W E E K 8 D I S C O U N T E D C A S H F L O W V A L U A T I O N

USTS

Announcements

  This is the last meeting of the quarter

  Next quarter, Melanie Gin, the co-president, will join me. She has been studying abroad this quarter.

  I’d like to resume member presentation on week 3 of next quarter. If you’d like to present, please come talk to me.

  Enjoy Thanks Giving, Good Luck on the Finals, and Have a great Winter Break!

Discounted Cash Flow Valuation

  What is it?   Intrinsic valuation

  Why use this?   Not susceptible to market error   Flexible to future changes – just apply different inputs.   No need for a peer group

  What’s the limitation?   The accuracy (rather, inaccuracy) of assumptions of future.

 Very sensitive to changes in those assumptions   A Subjective process

Process of DCF

  1. Calculate weighted average cost of capital (WACC)   Find out cost of debt   Find out cost of equity using CAPM

  2. Select forecast period & period of steady state condition

  3. Calculate/project the firms’ Unlevered Free Cash Flow (UFCF) from EBIDTA (just look up Morning star)

  4. Discount each UFCF by WACC to the present value and add them up.

Process of DCF

  5. Calculate the firm’s terminal value (TV) & Discount to present value   Exit Multiple Method   Perpetuity Growth Rate Method (or both) (personal choice)

  6. Derive Total Enterprise Value   Tot. EV = Net present value of Future FCF + present value of TV

  7. Derive the firms Total Equity Value from Enterprise Value   Equity Val.=Enterprise Val. – debt – preferred stock – minority

interest + cash & cash equivalents

Process of DCF

  8. Create a range of values by running different inputs & assumptions

  9. Compare it to other valuation methods & see if the DCF value is reasonable. If there’s a wild difference, figure out why.

1. Calculate WACC

  WACC = Ke * (E/D+E) + Kd * (1-T) * (D/D+E)   Ke = Cost of equity (using Capital Asset Pricing Model)

 Ke = Rf + (β * (Rm – Rf)  Rf = Risk free rate (T-bill 10 yr. most commonly used)  Β = Volatility of the stock compared to the market (can be found in

Yahoo! Finance, etc.)  Rm = Rate of Return in the market. This is SUBJECTIVE. May use

S&P 500 average return.   E = market value of equity = share price * diluted shares

outstanding   D = Market value of Debt = May use book value (caution!) or if

debt is publicly traded, that price may be used.   T = marginal tax rate

Calculate WACC

  WACC = Ke * (E/D+E) + Kd * (1-T) * (D/D+E)   Kd = Cost of Debt

 The company’s debt footnote in its 10-k or annual report.   If there was a recent debt issuance, use that rate   If the debt is publicly traded, get a quote from there  All else fail, look for a comparable company with a similar risk/

credit profile

  WACC will be your discount rate

Calculate & predict FCF

  Unlevered Free Cash Flow: Cash Flow independent of capital structure (i.e. cash flow after covering cap ex, working cap, investment needs but before interest and dividends)   No need to calculate this. Just look up in the internet

  Growth projections: may use the firm’s own projections or use analysts’ consensus.

  What life cycle is it in? steady state, growth, or demise?

  Use the rate to calculate each future years’ FCF

  Discount it to present Value:   PV = CF1/(1+r)^1 + CF2/(1+r)^2 + …

Calculate Terminal Value

  Exit Multiple method: Sell off concept   Terminal Value = Multiple * Financial Metric n

 Multiple = total enterprise value / EBIDTA  Financial Metric n = EBIDTA of year of ending forecast period

  Will the same multiple hold in the future?

  Perpetuity Growth Rate method: goes on forever   TV = (FCF n * (1+g)) / (r-g)

 FCFn = predicted UFCF of future year n  g = steady growth rate (SUBJECTIVE!)   r = WACC

Finally

  PV or FCF + PV of TV = Enterprise Value

  Equity Value = Enterprise Val. – debt, PFD, minority int. + cash & equivalents

  Equity Value per share = Equity Value / Diluted Shares