Discounted Cash Flow _ Earnings Models

Discounted Cash Flow & Earnings Models November 4, 2007 Max Perez Daniel Silverfield Agenda • • • • • Overview Financial Statement Concepts DCF Modeling Summary/Example Additional Sources/Comments Overview • Keys to modeling – Understanding how the financial statements interact and the purpose of the model you are building – Understanding incremental cash flows – Forecasting all relevant after-tax expected cash flows generated by project or company – Estimating the opportunity cost of capital (r) • Reflects time value of money and risk – Evaluation (NPV, IRR) – Excel mastery Key Finance Concepts – Income Statement • Revenues (sold vs. collected). – Gross vs. net. • Cost of goods sold: – Materials. – Labor. – Overhead (includes depreciation). • Other Income/expenses. • Earnings before interest and taxes (EBIT). • Interest expense. • Earnings before taxes (EBT). – Taxes (generally assume 40%) • Gross profit / Gross margin. • Operating expenses: – Selling, General, and Administrative. – Amortization. • Net income. • EPS (basic and diluted). • Discontinued operations. • Operating income. Key Finance Concepts – Income Statement • Earnings before interest, taxes, depreciation, and amortization (EBITDA). – Used as a proxy for unlevered free cash flow. • EBITDA – Pros: – Easy to calculate. – Industry standard. • EBITDA – Cons: – Not a proxy for unlevered free cash flow. – Accrual vs. cash accounting. – Includes other non cash charges. – Does not account for changes in working capital. Key Finance Concepts – Balance Sheet • Companies require an underlying capital base in order to operate. – Capital requirements are generally in the form of debt or equity. • Equity. – Pros: • No current-pay obligations. – Cons: • Can be expensive – share in upside so actual cost unknown. • Debt. – Pros: • Relatively inexpensive, known cost. • Hybrid securities. – Preferred stock. – Convertible securities. – PIK (payment in-kind) securities. – Cons: • Current-pay obligations. • Have first right to company assets. Key Finance Concepts – Cash Flow Statement • Change in cash balance – sources and uses of cash. • Cash flows from operating activities. – Reconciles net income to cash generated. – Increase/decrease in working capital – shows actual changes in company’s cash position as a result of current assets and current liabilities. – Depreciation and amortization expense – non cash charges. • Cash flows from investing activities. – Purchases and sales of PP&E (Capital Expenditures or CapEx). – Purchases of other companies. • Cash flows from financing activities. – Increase/decrease debt. – Issuance/repurchase of stock. – Dividends. • Total increase/decrease in cash will be reflected in the balance sheet. Key Finance Concepts – How Statements Tie Income Statement Revenues Cash Expenses Non Cash Expenses Net Income $ XX XX XX $ XX Cash Flow Statement Net Income Non-Cash Charges Changes in Working Capital Cash From Operations Cash From Investing (CapEx) Cash From Debt Financing Cash From Equity Financing Change in Cash Cash, Beg. of Year Cash, End of Year $ XX XX XX $XX $XX $XX XX $XX $XX $ XX Balance Sheet Cash Current Assets Total Assets Current Liabilities Debt Total Liabilities Owners' Equity Liabilities & Owners' Equity $ XX XX $ XX $ XX XX $ XX $XX $ XX Forecasting Cash Flows Projected Financial Information ($MM) Income Statement Total Revenue Direct Operating Expense Gross Profit Depreciation Amortization of Acquisition Intangibles SG&A Operating Income (EBIT) Total Interest Expense Interest Income Other (non-operating income) Pretax Income Less: taxes Tax Rate Net income $ 2007E $ 8,665 $ 4,766 3,898 1,888 102 742 1,269 873 293 (106) 36% 172 $ 2008E 9,332 $ 5,122 4,210 2,058 98 757 1,395 880 417 (150) 36% 251 $ 2009E 10,049 $ 5,506 4,543 2,216 98 816 1,512 893 521 (188) 36% 318 $ 2010E 10,822 $ 5,919 4,904 2,386 98 878 1,639 906 636 (229) 36% 391 $ 2011E 11,654 6,362 5,292 2,570 98 946 1,777 917 762 (274) 36% 472 Forecasting Cash Flows Projected Financial Information ($MM) Income Statement Total Revenue Direct Operating Expense (COGS) Gross Profit Depreciation Amortization of Acquisition Intangibles SG&A Operating Income (EBIT) Equity Taxes @ 36% NOPLAT Plus/Minus: Depreciation Amotization of Intangibles Changes in Net Working Capital Capital Expenditures Free Cash Flow $ 2007E $ 8,665 $ (4,766) 3,899 (1,888) (102) (742) 1,167 (420) 747 1,888 102 129 (2,718) 148 $ 2008E 9,332 $ (5,122) 4,210 (2,058) (98) (757) 1,297 (467) 830 2,058 98 40 (2,927) 99 $ 2009E 10,049 $ (5,506) 4,543 (2,216) (98) (816) 1,413 (509) 905 2,216 98 38 (3,153) 104 $ 2010E 10,822 $ (5,919) 4,903 (2,386) (98) (878) 1,541 (555) 986 2,386 98 42 (3,395) 117 $ 2011E 11,654 (6,362) 5,292 (2,570) (98) (946) 1,678 (604) 1,074 2,570 98 45 (3,657) 131 Forecasting Cash Flows - Summary Cash Flows from Operations Revenues Cost of Goods Sold Depreciation Selling, General & Admin. = = + + Operating Income (EBIT) Cash Taxes on Operating Income Net Operating Profit Less Adjusted Taxes (NOPLAT) Depreciation (Non-Cash Expense) Amortization of Intangibles (Non-Cash Expense) Capital Expenditures Increase in Net Working Capital = Cash Flow from Operations Forecasting Cash Flows • But wait, aren’t we overstating taxes! – No, the tax shield of interest expense will be accounted for in the discount rate (WACC) • Sensitivity Analysis – Create several scenarios and assign probabilities to get to an expected cash flow forecast (Base Case, Best Case, Worst Case) • Use operational parameters to build out your forecast: – Use historical financials to look at the following: • • • • • • Revenues trend: 3YR Sales Growth, P12M Sales Growth Gross Profit Margin: COGS as % of Revenues Selling & Administrative Expenses: SG&A as % of Revenues (look @ fixed costs) Depreciation: Depreciation as % of Revenues or Gross PP&E Net Working Capital: Net WC as % of Revenues CAPEX: CAPEX as % of Revenues – Makes sense that Revenues be key driver to forecast in most cases! Valuation • Four primary valuation methods – Discounted Cash Flow Analysis (DCF) – Multiples (aka “comps”) • Public or Trading Multiples (Last Week) • Transaction or M&A Multiples (Last Week) Discounted Cash Flow Analysis (“DCF”) PURPOSE: To discount projected free cash flows of the Company in order to obtain a present value of the enterprise. Pros • Theoretically, the most sound model because it is based upon expected future cash flows that will determine an investor’s actual return. • Based on expectations of performance specific to the business. • Not influenced by short-term market conditions or non-economic indicators. Cons • Present values obtained are sensitive to assumptions and methodology. • Values obtained can vary over a wide range and thus be of limited usefulness. • Only as good as management projections. • Terminal value can have significant influence on overall valuation. Not a problem as long as assumptions are reasonable. Time Value of Money (Review) • Suppose you have the following: Year Cash Flow 0 -1,000 1 250 2 350 3 450 4 550 • Question: Is this a good investment? – Some possible answers: • Payback Period. – How long to recover investments (3 years). • Accounting Rate of Return. – Average cash flow divided by investment = 40%. • Problems: opportunity costs and timing. Time Value of Money • Why Do We Care About the Timing of Cash Flows? – Money tomorrow is worth less than money today – Why do we care about OPPORTUNITY COSTS? • If you get the money today you could invest it and have even more tomorrow • Ask yourself: if you lent $1,000 today, what would you need to get back next year? – At least 5%. Why? Because you could get that risk free – Opportunity cost of capital is the expected return that an investor could have earned if they invested in other projects or companies with similar risk • THIS IS THE DISCOUNT RATE Time Value of Money • Discount Rate – Determined by the rates of return prevailing in the capital markets – The discount rate reflects the risk of projected cash flows (Company Specific Risk, Market Risk) – Market risk: cyclical vs. non-cyclical – Other names for the discount rate: • • • • Opportunity cost of capital Hurdle rate Weighted average cost of capital (WACC) Expected return [r or E(r)] Time Value of Money • The effect of an error in estimating the cost of capital is huge! • Finding the cost of equity and cost of debt • Cost of equity – Use the Capital Asset Pricing Model (CAPM) – Main assumption: investors are diversified (only concerned with market risk) Time Value of Money (Cost of Equity) – r = rf + βu (rm - rf) • βu = beta (proxy of how the company’s earnings fluctuate with macro-economic movements – proxy of market risk) – Variance of stock price with the market prices (market beta is 1) • rf = risk free rate for the period of the analysis. – Generally the 10-year U.S. treasury • rm = expected return of the market portfolio (stock index is a good proxy) – rm – rf is known as the “market risk premium” » Return above risk-free rate – Market risk premium has averaged 7.2% per annum for 1926-2003 Time Value of Money (Cost of Debt) – The cost of debt capital, rD is the current rate of return that debt holders of the company earn – Maturity of the debt should match maturity of the project (asset/liability duration matching) – If valuing the entire company, should use long-term maturity (10 to 30 year bonds) – Rate of return on bonds is measured by the yield to maturity (YTM) – Given that interest rates fluctuate constantly, need to look at current market rates! – Once we’ve established the cost of debt, need to reduce this cost by the tax shield (interest expense is a deductible expense for tax purposes) – True cost of debt is rD*(1-Tc) – Tc is the marginal cash tax rate (typically 35%) – With this adjustments we address the overstatement of tax payments in the free cash flow formula! Time Value of Money (Putting it all together) • WACC – Weighted Average Cost of Capital – WACC= rE (E / V) + (1 – Tc)rD (D / V) • rE = cost of equity capital • rD = cost of debt capital • E = market value of the equity • D = market value of the debt • V = enterprise value (sum of debt and equity) • Tc = marginal tax rate – Cost of debt is reduced by the interest tax shield. Discounting Free Cash Flow to get to PV • Present Value – Present Value (PV) = the current value of future cash flows, discounted at the appropriate discount rate (or WACC). – The present value of $1 one year from now must be less than $1 today. PV = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 … + CT/(1+r)T – Where: – C1 is the cash flow in period 1. – r is the discount rate or the expected return on comparable investments. Terminal Value • Terminal Value (aka Horizon or Continuing Value) • To properly value a company using the Discounted Cash Flow (DCF) analysis, you must discount the company’s cash flows in perpetuity • The perpetuity analysis calculates the NPV of free cash flows after a given year (the last year for which you have projections) by “capitalizing” the last available projected year’s cash flow at the appropriate discount rate. THIS IS THE TERMINAL VALUE. • The formula for calculating the NPV of the terminal value (TV) is: TV = ((Cx*(1+g))/(r-g) • Where: • Cx is the free cash flow in last period for which you have projections. • r is the discount rate or the expected return on comparable investments. • g is the growth rate of cash flows in perpetuity. • Be careful with g, NPV is very sensitive to this assumption! Forecasting Cash Flows: 10 Commandments • Depreciation and amortization of intangibles are not cash flows, but they reduce taxes • Do not ignore CAPEX, need to invest in fixed assets to fuel company growth • Do not ignore Net Working Capital – Include only charges in operating working capital. Shortterm debt, excess cash and marketable securities should not be accounted for (these are financing and lending activities) Working Capital • Working Capital • • • • • Current assets less current liabilities Net amount of liquid resources Indicates the short run liquidity of a company Current assets excluding cash Current liabilities excluding current maturities of debt • Net working capital: • Think of Net WC as an investment that owner makes in business • Generally, you can think of net working capital as net current assets: • • An increase in assets requires cash, an increase in liabilities produces cash If company has net current liabilities, liquidity crunch is on the horizon • Working capital needs vary by company, by industry (DELL COMP) • Seasonality in a business impacts working capital • • Retailers are especially impacted Reduction of the Cash Conversion Cycle (JIT systems, Lean Operations) • Net cash can be created though effective working capital management. Forecasting Cash Flows: 10 Commandments • Separate investment and financing decisions • Estimate cash flows on an incremental basis: – Forget sunk costs: cost incurred in the past and irreversible – Include all externalities – the effects of the project on the rest of the firm (e.g. cannibalization) • Opportunity costs cannot be ignored • Overhead costs (which costs are fixed an which are variable) • Do not forget terminal value (company is a going concern) Forecasting Cash Flows: 10 Commandments • Be consistent in your treatment of inflation – Nominal cash flows (include inflation) – use nominal cost of capital (r) – Real cash flows (without inflation) – use real cost of capital • Include excess cash and other relevant off balance sheet items (e.g. pension fund obligations –GM) Thank you! Our contact information: mperez2008@kellogg.northwestern.edu 787.349.9278 dsilverfield2008@kellogg.northwestern.edu 678.372.1556 Leveraged Buyout Analysis (“LBO”) PURPOSE: To determine the value a financial buyer could pay for the Company while providing adequate returns for all providers of capital. Pros • Only data point specifically used by financial buyers. • Allows you to determine what type of debt load the Company will be able to support. • Most comprehensive model. • Like the Discounted Cash Flow model, relies on management projections. Cons • Returns for providers of capital are dependent on an assumed exit multiple five years out. • Value highly dependent on fiveyear projections. • Does not take into account any roll-up or IPO strategies used by many financial buyers. Defining the LBO • Method of acquiring a company which allows the buyer to invest a minimum amount of capital to obtain equity ownership. • LBO strategy: – Buyer contributes a portion of the purchase price (equity). – Borrow the remainder of the purchase price (debt). – Pay down debt over time with the company’s free cash flows. • Potential for exponential return. • LBOs involve greater risk: – – – – – Eventually sell the company, pay off the remaining debt, and keep the remainder as proceeds. Highly leveraged businesses have increased financial obligations. Interest payments. Debt amortization. Default on debt threatens equity ownership. • As debt is paid down, the equity will comprise a larger percentage of the capital structure. • Significantly reduced liquidity. • Typical hold period is 3 to 5 years. Why the LBO Works • • Sponsor uses “borrowed” capital to obtain equity ownership. Strategy: – – – – Sponsor contributes a portion of purchase price with own capital (equity). Remainder of purchase price in borrowed (debt). Debt is paid down over time with company’s free cash flows. As debt is paid down, equity capital becomes a larger proportion of capital structure (remaining contributed capital). – Eventually sell the company, pay off remaining debt, and keep remainder of proceeds. Contributed Capital over Life of Investment 200,000 175,000 150,000 125,000 100,000 75,000 50,000 25,000 0 0 1 2 3 Debt Outstanding 4 5 Value of Company. 6 7 Equity Capital Incremental value to Sponsor upon subsequent sale Year % Equity % Debt 0 25% 75% 1 28% 72% 2 31% 69% 3 36% 64% 4 42% 58% 5 50% 50% 6 63% 38% 7 83% 17% Basic LBO Capital Structure • Varies among companies. • “Right side” of the balance sheet. • “Order” of claims on cash flows. • Debt statistics: – – – – Debt ratio Total debt to total assets. Debt to equity. Debt to EBITDA (x turns of EBITDA). – Higher ratios indicate higher leverage. Claims on Cash Flows of Business Senior Debt Term Loan A Term Loan B Bank Revolver Senior – Senior versus junior. Subordinated Debt (Mezzanine Debt) Senior Subordinated Debt Junior Subordinated Debt Preferred Stock • How do banks decide how much to lend to a company? – Asset-based lending versus cash flow lending. Equity Investor Equity Management Equity Junior The Key to the LBO is….. • Understanding how cash gets from the income statement through the cash flow statement to the balance sheet is key to understanding the LBO model. Income Statement Cash Flow Statement Balance Sheet More Suggested Readings • A few book recommendations: • Monkey Business. A skeptical and humorous look at investment banking by some former junior bankers. • Liar’s Poker. A fun read on the 1980s and Salomon Brothers. • Den of Thieves. Inside look at Michael Milken, Ivan Boesky, junk bonds, and the insider trading of the 1980s. – Michael Douglas’ character in Wall Street is based on Ivan Boesky (“Greed is good”). • Barbarian’s at the Gate. Narrative on RJR Nabisco LBO.