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)?
FVPV i N ( ) 1
• What is tomorrow’s dollar worth today (present value)?
PV /( i FV 1 )
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 * 10 000 $ 5 ( %) , 1 FV $ , 12 969
• Likewise…
10 years
PV /( %) , 1 $969 12 10 PV $ ,000 5
10 yea
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
Ya 0 er ( 3, 0) $ 00 0 D c u t Rt : is o n ae Nt Pe e t V l e e r s n au Ya 1 er $, 0 30 0 1% 0 ( 2 53 ) $2. 9 Ya 2 er $ 00 0 1, 0 Ya 3 er $ 50 0 2, 0
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 debtholders 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 Initial Cost (50,000) Operating Income Taxes (34%) Income Year 1 75,000 (25,500) $49,500 Year 2 84,000 (28,560) $55,440 Year 3 100,000 (34,000) $66,000
Plus: Depreciation Minus: CapEx
Free Cash Flow Discount Rate Present Value ($50,000) 10%
3,750 4,500
$48,750
4,200 5,040
$54,600
5,000 6,000
$65,000
Discounted Values ($50,000)
$88,277
$44,318
$45,123
$48,835
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
• 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
– Future performance is unknowable
Forecasting Cash Flows
• Historical Simple/Weighted Averages
– Primarily used when there is no discernable trend, or current trend is not expected to continue
Net Income Growth Simple Average Weighted Average Weight Growth 33.3% 5% 26.7% 1% 20.0% 8% 13.3% 12% 6.7% 7% 100.0% Year 1 7% Year 2 12% Year 3 8% 6.60% Year 4 1% Year 5 5%
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 6 6%
Year 2 4% Year 7 7%
Year 3 4% Year 8 8%
Year 4 5% Year 9 8%
Year 5 6% Year 10 8%
Estimated NI Margin
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