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 todays dollar worth tomorrow (future value)?

N FV PV ( 1 i )

What is tomorrows dollar worth today (present value)?

PV FV /( 1 i )

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 $ 5 , 000 * ( 1 10 %) FV $ 12 , 969
Likewise

10 years

PV $ 12 , 969 /( 1 10 %) PV $ 5 ,000

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
Y e a r0 ( $ 3 0 , 0 0 0 ) D is c o u n tR a t e : N e tP r e s e n tV a l u e Y e a r1 $ 3 , 0 0 0 1 0 % ( $ 2 2 5 . 3 9 ) Y e a r2 $ 1 0 , 0 0 0 Y e a r3 $ 2 5 , 0 0 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 Year 1 Year 2 Year 3

Initial Cost (50,000) Operating Income Taxes (34%) Income

Plus: Depreciation Minus: CapEx Free Cash Flow Discount Rate Present Value ($50,000) 10%

75,000 (25,500) $49,500

3,750 4,500 $48,750 $44,318

84,000 (28,560) $55,440

4,200 5,040 $54,600 $45,123

100,000 (34,000) $66,000

5,000 6,000 $65,000 $48,835

Discounted Values ($50,000) $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

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