Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF)Presented by Jane Shui

What is a DCF?Fair Value: Valuing a company today based on estimates of future cash flowsParts of a DCF: Projected Cash FlowFuture sales growth and profit marginsDiscount rate (rw.a.c.c.)Terminal ValueOther Factors: Risks that its stocks face

PV of cash flows during the forecasting periodTime value of money refresherPerpetuity & Annuity

illustration

Future ValuePresent ValueImportant formulaePerpetuity

Annuity

Projected Cash FlowCompany value during growthForecast PeriodGrowth RateUnlevered Free Cash Flow

1) Forecast periodOne YearSlow growing company that operates in highly competitive low-margin industryFive YearSolid company that operates with advantage such as strong marketing channels, recognizable brand names, or regulatory advantageTen YearOutstanding growth company that operates with very high barriers to entry, dominant with market position or prospects

Bottom Line: Aim to forecast cash flows until the firm is at a steady state

2) Growth rate: methodsLook at the pastHistorical growth in EPSLook at othersAnalysts estimate growth in EPS for many firms. Use them!!Look at fundamentalsHow much the firm is investing in new projectsWhat the new projects are making for the firm

3) UFCF OverviewUFCF (Unlevered Free Cash Flow)Cash flow that is available to all investors (shareholders & bondholders)Cash flow before the effects of debt & equity financing: Does NOT include cash flows from debt issuances or retiring, dividends or equity issuanceActual amount of cash that a company has left from its operations that could be used to pursue opportunities that enhance shareholders valueDevelop new productsPay dividends to investorsDo share buy backs

3) UFCF Approach ACash Flow to Firms

Equity Investors: Levered free cash flow or free cash flow to equity (r s)Debt Holders: Interest Expenses (1-TC) + Principle payments New Debt IssuesPreferred Stockholders: Preferred Dividends

Firm = Equity Investors + debt holders + preferred stockholders

Approach A: illustration

3) UFCF Approach BUFCF = EBIT * (1-TC) + D&A NWC CAPEXD&A: part of non-cash expenseNWC: NWC = (Current assets Cash & marketable securities) (Current liabilities current portion of interest-bearing debt/notes)NWC = NWC (current year) NWC (previous year)Represents: The amount of cash tied up in current assetsLess cash float from current liabilitiesCAPEX: Capital expenditure that will be a significant part of the cash flowExpansionary vs. maintenance

Approach B: illustration

EBIT * (1-T)(CAPEX Depreciation & Amortization)Increases in WC (or + Net decreases in WC)+ Other relevant CFs for an all equity firm_________________________________________

= UFCFEarnings Before Interest and Taxes x (1 - t) + Depreciation & Amortization - Capital Expenditure (CapEx) - Net increase in working capital (or + net decrease in working capital) + Other relevant cash flows for an all equity firm

13Approach B: ExampleEBIT = $5,559 MTax Rate = 36%Capital Spending = $1,746 MDepreciation = $1,134 MWorking Capital Change = $477 M

What is the UFCF?

Example in realityHow can you find the UFCF from the 3 financial statements?Balance Sheet, Income Statement, and Cash Flow StatementUsing Facebook as an example http://www.scmp.com/business/companies/article/1417348/facebook-stocks-surge-us15-billion-2013-earnings-and-risingPg. 70 75 of the 2012 Annual Reportshttp://files.shareholder.com/downloads/AMDA-NJ5DZ/2929681396x0x658233/46826077-D2FD-4E84-9BBE-C3F844B547A0/FB_2012_10K.pdf

Discount RateCost of capital (rw.a.c.c) = S/(B+S) (1-TC) (rB) + B/(B+S) (rS)

Cost of equityCAPMR s = E(r j)= r f + B j , M (r M r f)

r f: Short term / long term government securities used depending on the time horizon of your projectB j , M: Method 1: Regression using excel of of stock returns over market return Method 2: from variances & covariance of the stock to the marketr M r f: average of historical market risk premiums used

Capital Asset Pricing ModelProblem with equity risk premium (3)

Problems testing the CAPM due to the market portfolio. Generally find the slope of the SML is flatter than expected.Factors other than beta can help explain security returns.

We still use CAPM becauseEconomic intuition: systematic vs. idiosyncratic riskEquilibrium implicationsEasy to implementApplication to performance evaluationApplication to estimate cost of equity for capital budgeting

17Beta method 1

Beta method 2

A theoretical approach because most of the time Google Finance would provide you with the Beta estimated from historical dataR s ExampleThe stock Aardvark Enterprises has a beta of 1.5 and that of Zebra Enterprises has a beta of 0.7. The risk-free rate is 5 percent, and the difference between the expected return on the market and the risk-free rate is 4.53 percent. What are the expected return on the two securities?

Aardvark: 11.80% = 5% + 1.5 x 4.53%Zebra: 8.17% = 5% + 0.7 x 4.53%20Cost of DebtBonds?If firm has tradable bonds outstanding, the YTM of a long-term (typically 10 years) straight bonds can be used as the interest rateIf the firm has no bond, then use the YTM of comparable companies bondCredit Ratings?If firm is rated, apply the typical default spread on bonds with that rating over the risk free rate to estimate the cost of debtIf no credit rating, build a synthetic credit rating based on the companys credit and liquidity ratios

Illustrate the default spread with example

Rf + the default risk spread (for that specific rating)

The default risk spread: The interest rates on bonds are determined by the default risk that investors perceive in the issuer of the bond This default risk is often measured with a bond rating, and the interest rate that corresponds to the rating is estimated by adding a default spread to the riskless rate.A sampling of liquid, straight bonds from a specific rating class, with as little special features as possibleCorporate bonds are often illiquid and the interest rates on such bonds may not reflect current market rates. The presence of special features on bonds such as convertibility can affect the pricing of these bonds and consequently the interest rates estimated on them.Once a sample of bonds within each ratings class has been identified, you need to estimate the interest rate on these bonds. There are two measures that are widely used. The first is the yield on the bond, which is the coupon rate divided by the market price. The second is the yield to maturity on the bond, which is the interest rate that makes the present value of the coupons and face value of the bond equal to the market price. In general, it is the yield to maturity that better measures the market interest rate on the bond.

21R w. a. c. c. ExampleLevered Cost of Equity: 9.99%Proportion in Equity: 70%

Before Tax Cost of Debt: 4%Tax Rate: 40%After Tax Cost of Debt: 2.4%Proportion in Debt: 30%

Terminal ValueGordon Growth Model & Exit Multiple

Gordon Growth model

Assume perpetual constant slow growth rate of g after the maturity of the firm

Discount the terminal value by r w. a. c. c. given the forecast high growth period of t = nExit multiple modelThe terminal value of the company is determined through a multiplier of some income or cash flow measure:Net IncomeNet Operating ProfitEBITDAOperating Cash FlowFree Cash FlowThe multiple is determined by how the market values comparable companiesWas there a recent sale of a similar company?What is the standard industry valuation for a company at the same stage of maturity?Mostly used for companies in the blue-chip industry because we assume that their company is more mature and therefore experiencing less growth

Combining EverythingEV of the firm= PV of UFCFs + PV of Terminal Value

PV OF UFCFs

Gordon Growth model

Assume perpetual constant slow growth rate of g after the maturity of the firm

Discount the terminal value by r w. a. c. c. given the forecast high growth period of t = nPros & consAdvantages & Disadvantages of Using the DCF

ADVANTAGES

Produces the closest thing to an intrinsic value of the businessMultiples are not useful if the entire industry is over or under valuedRelies on FCF, a trustworthy measure that cuts through arbitrariness in financial accounting reporting of earningsCan apply DCF as a sanity check: can plug the current stock price into the DCF model, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock priceHelp investors identify where the companys value is coming from and whether or not its current share price is justifiedWorks the best when there is a high degree of confidence in the market performance and future cash flowsADVANTAGES

Only as good as the assumptions of its inputs: garbage in, garbage out principleTricky when the companys operations lack visibility: it is difficult to predict sales and cost trends with certaintyInvestors need to be able to make good forward looking predictionsValuation particularly sensitive to assumptions about the perpetuity growth rates and discount ratesDCF is a moving target that require constant vigilance and modification: never built in stoneThe model is not suited for ST investing since DCF focuses on LT valueCause you to miss ST price run ups that can be profitableFocusing too much on the DCF may cause you to overlook unusual opportunitiesThank you!Questions?