DCF MODEL

Discount Cash Flow (DCF) Valuation

• An important concept in valuing assets – Not just companies

• Basis of Fundamental Analysis– Intrinsic value of a company

• Cash flows• Time value of money• Opportunity cost• Financial statement analysis• Change the way you look at things in life?

Who uses DCF?

Career/Job Category To do what?

Investment Banking Advise sellers, buyers in M&A dealsEquity (e.g. IPO)Debt issuance

Investment Management Stock picks, shape and execute investment strategies (e.g. Long short equities)

Research Equity research (Buy/Sell/Hold)

Fixed income trading Price bonds

But who does what?

• An equity analyst work is to find the real value of a firm, then DCF is the work model!

• An portfolio manager job is to invest in the ”best” company, why relative valuation is more important tool!

Discounted Cash Flow Valuation - DCF

• What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flow on the asset.

• Philosophical basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk.

• Information needed: To use DSF valuation, you need– To estimate the life of the asset– To estimate the cash flow during the life of the asset– To estimate the discount rate to apply to these cash flows to get

present value• Market inefficiency: Markets are assumed to make mistakes in

pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

Advantages of DCF valuation

• Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions.

• If good investors buy businesses, rather than stocks, discounted cash flow valuation is the right way to think about what you are getting when you buy asset.

• DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

Disadvantages of DCF valuation

• Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches.

• These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by savvy analyst to provide the conclusion he or she wants.

• In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued . This can be a problem for– Equity research analysts, whose job it is to follow sectors and

make recommendations on the most under and over valued stocks

– Equity portfolio managers, who have to be fully (or close to fully) invested in equities.

When DCF valuation works best

• This approach is designed for use for assets (firms) that derive their value from their capacity to generate cash flows in the future. It does make your job easier, if the company has a history that can be used in estimating future cash flows. It works best for investors who either– have a long time horizon, allowing the market time to

correct its valuation mistakes and for price to revert to “true” value or

– are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm.

Merits of the DCF

Strengths:• Captures the time value of money and opportunity cost• Scientific• Widely used • Based on cashflow

Weaknesses:• Almost always results in overvaluation. Why?• Can we ever predict the future?

– “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Warren Buffett

• Based on many assumptions– Which assumptions are the most critical?– 5 years vs. 10 years estimation

Valuing a company using a DCF model

Steps:

1. Understand the business of the company you are valuing

2. Find Inputs:a) Calculate the Discount Rate

– Weighted Average Cost of Capital (WACC)

b) Build Future (Pro forma) Cash Flow and find the PV of these cash flow– Free Cash Flow (FCF)

c) Calculate Terminal Value– EBITDA Multiple

3. Analyze Outputs:a) Enterprise value (EV)

b) Equity (share price)

c) Perform Sensitivity Analysis– Range vs. Point Estimate

• There are many correct answers and many variations on methods and which numbers to use (academics vs. practitioners).

Pro Forma Cash Flow• Estimate the future cash flow of a company (horizon is 5 to 10 years)• An EBITDA world (Earnings Before Interest, Tax, Depreciation and Amortization), but

EBITDA is not cash• Need Free Cash Flow (FCF), estimated by

– FCF = EBIT * (1-Tc) + D&A – Change in net working capital – Capital Expenditure (CAPEX)Where to find the stuff?• EBIT (I/S)• D&A (C/S)• Net working capital (current asset – current liabilities) (B/S)• Capex (C/S, B/S)

• Find the PV of FCF (remember C/(1+r)n)• How do we estimate future cash flow?

– Probably the toughest task in the entire DCF valuation exercise– First thing is to get a better understanding of the business and the industry as a whole. Start with the 10-K– Estimate future growth profile from company filings. Is past history a good indication of the future? We want

to predict the trends.– Leverage analyst reports (ibankers)– Talk to management (research analysts)

• Start with the income statement. In real-life you often have to pro forma (at least parts of) all three financial statements but there are shortcuts

Terminal value

• The 5 to 10 year pro forma cash flow attempts to capture foreseeable changes in earnings

• The terminal value estimates the company’s value after it has entered “steady state”

Structure of a DCF model

Year 2007 2008 2009 2010 2011 2012 ……..

Period 0 1 2 3 4 5 ……..

FCF C1 C2 C3 C4 C5 ……..

……..

Terminal value (TV)

PV (CF) C1/ (1+r)1

C1/ (1+r)1

C1/ (1+r)1

C1/ (1+r)1

(C1+TV)/(1+r)1

Sum of PV(CF)

EV

Input: Cash FlowOutput: Value (Enterprise

Value)

EV of the company as of the end of year 2007

Company enters steady state

Year 1 to 5: Capture changes and volatility in the business (cash flow)

Industry standard: 5 to 10 yr horizon

Example: Kraft (NYSE: KFT)

• Kraft Foods

• Remember, before we jump into Excel:– What does Kraft do?

– Market position (market share, revenue, etc)?

– Established or emerging industry?

– Level of competition?

– Growth opportunities?

– Quality management?

• Excel demonstration

Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFFn+1/(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

VALUING A FIRM

 

    Q3 FY2006

  Consensus Reported Consensus

Contributors: 15 Rep. date:2006-11-22 Contributors: 12

Revenue (Group) 1022,64 842 3844,88

EBIT (Group) 71,91 40 217,13

Pre-tax Profit 59,98 25 158,48

Net profit 42,53 18 113,03

EPS 0,23 0,1 0,61

Dividend per share 0 0 0

Total global demand (MW) 0 0 11515

Vestas total volume (MW) 1015 0 5488,33

Vestas global market share 0 0 26,58

Non-recurring items 0 0 0

Recommendation 0 0 0

Daily Q/ VWS.CO [Bar, MA 20, VOL]8/15/2006 - 12/1/2006 (GMT)[Professional]

21 28 04 11 18 25 02 09 16 23 30 06 13 20 27Aug 06 Sep 06 Oct 06 Nov 06

PriceDKK

155

165

175

185

195

205

215

150

160

170

180

190

200

210

220

Vol

4M

8M

12M

0

Q/VWS.CO, Last Trade, Bar11/29/2006 217.00 220.00 215.75 219.00Q/VWS.CO, Close(Last Trade), MA 2011/29/2006 185.38

Q/VWS.CO, Last Trade, VOL11/29/2006 20,579

Industry Implications

• Everyone in the industry knows how to do a DCF• Every bank, every analyst uses , uses similar

assumptions, studies the same theories in school, but bankers and analysts come up with extremely different values and recommendations (Buy/Sell/Hold) for the same company

• Interesting trends• The industry always comes back to two questions:

– What percentage of a banker/analyst’s performance is due to luck vs. skills

– Is past performance a good indicator of future performance?

So is it all just a crapshoot?

• Experience leads to better valuation• Valuation is an art, not a science

– The key is to develop your own framework and style

• Understanding of the business is the key• Wall Street often gets it wrong?

Discounted Cash Flow Valuation• DCF is the cornerstone of valuations and is the "analytically most correct" way

– In reality: several "fudge-factors" and disagreement between practitioners• Robust in valuing anything that gives cash-flow in the future given assumptions

– Bonds, derivatives, companies, etc.

• Valuation of future cash that the investor will get from holding the firm. At the end of the day:

"Cash is King"

"Cash is fact – profit is an opinion"

"Earnings do not pay the bills"

• Used when significant information is available on company and its prospects• Also used to select between internal projects and to price the impact of various

scenarios e.g. during negotiations

Fundamentals of any Discounted Cash Flow Valuation

• Expected cashflow in each period

• Divided by the appropriate discount factor that reflects the riskiness of the estimated cashflows

• Example: How much is an infinite stream of ISK 15 million/year worth?

Assuming a 10% discount rate:

...)1()1()1()1(

Value4

43

32

21

1

r

CF

r

CF

r

CF

r

CF

Expected cashflow

Discount rateYear

150...46.1

15

33.1

15

21.1

15

10.1

15...

)1.1(

15

)1.1(

15

)1.1(

15

)1.1(

15Value

4321

Discounted Cash Flow Valuation in 4 Steps

• Step 1 Compile information– Historical accounts (last 2-3 years). Review

sales, margins, CAPEX, WC ratios, notes etc.– Research business, strategy, products,

customers, markets, competition etc.– Industry and environment forecasts (official

forecasts, KB research, news etc.)– Discuss main risk factors– Look up information on similar companies

Discounted Cash Flow Valuation• Key Drivers of Cashflow

– Sales growth rates• Market, strategic considerations, pricing, economy, competition

– EBITDA margin• Cost development, fixed vs. floating costs etc.

– Capital expenditure (CAPEX)• Maintenance and investment CAPEX

– Working capital requirement• Must support current operations and strategy (inventories, receivables &

payables)– Cash tax rate

• A specialist area (legislation, relief from previous tax loss, deferred tax)• Model also highly sensitive to

– Discount factor – Terminal value growth

År 1997 1998 1999 2000 2,001 2,002 2,003 Resultaträkning:Nettoomsättning: 118,955 162,521 182,923 191,567 291,643 426,310 503,418 Övriga intäkter 6,349 13,973 960 21,039 80 - - Rörelsens kostnader: 110,018 155,205 159,624 180,371 246,558 359,321 419,849 Bruttoresultat: 15,286 21,289 24,259 32,235 45,165 66,989 83,569 Avskrivningar: 2,756 3,696 3,491 6,184 6,335 6,841 6,849 Rörelseresultat(EBIT) 12,530 17,593 20,768 26,051 38,830 60,148 76,720 Finansiella intäkter: 1,022 984 1,456 2,489 2,137 4,607 9,253 Finansiella kostnader: 211 270 465 880 1,628 3,354 7,051 Resultat e fin poster: 13,341 18,307 21,759 27,660 39,339 61,401 78,922 Övriga avsättningar: - - - 3,574 - 142 - 96 - Resultat före skatt: 13,341 18,307 21,759 24,086 39,339 61,543 79,018 Skatt: 3,916 5,151 4,929 7,886 11,601 21,113 25,703

Resultat: 9,425 13,156 16,830 16,200 27,738 40,430 53,315

Balansräkningen:Omsättningstillgångar:Kassa, bank - 13,151 32,916 42,450 87,401 130,439 170,479 Kundfordringar - 23,436 63,340 60,096 85,270 138,004 154,999 Varulager - 4,096 5,351 3,639 15,909 16,393 11,719 Övriga OT - 27,564 19,305 38,317 18,252 11,363 26,437 Totala OT - 68,247 120,912 144,502 206,832 296,199 363,634

Anläggningstillgångar:Maskiner o inventarier - 9,198 11,422 11,580 13,925 17,442 14,352 Övriga AT - 664 671 18,834 28,089 47,827 94,542 Totala AT - 9,862 12,093 30,414 42,014 65,269 108,894 Totala tillgångar - 78,109 133,005 174,916 248,846 361,468 472,528

Kortfristiga skulderLeverantörsskulder - 6,311 11,395 6,926 21,256 34,301 14,260 Skatteskulder - 3,480 2,704 5,186 6,030 7,748 13,100 Räntebärande KS - 2,380 21,148 16,183 9,004 19,818 47,955 Övriga KS - 9,733 11,838 21,006 31,447 55,412 118,126 Totala KS - 21,904 47,085 49,301 67,737 117,279 193,441

Långfristiga skulderCheckkredit - - 1,902 718 1,601 - - Räntebärande lån - 2,701 1,842 2,956 3,379 22,721 57,626 Övriga LS - - 315 5,460 32,987 45,310 - Totala LS - 2,701 4,059 9,134 37,967 68,031 57,626

Obeskattade reserverTotala OR - 2,973 4,623 6,558 8,440 11,610 15,389

Eget kapitalAktiekapital - 20,801 26,250 27,301 32,761 32,761 33,077 Bundna reserver - 11,538 24,037 48,184 52,059 59,568 63,583 Balanserad resultat - 5,324 10,481 18,238 22,144 31,901 56,055 Årets resultat - 12,868 16,470 16,200 27,738 40,430 53,315 Totalt EK - 50,531 77,238 109,923 134,702 164,660 206,030 Totala skulder/EK - 78,109 133,005 174,916 248,846 361,580 472,486

Discounted Cash Flow Valuation• Step 2 Estimate the appropriate discount factor weighted average cost of capital

(WACC)

Components of WACC are:

1) Cost of Debt (Kd)

– Risk Free Rate (e.g. 10 year government bond) Nominal or real – must harmonize with forecasts

– Appropriate Credit Risk Premium

2) Cost of Equity (Ke) (CAPM)

– Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most common– Equity risk premium is an estimate of the premium investors require in excess of risk-free assets

for owning equities (4-7% most typically used) – Beta is a measurement of firm's/similar firms volatility compared to the

market (if higher than 1 company/sector is riskier than market in average). When compiling and averaging betas it is necessary to take into account different company leverage

PremiumMarket Equity *β(Beta)Rate FreeRisk Ke

%)tax1(*Premium)Risk Credit Rate FreeRisk (Kd

)ED

D(K)

ED

E(*KWACC de

)

ED

tax)(-(11

ββ levered

unlevered

CAPM

• Re = Rf + βe * RmSymbol What is it Where to find it

Rf Use a long-term treasury rate (e.g. 10 year)

Bloomberg web (http://www.bloomberg.com/markets/rates/index.html)βe Equity beta (levered), “risk” (how

the company’s share price moves compared to the market1)

Bloomberg terminal, Google Finance

Rm Market risk premium (excess return of market over Rf)

Use rule of thumb (e.g. 6%)

1E.g. The “market” can be the S&P 500

Discount Rate (WACC)

Symbol What is it Where to find it

Re cost of equity Calculated (via CAPM)

Rd cost of debt Company’s borrowing rate (Corp bonds)

E market value of the firm's equity 10-K (Balance Sheet)

D market value of the firm's debt (long-term interest bearing debt)

10-K (Balance Sheet)

V D+E Calculated

Tc Corporate tax rate 10-K / Estimate

Discounted Cash Flow Valuation

• Step 2 cont.– WACC calculation example (typical Icelandic firm)

• Or…... as is very common: Present WACC as a figure (8..15%) and provide a

sensitivity table

Discounted Cash Flow Valuation• Step 3 Prepare a "visible" forecast period (5-10 years and longer for some

industries)

– Forecast Sales, margins, capital expenditure, working capital requirement

– And derive Free Cash Flow to Firm

KassaflödetOmsättningen 654,443 850,776 1,106,009 1,437,812 1,869,156 2,429,903 3,158,873 3,917,003 4,778,744 5,734,492 - rörelsekostnad 549,732 714,652 940,108 1,236,518 1,626,166 2,114,015 2,716,631 3,368,622 4,157,507 4,989,008 - avskrivningar 22,906 28,926 36,498 46,010 57,944 72,897 91,607 109,676 129,026 149,097 EBIT 81,805 107,198 129,403 155,284 185,046 242,990 350,635 438,704 492,211 596,387 Skattesats 28% 28% 28% 28% 28% 28% 28% 28% 28% 28%EBIT (1-skatt) 58,900 77,182 93,170 111,804 133,233 174,953 252,457 315,867 354,392 429,399 + Avskrivningar 22,906 28,926 36,498 46,010 57,944 72,897 91,607 109,676 129,026 149,097 - Förändringar i AT 22,906 32,330 44,240 60,388 82,243 97,196 110,561 137,095 143,362 172,035 - Förändringar i RöK 40,777 51,047 63,808 79,633 99,209 123,364 160,374 166,789 189,583 210,265 = FCFF 18,123 22,733 21,620 17,793 9,725 27,290 73,130 121,660 150,472 196,196

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Historical analysis of Sectra

Year Revenue % change in revenue EPS % change in EPS 1997 118955 1998 162521 36,6% 1999 182923 12,6% 0,56 2000 191567 4,7% 0,51 -8,9% 2001 291643 52,2% 0,85 66,7% 2002 426310 46,2% 1,23 44,7%

Based on revenue Based on EPS Aritmetric 30,5% 34,1% Geometric 29,1% 30,0%

Regression: Revenue = 35708 + 55222 * Revenue

%1,24228986

55222

omsättning ligGenomsnitt

lösningen sRegression

Different models – different outcome?

Year Aritmetric Geometric Regression solution

Analysts forecast

Sectras own forecast

2003 556,3 Mkr 550,4 Mkr 529,1 Mkr 552 Mkr 554,2 Mkr 2004 726,0 Mkr 710,5 Mkr 656,6 Mkr 675 Mkr 720,5 Mkr 2005 947,5 Mkr 917,3 Mkr 814,8 Mkr 811 Mkr 936,6 Mkr

Actual numbers: 2003: 503, 2004: 495, 2005: 455

Analysts mainly focus on

• Information from companies, press release, meetings etc.

• Macro information important for the company – airliner/oil

• Information from other companies in the same industry Nokia/Ericsson

• Other sector specific analysts – Gartner Group

Do equity analysts forecast wellDo equity analysts forecast well??

• Old studies show they no more than – bad! But we can see a shift about 1995 – why?

• Resent research in Sweden show that newspaper/magazines: Affärsvärlden, Veckan Affärer and Aktiespararna all are over optimistic.

• In the period 1987 to 2002 analysts are 11 % over optimistic in there p/s forecast but with changing spread due to volatility.

Discounted Cash Flow Valuation

• Step 3 cont.

* Assumptions should be reviewed for consistency with past performance and business model

* Forecasts should trend downwards to achieve long run growth rates

* Depreciation should harmonize with CAPEX & the value of property, plant and equipment (PP&E) in the long run

* COGS & SG&A include Depreciation so it needs to be subtracted (non-cash item)

Discounted Cash Flow Valuation• Step 3 cont.

* Tax relief from debt is included in the discount factor

* Helpful to create a balance sheet and model the difference in inventories, receivables and payables between years.

* CAPEX needs to be sufficient to fund the strategy (e.g. the opening of new stores)

Discounted Cash Flow Valuation• Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to

Firm with the WACC

– Deal properly with Terminal Values• Beyond the visible cashflow period, the value of the company is captured

using a terminal value calculation (using either a DCF to perpetuity or comps calculation)

YearWACC)(1

1DF

* Equity Value calculated from EV

* 0..5% often used for perpetual growth

g-WACC

g)(1*year)forecast FCF(finalTV

* 30-70% split is a

rough guide for mature companies

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Betavärdet 1.2 1.2 1.2 1.2 1.2 1.18 1.16 1.14 1.12 1.1Cost of equity 11.0% 11.0% 11.0% 11.0% 11.0% 10.9% 10.8% 10.7% 10.6% 10.5%Andelen equity 66% 66% 68% 70% 70% 72% 72% 74% 74% 74%Efterskatt lån 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8%Andelen lån 34% 34% 32% 30% 30% 28% 28% 26% 26% 26%Cost of capital 8.9% 8.9% 9.0% 9.1% 9.1% 9.2% 9.1% 9.2% 9.1% 9.0%Kumultativ WACC 1.0888 1.186 1.292 1.410 1.539 1.680 1.833 2.001 2.183 2.380

KassaflödetOmsättningen 654,443 850,776 1,106,009 1,437,812 1,869,156 2,429,903 3,158,873 3,917,003 4,778,744 5,734,492 - rörelsekostnad 549,732 714,652 940,108 1,236,518 1,626,166 2,114,015 2,716,631 3,368,622 4,157,507 4,989,008 - avskrivningar 22,906 28,926 36,498 46,010 57,944 72,897 91,607 109,676 129,026 149,097 EBIT 81,805 107,198 129,403 155,284 185,046 242,990 350,635 438,704 492,211 596,387 Skattesats 28% 28% 28% 28% 28% 28% 28% 28% 28% 28%EBIT (1-skatt) 58,900 77,182 93,170 111,804 133,233 174,953 252,457 315,867 354,392 429,399 + Avskrivningar 22,906 28,926 36,498 46,010 57,944 72,897 91,607 109,676 129,026 149,097 - Förändringar i AT 22,906 32,330 44,240 60,388 82,243 97,196 110,561 137,095 143,362 172,035 - Förändringar i RöK 40,777 51,047 63,808 79,633 99,209 123,364 160,374 166,789 189,583 210,265 = FCFF 18,123 22,733 21,620 17,793 9,725 27,290 73,130 121,660 150,472 196,196

DCF 16,645 19,175 16,730 12,617 6,319 16,241 39,889 60,791 68,927 82,441

Discounted Cash Flow – Presenting the Results

• The Ultimate Answer to the Great Question of Life, the Universe and Everything

-Hitchhiker's guide to the Galaxy

All diligent valuations are presented as sensitivity tables

– Demonstrate the link between assumptions and the final value

– Allow the reader, which probably disagrees with some assumptions, to use the analysis