Discounted Cash Flow (DCF) Tutorial Part II Wednesday, February 7th, 2007

Recap from Last Week Basic Underlying Principles – Time Value of Money (A dollar today is worth more than a dollar tomorrow) – Present/Future Value PV=FV/(1-i)^n FV=PV(1+i)^n – Opportunity Cost What is a business worth? – A business is worth the present value of the expected future cash flows of the business. – Ex. Target Corp (TGT): $60 Share Price x Shares Outstanding (mm) = $51,533 Market Capitalization or Market Value of Equity

Recap cont. What is Free Cash Flow? Net Income Add: Depreciation Less: Capital Expenditures (CAPEX) = Free Cash Flow to Equity Basics of DCF Analysis – Compostion – Computation – Forecasting

Tonight's Objectives Screening for companies Where do you find the financial data Introduction to the DCF Model Example of ‘how to use’ the model – Dell Inc. – Currently trading at $23.90/share, with a 52.42b Market Cap

Screening for Companies Web-site to use: Yahoo Finance – Web Address: finance.yahoo.com – On the left margin click on ‘Stock Research -> Screener’ Initial Screen Criteria – Price to Earnings (P/E) ratio no greater than 20 – The Company’s Return on Equity (ROE) should be greater than or equal to 10%

Where to find the data? On-line – Edgar ( – Yahoo Finance, or Reuters File Looking for? – 10-K: Annual Filing – 10-Q: Quarterly Filing Important Sections – Part I: (Business/Risk Factors) – Part II: Management Discussion and Analysis of Financial Condition Consolidated Statements of Financial Position

Introduction to the DCF Model Four main sections of the DCF Model 1.Historical Values 2.Future Projections 3.Discount Rate & Perpetuity Growth 4.Comparison of the Fair Value to the Current Market Price Variables to change within the Model –‘Blue’ cells change –‘Black’ cells DO NOT change

Example: ‘How to use’ the Model Six Step Process 1.Screen for the company 2.Find the financial data 3.Input the historical data into the model 4.Make future projections based upon research and information within the 10-K/10-Q 5.Apply the Discount Rate & Perpetuity Growth 6.Compare the Fair Value to the Current Market Price

Step 1: Screen for the Company Go to Yahoo Finance – Website: finance.yahoo.com – On the left margin click on ‘Stock Research -> Screener’ – Screen initially for: Price to Earnings (P/E) ratio no greater than 20 The Company’s Return on Equity (ROE) should be greater than or equal to 10% – Secondary Screen Price to Book less than 1.5 – 2.0 Debt to Equity Ratio less than 1.5 – 2.0 Current Ratio greater or equal to 1.0

Step 2: Find the Financial Data Use: – Edgar ( html) – Yahoo Finance, or Reuters Search for the 10-K/Annual Data 10-K – Financial data found in Part II of ‘Consolidated Statements of Financial Position’

Step 3: Input Historical Data into the Model Want to input historical data for the past five years Historical Data that we are looking for: – Revenues – Net Income – Depreciation – Capital Expenditures (CAPEX) Note: Revenues and Net Income will be found on the Income Statement and Depreciation and CAPEX will be found on the Cash Flow Statement

Step 4: Make Projections Need to forecast in the areas of (blue text): – Revenue Growth Rate – Net Income Margin – Depreciation as a % of Sales – CAPEX as a % of Sales

Step 4: Projections (cont.) Dell Example – Revenue Projection facts to consider Historical Revenue Growth: 5 year average of 15.8% – Too high to use for a five year forecast? 41% of sales in 2006 came from outside the U.S. In 2007 are looking to expand their sales outside U.S. Desktop PC sales growth continues to decline, as a result of cheaper laptop prices, while mobility products sales are increasing as a percentage of sales ‘Servers’ business continues to grow as a percentage of sales As they expand outside the U.S. ‘enhanced services’ business may increase sales Michael Dell will take the position of CEO once again – Will he realign the company back to their core business? Is the industry saturated from a domestic and international perspective? – Growth rates based off of sectors of Dell’s business Generally assumed that Revenues would grow for the next two years, then slowly decrease

Step 4: Projections (cont.) Net Income Margin – Assumed that over time Dell will keep their margin in line with their historical average – Used the historical five year average of 5.8% Depreciation as a % of Sales – Used the historical five year average of 0.7% CAPEX as a % of Sales – Used the historical five year average of 1.3% Question: Why forecast Depreciation and CAPEX as a % of Sales?

Step 5: Apply a Discount Rate and Perpetuity Growth Discount Rate: – Will assume a 10% Discount Rate as the opportunity cost of my money Perpetuity Growth – Assumed the company is a ‘Going Concern’ – Use a rate at or below the rate of inflation – Used: 2.5%

Step 6: Compare the Fair Value to the Current Market Price *Note: This tells you that according the DCF Model, we can buy 1 share of Dell for $23.52 today, while the NPV of their future cash flows are valued at $26.14 per share.

Results from Dell Inc. DCF

What We’ve Covered Tonight Screening for companies Where do you find the financial data Introduction to the DCF Model Example of ‘how to use’ the model – Dell Inc. – 6 Step Process