Discounted Cash Flow (DCF) Tutorial Wednesday, January 31 st, 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)? What is tomorrow’s dollar worth today (present value)?

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? Likewise…

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 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

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 debt- holders 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) Taxes (34%) (25,500) (28,560) (34,000) Operating Income 75,000 84, ,000 Income $49,500 $55,440 $66,000 Plus: Depreciation 3,750 4,200 5,000 Minus: CapEx 4,500 5,040 6,000 Free Cash Flow ($50,000) $48,750 $54,600 $65,000 Discount Rate 10% Discounted Values ($50,000) $44,318 $45,123 $48,835 Present Value $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 – Future performance is unknowable 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

Forecasting Cash Flows Historical Simple/Weighted Averages – Primarily used when there is no discernable trend, or current trend is not expected to continue

Forecasting Cash Flows Historical Trend Exrapolation

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