Kelvin Xu Slides prepared by: Asthon Wu, Garrett Kuhlmann

2 Introduction ► Need to learn theory of DCF before learning how to use the spreadsheet ► The Forecasting Period & Forecasting Revenue Growth ► Forecasting Free Cash Flows ► Calculating the Discount Rate ► The Fair Value UTEFA

3 Background UTEFA ► Projects how much money a company will make in the future ► Determines a fair price based on this projection ► “Time value of money” ► Several approaches: free cash flow to equity, dividend discount model, cash flow to firm

4 The Forecast Period UTEFA ► Need to determine how far into the future to project cash flows (the forecast period)

5 Revenue Growth Rate UTEFA ► One of the most important assumptions one can make about the company’s future cash flows ► Consider future of company and market ► What does the company predict? ► Is the market expanding or contracting?

6 Example UTEFA ► Company predicts revenue to grow by 20%, but has been growing consistently at 10% in the past

7 Free Cash Flow UTEFA

8 Alternate Formula UTEFA ElementSource EBIT * (1 – Tax rate)Current Income Statement + Depreciation/AmortizationCurrent Income Statement - Change in WCPrior & Current Balance Sheet: A&L = Cash Flow from OperationsStatement of Cash Flows - Capital ExpenditurePrior & Current Balance Sheet: PP&E = Free Cash Flow

9 Operating Costs UTEFA

10 Example UTEFA ► Operating cost margin of 70% for three years ► Company says cost cutting will push down operating cost margin to 60% over 5 years ► Make an educated prediction

11 Tax Rates Introduction Forecasting Revenue Forecasting FCF Conclusion UTEFA ► Many companies do not actually pay corporate tax rate due to tax breaks ► Look at average tax paid over past few years as a prediction for future tax rates

12 Net Investment UTEFA

13 Change in WC UTEFA

14 FCF UTEFA

15 Discount Rate UTEFA ► We need to discount the projected free cash flows to find out what they are worth today ► This discount rate is different for every company ► We discount the cash flows at the Weighted Average Cost of Capital (WACC)

16 Discount Rate UTEFA ► Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

17 Cost of Equity (Re) UTEFA ► Investors generally wish to receive a premium for investing their money in the company ► Use Capital Asset Pricing Model to find this value ► Re = Rf + β(Rm – Rf)

18 Cost of Equity (Re) UTEFA ► Re = Rf + β(Rm – Rf) ► Beta may be found on any finance website and is a measure of how correlated the companies stock price is with the market ► Rf is the Risk Free Rate ► Rm is the rate of return on the market

19 Cost of Debt (Rd) UTEFA ► Rd may usually be found on a companies financial statements ► Tells the investor what rate the company borrows at ► If it is not in the financial statements, it may be estimated from similar companies

20 WACC UTEFA ► Suppose The Widget Company has a capital structure of 40% debt and 60% equity, with a tax rate of 30%. The borrowing rate (Rd) on the company's debt is 5%. The risk-free rate (Rf) is 5%, the beta is 1.3 and the risk premium (Rp) is 8%. The WACC comes to 10.64%.

21 Terminal Value UTEFA ► To forecast the companies growth into the future, we use the Gordon Growth Method: ► Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) (Discount Rate – Long-Term Cash Flow Growth Rate)

22 Terminal Value UTEFA ► Assume that the company's cash flows will grow in perpetuity by 4% per year. At first glance, 4% growth rate may seem low. But seen another way, 4% growth represents roughly double the 2% long-term rate of the U.S. economy into eternity. ► Widget Company Terminal Value = $21.3M X 1.04/ (11% - 4%) = $316.9M

23 Enterprise Value UTEFA ► We have forecasted five years of short term growth, plus found the terminal value of the company ► Now we need to piece it all together to find the total value of the company

24 Enterprise Value UTEFA ► Discount all the free cash flows using the WACC to find the Net Present Value (NPV) of the flows ► EV = ($18.5M/1.11) + ($21.3M/(1.11) 2 ) + ($24.1M/(1.11) 3 ) + ($19.9M/(1.11) 4 ) + ($21.3M/(1.11) 5 ) + ($316.9M/(1.11) 5 ) EV = $265.3M

25 Fair Value UTEFA ► Need to account for the debt that a company has ► As investors, we are only purchasing equity of a company so we subtract the debt that the company has on its balance sheet ► Fair Value of Widget Company Equity = Enterprise Value – Debt

26 Fair Value UTEFA ► After we find the fair value for the company, divide that number by the amount of shares outstanding to find the share price ► Say the Widget Company had no debt, and 2 million shares outstanding: ► M/2 M = $ per share fair value

27 Any Questions or Comments?