Introduction to Discounted Cash Flow Valuation Nicholas Ramm Finance Sector, Madison Investment Fund October 29, 2007

What is DCF analysis? Method of valuing a financial asset Method of valuing a financial asset Focus on firms Focus on firms Uses cash flows Uses cash flows Find present value of these cash flows Find present value of these cash flows

Present Value Value of future money today Value of future money today PV= FV (1+R) T

The Concept-Part 1 Firm Value = $ 1 + $ 2 + $ 3 + $ 4 + $ 5 + … (1+R) 1 (1+R) 2 (1+R) 3 (1+R) 4 (1+R) 5 Cash Flow Discount RateNeed CFs forever

Free Cash Flow Measure of money available to investors Measure of money available to investors FCF = (Net Inc.) + FCF = (Net Inc.) + (Depreciation/Amortization) - (Depreciation/Amortization) - (CapEx) - (CapEx) - (Increase in Working Capital) + (Increase in Working Capital) + (Misc. firm-specific items) (Misc. firm-specific items) All items available in financial statements All items available in financial statements

Forecasting Inherently subjective Inherently subjective Choose a forecast period and a method to generate FCFs Choose a forecast period and a method to generate FCFs Percentage of sales, Construct new financial statements Percentage of sales, Construct new financial statements

The Concept-Part 2 Firm Value = FCF 1 + FCF 2 + FCF 3 + FCF 4 + FCF 5 + … (1+R) 1 (1+R) 2 (1+R) 3 (1+R) 4 (1+R) 5 Discount Rate Need CFs forever

Terminal Year Can’t forecast forever Can’t forecast forever Assume company stabilizes Assume company stabilizes Grows at G forever Grows at G forever

Terminal Year TYV = FCF TY * (1 + G) R - G

The Concept-Part 3 Firm Value = FCF 1 + FCF 2 + FCF 3 + FCF 4 + FCF 5 +…+ TYV (1+R) 1 (1+R) 2 (1+R) 3 (1+R) 4 (1+R) 5 (1+R) TY Discount Rate

Cash Flows and Terminal Year Value must be discounted Cash Flows and Terminal Year Value must be discounted Need rate that takes into account relative risks of business Need rate that takes into account relative risks of business

Weighted Average Cost of Capital R * =R E * E D+E + R D * D D+E Obtain Using CAPM Weighted Average Debt interest rate * (1-t)

Capital Asset Pricing Model R E =R F + β * (R m – R f )

Putting it All Together Firm Value = FCF 1 + FCF 2 + FCF 3 + FCF 4 + FCF 5 + …+ TYV (1+R*)1 (1+R*) 2 (1+R*) 3 (1+R*) 4 (1+R*) 5 (1+R*) TY

Limitations Forecasting error: Forecasting error: Future cash flows Future cash flows Future capital structure Future capital structure Terminal growth rate Terminal growth rate Assume unchanging firm Assume unchanging firm Capital Structure Capital Structure Terminal growth rate Terminal growth rate

Questions?