DISCOUNTEDCASHFLOW:CONCEPTANDMODEL

MarcinSiwicki NewMemberEduca2on

the blue chips

Overview

Stockscurrentpricereectsthetotalvalueofthecompanyforever Projectthefuturefreecashows CashthatcompanygeneratesaKerthemoneyrequiredforitsoperaNonsandassetbase AllowscompanytopursueopportuniNestoenhanceshareholdervalue Discountthesecashowsbytheweighedaveragecostofcapitalthecostofnancingthecompany Keyconceptscoveredinlecture:FreeCashFlows,CapitalStructure,CAPM,WACC,TerminalValue

DCF Analysis
($ in millions of US dollars) Fiscal Year Ending: 12/31 2004 Historical 2005 2006 2007 Projected 2008

2009

2010

2011

2012

Operating Income Taxes Depreciation and Amortization Decreases (Increases) in Working Capital Capital Expenditures Free Cash Flows Free Cash Flows Already Received

$8.0 (1.0) 12.0 (1.0) (110.0) (92.0)

$7.0 (0.9) 14.5 (1.8) (121.6) (102.9)

$100.3 (4.8) 56.6 (40.0) (828.9) (716.8)

$214.7 (7.7) 127.2 (74.5) (2,321.2) (2,061.5) -

$303.9 (9.1) 193.4 (134.2) (331.5) 22.5 -

$298.4 (11.9) 182.4 (27.6) 441.2 -

$298.7 (11.9) 191.6 (0.6) (281.8) 196.0 -

$286.6 (11.5) 194.9 (0.5) (252.2) 217.3 -

$261.6 (10.5) 197.6 (0.4) (220.9) 227.4 -

Discounted Free Cash Flows

20.9

381.8

157.8

162.8

158.5

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FreeCashFlow

RepresentscashthermisabletogenerateaKerlayingoutthemoneyrequiredforitsassetbase Allowscompanytopursuewaystoenhanceshareholdervalue Cashisneededtodevelopproducts,makeacquisiNons,paydividends,reducedebt ShouldbenotedthatnegaNveFCFisnotnecessarilybadcouldmeanthatrmismakinglargeinvestments,iftheseinvestmentsearna highreturnthenthermsstrategycouldpayo TwomainmethodstocalculateFCF: WorkingCapitalmethods StatementofCashFlowsMethod

WorkingCapital

StatementofCashFlows

NetIncome +D/A CapitalExpenditures IncreasesinWorkingCapital FCF

CashFlowFromOperaNons CapitalExpenditures FCF

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WorkingCapital

Calcula2on

RepresentsoperaNngliquiditythecapitalavailabletorunthe business PosiNveworkingcapitalisrequiredtoensurethatarmisableto conNnueoperaNonsandsaNsfydebtobligaNons Ingeneral,companieswithmoreWCwillbemoresuccessfulsince theywillbeabletofundandexpandtheiroperaNons

CurrentAssets Cash STInvestments TotalWCAssets CurrentLiabiliNes ShortTermDebt CurrentPorNonLongTermDebt TotalWCLiabiliNes TotalWCAssets TotalWCLiabiliNes WorkingCapital

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CapitalStructure ThecapitalstructureofacompanyisessenNaltocalculaNngWACC SinceWACCisaweightedaverageofthecostsofequityanddebt, knowingwhattheproporNonsareisnecessary Ideally,youaregivenatargetcapitalstructurethatyouareaimingfor, unfortunatelythatisnotthecaseinTBC Tondcapitalstructureweusethebookvalueofdebtandthemarket valueofequityaddedthesemakeupthetotalcapitalizaNonoftherm. Debtiscommonlyviewedasloansandbonds Thecapitalstructureisthenjustameasurementofwhatpercentageof theassetsofacompanywherenancedthroughdebtandwhat percentagethroughequity CostofDebt

CapitalAssetPricingModelCostofEquity

Todeterminethecostofequityforthermorthecostof nancingthecompanythroughequityweuseCAPM Theinputsincludetheriskfreerate,thermsobservablebeta, andtheexpectedreturnforthemarket Theriskfreerateistheappropriatetreasurybond(either10or30 year) Thermsbetaispulledfromanynancialwebsite(althoughifit doesnotmakesenseconceptually,itshouldberecalculated) Expectedmarketreturnissomethingthatisprojectedbythe analystbasedonhistoricalmarketreturns
WeightedAverageCostofCapital

ThecostofdebtintheTBCmodelisbasedothermscredit raNng,aswellastheriskfreerate ThecreditraNngcanbeusedasanindicatorforthecostofdebtby providingadebtpremiumovertheriskfreeratethattherms corporatebondstradeat Inreality,youwoulduseaBloombergterminaltopulltherelevant dataonthebondswiththelongestmaturitythermhas

Theendresultofoureortsthecostofnancingtherm throughacombinaNonofdebtandequity Weusethecostofdebtandthecostofequity,weighted respecNvelybytheirproporNonsincapitalstructure,and accounNngfortax Thisnalvaluegivesusthecostofthermsnancingthe undertakingnewprojectsetc Itwillalsoserveasthediscountrateforourfuturecashows

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CapitalAssetPricingModel

Therateofreturnonastockshouldbedependentupontheriskfreerateofreturn,themarketsreturn,andthestockstendencytofollow themarket ThisistosaythatequityinvestorsexpectarateofreturnontheirinvestmenttobeafuncNonofhowcloselyastockfollowsthebroader market;thosewithhigherbetas,shouldhavehigherratesofreturn Formoreinterest,consultpapersbySharpe&Litner,andarevisedCAPMbyFischerBlack CAPMfollowsseveralmainassumpNons NotransacNoncosts Assetsarealltradableandinnitelydivisible Notaxes Noindividualcanaectsecurityprices Decisionsaremadesolelyintermsofexpectedreturnsandvariances Unlimitedshortsalesandborrowingandlendingattheriskfreerate HomogenousexpectaNonssameviewsonexpectedreturnandrisk GiventheseassumpNons,itcanbeclearwhyCAPMdoesntholdupempirically IfthemodelisrightthereshouldbelinearrelaNonshipsbetweenreturnsandbetas,andtheonlyvariablethatshouldexplainreturnisbeta However,inrealitytherelaNonshipbetweenreturnandbetaisweak,andthatothervariables(size,price/book)explaindierencesin returnbeier

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CostofEquity

Normally,thereisariskpremiumthatyouaregivenasananalyst.ForourDCFvaluaNonsinTBC,werelyonusingtheriskfreeratein combinaNonwiththeexpectedmarketreturntocalculateourriskpremium.

Re = rf + ! E(rm ) " rf !# # " $

where: rf is the risk free rate

market risk premium

! is the firms equity beta

AsmenNoned,thebetashouldbepulledfromeitherYahoo!Finance,Bloomberg,oranyotherdatasitethatisreputable.Iftheir calculaNonsorthebetadoesntmakesense(i.e.negaNvebeta),considerrevaluaNngthecomputaNonthrougheitherregressionanalysisor throughthenormallyacceptedequaNonforbeta TheriskfreerateistheyieldontheUStreasurybond.However,whenevaluaNngaforeigncompanyitmaybeappropriatetousethe representaNvegovernmentbondforthatcountry.However,theriskwillbehigher,sotheratewillbehigher.ThisisbecauseevenRussia defaultedonitsbonds,andcausedthehedgefundLTCMtolosemoneyandthis,compoundedwithotherfactors,broughtWallStreettoits kneesin19981999

WACC

BelowistheWACCequaNon,alongwiththenecessaryinputs

! Market Value of Equity $ ! Book Value of Debt $ WACC=Re # & + Rd # & (1 ' ( ) Total Capital Total Capital " % " % where: Re is the cost of equity Rd is the cost of debt ! is the effective tax rate

ThebookvalueofdebtshouldbethesumofShortTermDebt,CurrentPorNonofLongTermDebt,LongTermDebt,lessCash However,theTBCDCFtemplatewillcalculatethebookvaluebasedotheinputyougiveit

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GrowthRate

AspreviouslymenNoned,theFCFsareforecastedoutforeachindividualyearforthenextveyears.However,thisisnotenoughtovalue thecompany,sinceitwillmostlikelybeexistentforlongerthanthat.ForecasNngforeachindividualyearfortherestofthermsexistence isnotaviableideaeither

Toaccountforthisweneedtosetaterminalgrowthrate,onethatthermsgrowthwillconvergetoandconNnueforintoperpetuity.The DCFvaluaNonisverysensiNvetothisgure.

TherearemulNplewaystocheckyourterminalgrowthrate,twoarediscussedhere:

ValueofPerpetuityRela2vetoTotalValue

ComparingTradingMul2ples

OnemethodistoseewhatthePresentValueofthePerpetual CashFlows(TerminalValue)isrelaNvetothePresentValueofTotal CashFlows. IfthisraNoofPV(TV)/PV(Total)isabove6575%,yourterminal growthrateshoulddenitelybereconsidered. Highgrowthcompanies(tech,biotech,etc)mightindeedhavea valueforthisraNothatisquitehigh.Thisisbecausetheydonot havemuchincomingcashownow,anditisexpectedthatthey willinthefutureastheirproducttakeso

Acommonlyusedmethodfordoublecheckinggrowthratesused ontheStreetiscomparingthetradingmulNplesinthefuture,and thetradingmulNplesofthecompanynow TodothiswetakethelastforecastedEBITDAandrollitforward oneyearbyusingtheterminalgrowthrate WethendividetheTerminalValuebythisrolledEBITDAandnd theimpliedforwardmulNple WethencomparetothecurrentmulNple(FirmValue/EBITDA)

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GrowthRate ThecommonlyacceptedmethodfordeterminingagrowthrateistobeginwiththeexpectedinaNonrate,andalterthisgurebasedontherms factors,macroeconomicfactors,industryfactors,etc.Forexample,armthatspecializesinhardcopyyellowpageswillmostlikelyhaveanegaNve terminalgrowthrateasthatparNcularindustryasawholeindecline. ActualorforecastednominalGDPwillyieldanumberthatistoohigh,sinceGDPincludesproducNvity,populaNon,marketsharegains,alongwith inaNon.However,ifFCFaregrowingandhavegrownattherateofnominalGDPinthepast,andwebelieveitwillconNnuetodosointhefuture,this mightbeokay Calibrateforyourbusinessandindustry,willthepricinggrowfasterorslowerthaninaNon10yearsoutinperpetuity? Youwilltypicallyhavea24%number Oneinputtothinkaboutistheorganicgrowthrateofearnings(orifstable:revenue)forthelast10years Wereseekingalevelofstability,wheremargins,marketsharearestableandproducNvitygainsarealmostzero ValueofPerpetuityRela2vetoTotalValue ComparingTradingMul2ples

EBITDA Present Value of Forecasted Cash Flows: Present Value of Perpetual Cash Flows: Present Value of Total Cash Flows PV(Perpetuity)/PV(Total) $! $! $! 929.86 3,747.76 4,677.61 Rolled Terminal Value Forward Multiple 2007 EBITDA 2007 Firm Value Multiple

$! $! $!

459.18 463.77 4,934.37 10.64

80.12%

$! $!

461.87 3,169.36 6.86

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TerminalValue

Theterminalvaluegivesusavalueofthecompanybeyondtheyearsforecastedinthemodelbasedontheterminalgrowthrategure Thedenominator(WACCg)discountsthisfuturevalueintermsofdollarsofthelastyearforecasted ThismeanstheTVvaluewillbediscountedbythesamefactorasthelastforecasts

Equa2on

TV=

FCFlast year (1 + g ) WACC-g

! FCFlast year (1 + g ) $ # & " WACC-g % PV(TV)= (1 + WACC)N

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the blue chips

Discoun2ng

WediscountcashowsbecauseofthenoNonthatadollartodayisnotthesameasadollartomorrow BecausediscounNngiscompounded,thecashowsfurtherawayfromthepresent,eveniftheyareallequal,areworthrelaNvelylessin presentterms Investmentsthathavehigherriskwillalsousuallyhavehigherdiscountrates.Sincethediscountratecanbethoughtofastherequired returntomaketheinvestmentairacNve(intermsofyieldsonbonds),investorsrequireahigherreturnfortheirhigherrisk,hencethe discountrateendsupbeinghigher Yourdiscountrateshouldneverbebellowthatofrfsincetreasurybondsorbillsareconsideredthesafestinvestmentthatcouldbemade, sinceasmenNoned,itisunlikelythattheU.S.Governmentwilldefault

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the blue chips

TaxRate

TerminalSharesOutstanding

WeusetheeecNvetaxratethatthecompanyprovidesinthe notesofitsquarterlyandannuallings SomeNmes,theyforecastexpectaNonsforwhattheirtaxratein thefutureshouldbe,thisshouldbetakenintoaccountforthe valuaNonitcansomeNmesbefoundinthetranscriptfortheir earningscalls

AmountofsharesthecompanywillhaveleKoutstandingatthe endoftheDCFsperiod Basethisoofthermshistorywithsharebuybacks,and secondaryoeringstodeterminetheballparkforthisgure ItwillnotaectthepresentvalueoftheDCF,butitwillaectthe pricepersharegure

Forecas2ng

LastTwelveMonths(LTM)

WestartowithgrowthandthentailoritdownforeachyearunNl itconvergestoalownumber OKen,afewyearsoutwillbeforecastedorreleasedbythe companyinanearningscall.Iftheyhaveasolidtrackrecordof meeNngthis,itmaybesafetouse

Foundusingthelatestreportandthenpluggingitintothestub andpreviousstubcolumns Thiscalculatesthechangeintheprevioustwelvemonthsandis whatweshouldbeusingtovaluethecompany Ideally,theseguresarewhatisusedforthecomparablesanalysis aswelltocompareapplestoapples

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the blue chips

PuNngItAllTogether

AKerappropriateforecasNngandterminalassumpNons,wediscountthevaluesofthefuturecashowsaccordinglywithWACC.Wethen sumthesevaluestogethertogaintheintrinsicvalueofthecompany Sincewearelookingforequityvaluewemustnowsubtractthermsdebt(sincebondholdershaveseniority)andaddbackcashasthisis availabletoshareholders(intheformofdividendsorstockrepurchases) Wethentakethistotalvalue,anddividebytheterminalnumberofsharesoutstanding. ThisprovidesuswithanesNmateofwhatthetruestockpriceofthecompanyshouldbe.OurDCFmodelprovidesarangeaswellasthe potenNalupsideanddownsidemulNples Remember,theDCFisnoteverything.Tradingcomparablesareequallyimportant.IntheindustrytherearemulNplevaluaNontechniques includingtheDCF,tradingcomparables,andtransacNoncomparables

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