Discounted Cash Flow (DCF)

Tutorial
Wednesday, January 31st, 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)?
FV  PV (1  i ) N
• What is tomorrow’s dollar worth today (present value)?

PV  FV /(1  i ) N
 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?
FV  $5,000 * (1  10%) 10 years

FV  $12,969
• Likewise… PV  $12,969 /(1  10%) 10 years

PV  $5,000
 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 858.89 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

Year 0 Year 1 Year 2 Year 3

($30,000) $3,000 $10,000 $25,000

Discount Rate: 10%

Net Present Value ($225.39)
 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)
Operating Income 75,000 84,000 100,000
Taxes (34%) (25,500) (28,560) (34,000)
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
Y ear 1 Y ear 2 Y ear 3 Y ear 4 Y ear 5
N e t I n c o m e G r o w th 7% 12% 8% 1% 5%

S im p le A v e r a g e 6 .6 0 %

W e ig h te d A v e r a g e W e ig h t G r o w th
3 3 .3 % 5% 1 .7 %
2 6 .7 % 1% 0 .3 %
2 0 .0 % 8% 1 .6 %
1 3 .3 % 12% 1 .6 %
6 .7 % 7% 0 .5 %
1 0 0 .0 % 5 .6 %
 Forecasting Cash Flows
• Historical Trend Exrapolation

Y ear 1 Y ear 2 Y ear 3 Y ear 4 Y ear 5

N e t In c o m e M a r g in 4% 4% 4% 5% 6%

Y ear 6 Y ear 7 Y ear 8 Y ear 9 Y ear 10

E s tim a te d N I M a r g in 6% 7% 8% 8% 8%
 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