discounted cash flow (dcf) tutorial - international basics of dcf analysis –compostion...
TRANSCRIPT
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)?
NiPVFV )1(
NiFVPV )1/(
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 $5,000 worth 10 years from now?
• Likewise…
yearsFV 10%)101(*000,5$
969,12$FVyearsPV 10%)101/(969,12$
000,5$PV
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)
Taxes (34%) (25,500) (28,560) (34,000)
Operating Income 75,000 84,000 100,000
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 Year 1 Year 2 Year 3 Year 4 Year 5
Net Income Growth 7% 12% 8% 1% 5%
Simple Average 6.60%
Weighted Average Weight Growth
33.3% 5% 1.7%
26.7% 1% 0.3%
20.0% 8% 1.6%
13.3% 12% 1.6%
6.7% 7% 0.5%
100.0% 5.6%
Forecasting Cash Flows
• Historical Trend Exrapolation
Year 1 Year 2 Year 3 Year 4 Year 5
Net Income Margin 4% 4% 4% 5% 6%
Year 6 Year 7 Year 8 Year 9 Year 10
Estimated NI Margin 6% 7% 8% 8% 8%