Discounted Cash Flow (DCF) Tutorial

1. Discounted Cash Flow (DCF) Tutorial Wednesday, January 31st, 2007

2. 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

3. 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)?

4. 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…

5. 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?

6. 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

7. 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

8. 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)

9. 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%.

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.

11. 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!

12. Free Cash Flow – Equity (FCFE) Net Income Add: Depreciation Less: Capital Expenditures (CAPEX) = Free Cash Flow to Equity

13. 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

14. 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

15. 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

16. Forecasting Cash Flows • Historical Simple/Weighted Averages • Primarily used when there is no discernable trend, or current trend is not expected to continue

17. Forecasting Cash Flows • Historical Trend Exrapolation

18. 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