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Discounted Cash Flow (DCF) Tutorial Part II. Wednesday, February 7th, 2007. Recap from Last Week. Basic Underlying Principles Time Value of Money (A dollar today is worth more than a dollar tomorrow) Present/Future Value PV=FV/(1-i)^n FV=PV(1+i)^n Opportunity Cost

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Discounted cash flow dcf tutorial part ii l.jpg
Discounted Cash Flow (DCF) Tutorial Part II

Wednesday, February 7th, 2007


Recap from last week l.jpg
Recap from Last Week

  • Basic Underlying Principles

    • Time Value of Money (A dollar today is worth more than a dollar tomorrow)

    • Present/Future Value

      • PV=FV/(1-i)^n

      • FV=PV(1+i)^n

    • Opportunity Cost

  • What is a business worth?

    • A business is worth the present value of the expected future cash flows of the business.

    • Ex. Target Corp (TGT):

      $60 Share Price

      x 858.89 Shares Outstanding (mm)

      = $51,533 Market Capitalization or Market Value of Equity


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Recap cont.

  • What is Free Cash Flow?

    Net Income

    Add: Depreciation

    Less: Capital Expenditures (CAPEX)

    = Free Cash Flow to Equity

  • Basics of DCF Analysis

    • Compostion

    • Computation

    • Forecasting


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Tonight's Objectives

  • Screening for companies

  • Where do you find the financial data

  • Introduction to the DCF Model

  • Example of ‘how to use’ the model

    • Dell Inc.

    • Currently trading at $23.90/share, with a

      52.42b Market Cap


Screening for companies l.jpg
Screening for Companies

  • Web-site to use: Yahoo Finance

    • Web Address: finance.yahoo.com

    • On the left margin click on ‘Stock Research -> Screener’

  • Initial Screen Criteria

    • Price to Earnings (P/E) ratio no greater than 20

    • The Company’s Return on Equity (ROE) should be greater than or equal to 10%


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Where to find the data?

  • On-line

    • Edgar

      • (http://www.sec.gov/edgar/searchedgar/companysearch.html)

    • Yahoo Finance, or Reuters

  • File Looking for?

    • 10-K: Annual Filing

    • 10-Q: Quarterly Filing

  • Important Sections

    • Part I: (Business/Risk Factors)

    • Part II:

      • Management Discussion and Analysis of Financial Condition

      • Consolidated Statements of Financial Position


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Introduction to the DCF Model

  • Four main sections of the DCF Model

    • Historical Values

    • Future Projections

    • Discount Rate & Perpetuity Growth

    • Comparison of the Fair Value to the Current Market Price

  • Variables to change within the Model

    • ‘Blue’ cells change

    • ‘Black’ cells DO NOT change


  • Example how to use the model l.jpg
    Example: ‘How to use’ the Model

    • Six Step Process

      • Screen for the company

      • Find the financial data

      • Input the historical data into the model

      • Make future projections based upon research and information within the 10-K/10-Q

      • Apply the Discount Rate & Perpetuity Growth

      • Compare the Fair Value to the Current Market Price


    Step 1 screen for the company l.jpg
    Step 1: Screen for the Company

    • Go to Yahoo Finance

      • Website: finance.yahoo.com

      • On the left margin click on ‘Stock Research -> Screener’

      • Screen initially for:

        • Price to Earnings (P/E) ratio no greater than 20

        • The Company’s Return on Equity (ROE) should be greater than or equal to 10%

      • Secondary Screen

        • Price to Book less than 1.5 – 2.0

        • Debt to Equity Ratio less than 1.5 – 2.0

        • Current Ratio greater or equal to 1.0


    Step 2 find the financial data l.jpg
    Step 2: Find the Financial Data

    • Use:

      • Edgar

        • (http://www.sec.gov/edgar/searchedgar/companysearch.html)

      • Yahoo Finance, or Reuters

    • Search for the 10-K/Annual Data

    • 10-K

      • Financial data found in Part II of ‘Consolidated Statements of Financial Position’


    Step 3 input historical data into the model l.jpg
    Step 3: Input Historical Data into the Model

    • Want to input historical data for the past five years

    • Historical Data that we are looking for:

      • Revenues

      • Net Income

      • Depreciation

      • Capital Expenditures (CAPEX)

        Note: Revenues and Net Income will be found on the Income Statement and Depreciation and CAPEX will be found on the Cash Flow Statement


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    Step 4: Make Projections

    • Need to forecast in the areas of (blue text):

      • Revenue Growth Rate

      • Net Income Margin

      • Depreciation as a % of Sales

      • CAPEX as a % of Sales


    Step 4 projections cont l.jpg
    Step 4: Projections (cont.)

    • Dell Example

      • Revenue Projection facts to consider

        • Historical Revenue Growth: 5 year average of 15.8%

          • Too high to use for a five year forecast?

        • 41% of sales in 2006 came from outside the U.S.

        • In 2007 are looking to expand their sales outside U.S.

        • Desktop PC sales growth continues to decline, as a result of

          cheaper laptop prices, while mobility products sales are increasing

          as a percentage of sales

        • ‘Servers’ business continues to grow as a percentage of sales

        • As they expand outside the U.S. ‘enhanced services’ business may

          increase sales

        • Michael Dell will take the position of CEO once again

          • Will he realign the company back to their core business?

        • Is the industry saturated from a domestic and international

          perspective?

      • Growth rates based off of sectors of Dell’s business

        • Generally assumed that Revenues would grow for the next two years, then slowly

          decrease


    Step 4 projections cont14 l.jpg
    Step 4: Projections (cont.)

    • Net Income Margin

      • Assumed that over time Dell will keep their margin in line with their historical average

      • Used the historical five year average of 5.8%

    • Depreciation as a % of Sales

      • Used the historical five year average of 0.7%

    • CAPEX as a % of Sales

      • Used the historical five year average of 1.3%

    • Question: Why forecast Depreciation and CAPEX as a % of Sales?


    Step 5 apply a discount rate and perpetuity growth l.jpg
    Step 5: Apply a Discount Rate and Perpetuity Growth

    • Discount Rate:

      • Will assume a 10% Discount Rate as the opportunity cost of my money

    • Perpetuity Growth

      • Assumed the company is a ‘Going Concern’

      • Use a rate at or below the rate of inflation

      • Used: 2.5%


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    Step 6: Compare the Fair Value to the Current Market Price

    *Note: This tells you that according the DCF Model, we can buy 1 share of Dell for $23.52 today, while the NPV of their future cash flows are valued at $26.14 per share.



    What we ve covered tonight l.jpg
    What We’ve Covered Tonight

    • Screening for companies

    • Where do you find the financial data

    • Introduction to the DCF Model

    • Example of ‘how to use’ the model

      • Dell Inc.

      • 6 Step Process