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 todays dollar worth tomorrow (future value)?
FV PV (1 i ) N
What is tomorrows 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