Introduction to Discounted Cash Flow Analysis

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Introduction to
Discounted Cash Flow Analysis
CHRIS DELL’AMORE
COLGATE FINANCE CLUB
2/12/11
What is a DCF?
 Value can be derived from the present value of its
projected free cash flows
 Intrinsic Value ≠ Market Value
 Assumptions:




Growth rates (i.e. sales)
Profit margins
CAPEX
Net Working Capital requirements
When do we use a DCF?
 No “true” comparable companies
 Times of economic turmoil
 Flexibility in assumptions
 Fundamental approach
Process of a DCF
Analyze Target and Determine Drivers
2. Project the Free Cash Flow (FCFs)
3. Calculate Weighted Average Cost of Capital (WACC)
1.
•
Capital Asset Pricing Model (CAPM)
4. Calculate Terminal Value (TV)
5. Calculate Present Value (PV)
Disclosure: This presentation will go over the basics of each step and will not analytically delve into the development of each calculation.
Target Analysis (Step 1)
 Public
 SEC filings, earnings call transcripts, analyst research and
Management Discussion and Analysis portion of the 10-K and
10-Q
 Private:
 Confidential Information Memorandum (CIM), analyst research,
trade journals and SEC filings
 Business model
 Financial profile
 End markets
 Competitors
Driver Analysis (Step 1)
 Sales Growth
 Internal: new facilities, new products, capital efficiency
improvements, costumer contract expansion
 External: acquisitions, end market trends, regulatory changes
consumer buying patterns
 Profitability
 Management, brand, customer base, marketing, technology
 Free Cash Flow Generation
 CAPEX (i.e. owning vs. leasing)
Projecting Free Cash Flows (Step 2)
 Historical Performance
 Projection Period Length (~5-10 years)
 Best Case, Base Case, Worst Case
 Projections:
 Sales, COGS and SG&A, EBITDA, EBIT, Tax, D&A, CAPEX,
NWC
EBIAT /NOPAT= EBIT – Marginal tax rate (~35-40%)
NWC = Current Assets – Current Liabilities
FCF= EBIAT + D&A - CAPEX - ΔNWC
Calculating WACC (Step 3)
 Represents the weighted average of the required return
on the invested capital

Debt and Equity have different risk and tax benefits/detriments
 Determine target capital structure
 Debt-to-total capitalization [D/(D+E)]
 Equity-to-total capitalization [E/(D+E)]
Calculating WACC (Step 3)
(Cost of Equity)
(Cost of Debt)
Calculating WACC (Step 3)
 Estimate Cost of Debt (rd)
 Credit Profile at target capital structure
 Bonds: current yield on all outstanding issues
 Credit Facilities: analyzed by DCM team internally
 Tax-effect your cost of debt by marginal tax rate
 Estimate Cost of Equity (re) – CAPM
 Annual rate of return that equity investors expect to receive
 Use CAPM to find this rate
re = rf + βL * (rm - rf )
Disclosure: Did not discuss process of unlevering and relevering beta for sake of simplicity
Calculating WACC (Step 3)
WACC
=
(
E
(D+E)
)
(re) +
(
D
(D+E)
)
(1-t)(rd)
D = market value of debt
E = market value of equity
rD = discount rate for longterm debt
re= discount rate for equity (from CAPM)
Calculating Terminal Value (Step 4)
 Captures the value beyond the projected period
 Steady state; accounts for ~75% of valuation
 Exit Multiple Method (EMM)
 Based on the current LTM trading multiples of comps
 Must normalize to account for peaks and troughs in industry
TV = EBITDAn * Exit Multiple
 Perpetuity Growth Method (PGM)
 Treats company’s terminal year FCF as a perpetuity growing at an
assumed rate. (Must be cautious when choosing growth rate)
TV =
FCFn * (1 + g)
(re -g)
Calculating Present Value (Step 5)
 Time value of money
 Discount Rate:
 Fractional value representing the present value of a dollar
received at a future date given an assumed discount rate
(WACC)
Discount Factor =
1
(1 + WACC)n
PV of FCFn = FCFn *Discount Factor
Final Valuation
 Enterprise Value
 Discount and sum the present values of the FCF for each
period and the TV
 Equity Value
Implied Equity Value = Enterprise Value – (Net Debt + Preferred Stock +
Non-controlling Interest)
 Share Price
Implied
Share Price =
Implied Equity Value
Fully Diluted Shares Outstanding
Works Cited
Pearl, Joshua, and Joshua Rosenbaum. Investment
Banking Valuation, Leveraged Buyouts and
Mergers & Acquisitions. Hoboken: John Wiley &
Sons, 2009. Print.

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