Workshop VI: DCF
Theory & Principle
ƒ Measures current value of future cash earnings of a company
• Based on the present value rule:
• Firm valuation very similar to bond pricing:
•
But:
o
(1) “risk” or discount rate for firm valuation is different
o
(2) “coupon” is not fixed
o
(3) “principal payment” does not exist in the same essence
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Where To?
DCF =
CF
1+R
+
CF terminal
R
Theory & Principle
ƒ Risk and discount rates
• Discount rate of one investment is the return one can make in another
similar or identical investment
• Bond risk is “cash-flow matching” and “no arbitrage”
o
Discount rate is equal to returns on a replicating portfolio of zero-coupons
• Firm risk is “opportunity cost of capital” or “similar asset arbitrage”
o
Discount rate is a function of the (1) interest payment on debt and (2)
“interest” payment and capital gains on equity on similar firms
o
Adjusted for “average extra returns” that come with each level of extra risk
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Quantifying risk
ƒ Firm risk is the alternate use of of capital (debt + equity)
ƒ Debt risk or Cost of Debt (COD) is:
• Opportunity cost of debt
• The risk-free rate + default spread
o
Can be found using current “interest” rate on debt, or Moody’s and S&P
500 ratings and spreads
ƒ Equity risk or Cost of Equity (COE) is:
• Opportunity cost of equity
• Return on similar equity investments
o
Many ways to estimate: (1) CAPM (2) APM (3) Multi-Factor
Quantifying risk
We use CAPM:
COE = Risk-free rate + Beta * (Mkt premium) + Other risk premiums + E
Equity discount rate is a function of:
SYSTEMATIC RISK
• Risk-free rate (i.e. U.S. government bonds)
• Beta (correlation factor with market movement)
• Other risk premiums (i.e. default spreads, country risk premiums)
UNSYSTEMATIC RISK
• Epsilon (project-specific risk, operating risk, catalyst-driven risk, etc.)
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Beta
Subject Returns
Market Returns
Quantifying risk
ƒ
ƒ
If valuing equity:
•
Use COE
•
Discount Free Cash Flow to Equity (FCFE)
If valuing firm:
•
Use Weighted Average Cost of Capital (WACC)
•
Discount Free Cash Flow to Firm (FCFF)
o
ƒ
COE * [ Equity / (Debt + Equity)] + COD * [ Debt / (Debt + Equity)] * (1- t)
ALTERNATIVELY (my favorite):
•
8% - completely safe project and firm, i.e. nothing can go wrong
•
10% - normal firm with normal risk (AKA 10% yield requisite)
•
15% - pretty risky firm (i.e. international, uncertain economics, ect.)
•
>15% - very risky firm (i.e. project specific risks, bankruptcy risks)
4
Where Are We?
CF
1+R
DCF =
+
CF terminal
R
Theory & Principle
ƒ Cash-flow
• Normal bonds are “fixed-income” instruments
o
Determined by fixed or mathematically predictable rate on principal
• Firms are “variable-income” instruments
o
Determined by the operations of a business
ƒ Terminal Value
• “Terminal value” of a bond is PV of the final payment
• Terminal value of a firm is PV of a perpetual annuity in cash-flow
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Measuring Earnings
ƒ This is Financial Statement Analysis
ƒ Recap:
• Key items:
1.) Revenue 2.) COGS 3.) SG&A 4.) Interest 5.) Taxes
6.) Below the Line and extraordinary items
• Income Statement Math:
o
Revenue – COGS = Gross Profit
o
Gross Profit – SG&A = Operating Income AKA EBIT
o
EBIT – Interest – Taxes – XO Items = Net Income to Equity
ƒ See Financial Statement Analysis Workshop
ƒ Use “best judgment” when estimating items going forward
Measuring Earnings
ƒ Crucial estimation tools:
• Growth rates: year-over-year (Y-o-Y), quarter-over-quarter (Q-o-Q)
• Business breakdown: segments, geographic regions, ect
• Margins: EBIT, EBITDA, Net Income, Segment
• % of sales: line items as a percent of total or segment revenue
ƒ No “right answer”
ƒ Estimate confidently with as much data as possible
ƒ Afterwards…
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Cash is King
ƒ
ƒ
ƒ
Shareholders and debt-holders don’t care about “accounting” earnings…
only cold hard cash
•
It is what dividends are paid in
•
It is what is available for reinvestment
•
It is what is available to service debt and other claims
CASH IS KING
•
Discounted CASH-FLOW valuation
•
Free CASH-FLOW to equity, free CASH-FLOW to firm
•
CASH MONEY DOLLA, not net income money dolla
How do we estimate cash-flow?
Cash is King
ƒ This is Financial Statement Manipulation
• Key items:
1.) Revenue 2.) COGS 3.) SG&A 4.) D&A
5.) CapEx 6.) Change in Working Capital 7.) Interest 8.) Taxes
• Cash-flow math:
o
Revenue – COGS – SG&A + D&A = EBITDA
o
EBITDA – Interest - CapEx – Change in Working Capital = IBT
o
IBT – Taxes = FCFE
o
FCFE + Interest * (1 – t) = FCFF
– (1 – t) is assuming FCFF will eventually equal FCFE
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Cash is King
ƒ Cash-flow math variations:
• EBIT (1 – t) + D&A – Reinvestment = FCFF
o
Assume no interest, no tax-effect, or constant interest/debt structure
• (EBIT – Interest) * (1 – t) + D&A – Reinvestment = FCFE
ƒ Considerations and adjustments:
• Capitalizing & decapitalizing R&D and various SG&A expenses
• Liability-izing operating leases and pension obligations
• Marginal vs. effective tax rates (be conservative)
o
Difference between GAAP and IRS reporting
o
Deferred tax assets/liabilities
• Net operating loss carryforwards
Reinvestment & Growth
ƒ Reinvestment = Capital Expenditures & Working Capital
• Management discussion & analysis
• Estimates of maintenance CapEx vs. growth CapEx
• Working capital calculation and normalization
ƒ Growth
• Use this as a reality check, not strict rule
• Adjust growth, look at return on capital
• Companies with no moat: anything north of 10% ROC is hard
• Companies with a moat: anything north of 30% ROC is hard
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Where Are We?
CF
1+R
DCF =
+
CF terminal
R
Terminal Value
ƒ Business as a perpetuity:
• Stable Growth Model
o
Based on Dividend Discount Model (DDM)
o
Value = [ Cash-flow / ( r – g) ]
o
r = terminal WACC
o
g = terminal growth
– Terminal Cost of Equity and Terminal Cost of Debt is lower
ƒ Counting in the probability of distress:
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Terminal Value
ƒ Terminal value:
• A guesstimate at best, completely wrong at worst
• May not exist in project based businesses
• Terminal value sometimes can also be an “average” performance into
perpetuity for cyclical businesses.
• Sometimes, better to use as a “reality check” against the market value
Putting It All Together
ƒ DCF estimates the value of a business by discounting variable
cash-flows for a number of periods ending with discounting a
perpetual cash-flow to the present.
ƒ Not an exact science, use it with discretion.
ƒ Conservatism over optimism
ƒ Margin of Safety
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Example
ƒ See external document
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