Strategic Capital Group
Workshop #6: DCF
Modeling
Agenda
Discounted Cash Flow Overview
Forecasting 101
Projection Walkthrough
Net Working Capital and WACC
Calculating Terminal and Equity Value
Walkthrough of the DCF
Please open up the DCF template in excel (found on the USIT Website)
Revenue
-COGS
Gross Profit
Line Items
-SG&A Expenses
-R&D Expenses
-Other Expenses
EBIT
x(1-Tax)
NOPAT
+D&A
-CapEx
+Δ NWC
FCF Proxy
The Idea Behind It
1.) We are converting revenue to cash (due to accounting
gimmicks making metrics like revenue and net income
“tainted”).
2.) We project out revenue and the subtractions required to get
to cash for the period of 5 years
3.) Discount the cash flows back to present value and add them
back up
4.) Calculate an enterprise value by summing the PV’d cash
flows
5.) Solve for equity value
6.) Divide equity value by shares outstanding to find implied
share price
The First Step: Forecasting
• We need to figure out what the revenues and
associated costs for the next 3-5 years will be
in order to find what the cash flows will be for
the next five years
• Goal: To create a defensible argument for our
projections
• Several components to forecasting
Why 3-5 Years?
Depends on the investment horizon you have
Many times 3 years will be explicitly stated (numbers)
and the next two will be analyzed but not entered.
5 years to reach a steady state – go through an economic
cycle and realize any projects/initiatives
Forecasting: Company Overview
UNDERSTAND THE COMPANY
UNDERSTAND THE COMPANY
UNDERSTAND THE COMPANY
Things to look at:
• Management Philosophies (ex. Steve Jobs did a great job of innovating, good sign)
• Products/Services (will people still use this product in the future, do people like it?
Ex. NewsCorp’s print business)
• Competition in the Industry (does the company risk others beating its product line
ex. HP vs. Dell)
• Where the company is going (Does the company want to reinvent itself? Ex. Dell
moving toward enterprise and away from consumer PC’s)
• What does it do? (Avoid critical mistakes like Microsoft selling PC’s, they sell OS’s,
totally different markets)
Forecasting: Company Overview
• Where can I find this information?
http://www.wikiwealth.com/swot - Company SWOT analysis (Strength,
Weakness, Opportunity, Threat)
10-K and Annual report covers- Give a run down of the company, its
business segments, who it sells to, what regions drive its revenue, how
big it is
10-K Management Discussion & Analysis- Management gives its opinions
on where it wants to take the company and its own SWOT
Forecasting: Markets and Industries
• Now that we’re nice and comfy with the
company and know how it will make money,
we need to figure out how much it will make.
• We look at industry and market growth to try
and understand wide trends that will benefit
the company.
Forecasting: Markets and Industries
We have a number of sources to get information on
markets and industries:
-Capital IQ
-FactSet
-News Articles
-Other industry report generating sources
-academic.mintel.com
These are the two best, tune into factset and CIQ
workshops to learn how to use them effectively.
Forecasting: Targets
How do we know we’re close to picking the correct revenue
amount?
-Past History- typically we cap growth rates at their 5-10 year
averages to be conservative.
-Analyst Estimates- analysts will come out an give their
forecasts for quarterly and annual revenue reporting,
typically up to 5 years into the future.
-MD&A- Management will typically come out set their EPS
and Revenue targets for the 1-2 years in the future, then give
a long term, 10 year goal.
Forecasting: Targets
• Past History:
– Pros: give us the bounds of what a company is
capable of achieving (a company that has grown
only 1-2% in the past isn’t likely to see 30% YoY
growth)
– Cons: Past history isn’t always a measure of future
performance, a new product or market can jump
start aggressive growth
Forecasting: Targets
• Analyst Estimates:
– Pros: Typically a large number of analysts that
spend a lot of time tracking a company and
understanding it- making some of their
predictions fairly close
– Cons: Some analysts work for in divisions of an
Investment Bank and can be pressured to give a
“buy” rating to company’s the iBank works with,
so many times Analysts are a little too optimistic
Forecasting: Targets
• MD&A:
– Pros: Since they run the company, there’s a good
chance the direction they say they want to take
the company is the direction it will go. Also very
good at forecasting CapEx
– Cons: Incentive to overstate their income and
revenue predictions, typically they are a good
benchmark for an aggressive prediction, rather
than conservative.
Forecasting: Digesting It All
• So we understand the company’s offerings,
where management thinks its going, where
the market is going, past growth, and where
analysts who have studied the company think
it’s going.
• We need to translate this into a growth rate.
Forecasting: Digesting it All
• Unfortunately there are no equations for
translating qualitative information into an
exact quantitative number, it’s something you
have to practice and get good at.
• However, we can get close to predicting a
correct number.
• Let’s use AAPL as an example
Key Revenue Drivers
• What drives revenue?
– Either Price must go up, or Quantity must go up
– Or new products must emerge
• Most often, we model revenue based on
drivers
– Ex: Apple has # phones and avg. cost per phone
– Ex2: WSJ has subscribers and ARPU
Cost of Goods Sold
• Not being able to use chinese sweatshop labor
will drive up costs per phone a little, but in
general it should stay constant
• Most logical way would be to model it out as a
percentage of revenue
SG&A and R&D
• We see Apple keeping its SGA& stable at its
past average growth rate
• SG&A is usually modeled on a constant
growth rate.
– Why? Why not as % revenue?
– Are there parts that maybe should be % rev?
Other Operating Expenses
• Could be basically anything really, but
obviously nothing that we already listed
• No R&D, No interest or other income.
Breathe!
• That was more than half of the “hard stuff”
• Where are we?
Revenue
-COGS
Gross Profit
-SG&A Expenses
-R&D Expenses
-Other Expenses
EBIT
x(1-Tax)
NOPAT
+D&A
-CapEx
+Δ NWC
FCF Proxy
Capital Expenditures
• Let’s look at MD&A for a good estimate for
Capital Expenditures (purchases of long-term
assets, found in the statement of cash flows
investing section). In non-time constrained
environments we would go back and check
Management’s accuracy of predictions.
Capital Expenditures
• As a company matures, typically its Capital
Expenditures tails off
• Maintenance CapEx vs Growth CapEx
Depreciation
• Depreciation is tied to long-term assets, (long-term
assets are the only assets that generate depreciation
expense, we don’t depreciate cash or accounts
receivable).
• We can look at a depreciation schedule in the 10k to
figure out how much depreciation will come due from
year to year and forecast that way, or tie it to CapEx
growth (eventually D&A growth will tie to CapEx
growth).
• We add depreciation back to Revenue in order to
eliminate non-cash expenses and get to a more
accurate Free Cash Flow
So where are we?
• We’ve learned forecasting tools for revenues,
costs, and learned the general form of a DCF’s
line items.
• We’ve gone over how depreciation and CapEx
are forecasted and how they affect free cash
flows.
Change in Net Working Capital
• Working Capital = Current Assets – Current Liabilities
• We deal with non-cash current assets and non-interest bearing
current liabilities
• Represents operating liquidity of the business.
• We add/ subtract this from Revenue due to the involvement of
changes in current assets and liabilities to cash
– We pay cash to increase current assets, and gain cash when current
assets are sold, the inverse applies to liabilities
• So if the change in NWC is positive, then we added more assets
than liabilities so we subtract this from Revenue. If change in NWC
was negative (more liabilities added than assets), this will increase
the amount of cash we received during the period
How do we forecast NWC?
• Most often, NWC will be fairly constant as a
percentage of revenue
– Why?
– If this isn’t the case you might have some
problems
• So to forecast the change, you can forecast
NWC for every period and get the change that
way
What is the change in Net Working
Capital?
Cash grew from 2012 to 2013 by 200M
Inventory grew from by 12M
Accounts Receivable decreased by 4M
Prepaid Expenses grew by 1M
Accrued Liabilities grew by 8M
Accounts Payable grew by 13M
So what’s left?
• We know what our revenue and costs will be over
the next 5 years, we know NWC and the
depreciation and CapEx.
• We’ve reached free cash flow, but we need to
figure out what the cash flows are worth today.
We need to “discount” them back to the future.
• But what discount rate do we use? How do we
find an discount rate that reflects the diversity of
risk within our specific company?
That will be covered next week