Strategic Capital Group
Workshop #6: DCF
Modeling
Agenda
Discounted Cash Flow Walkthrough
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
-Other Expenses
-R&D 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 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 5 Years?
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.
Filling in the Blanks
• Let’s flip back to the DCF template and fill it in.
• Start with the user inputs for the 2012 year (in
gray boxes)
• To save time, we will target Apple, a fairly
known company.
Key Revenue Drivers
• What drives revenue?
– Either Price must go up, or Quantity must go up
– Or new products
Costs
• Not being able to use chinese sweatshop labor
will drive up costs a little, but Apple will still
probably do it a little.
SG&A
• We see Apple keeping its SGA& stable at its
past average growth rate
Other Operating Expenses
• No R&D, No interest or other income.
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
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
Net Working Capital
• Flip to the NWC page on the DCF Template
• Here we forecast out changes in major current
assets: Accounts Receivable, Inventory,
Prepaid Expenses and current liabilities:
accrued liabilities and accounts payable
• Not cash, want this to be independent of cash
flows generated.
Net Working Capital
• Current Assets:
– Accounts Receivable: customers paid on credit
• Calculate DSO (Days Sales Outstanding)
– (AR / Sales) * 365 – tells us how long it takes to collect a full A/R
account
– Inventory: RM, WIP, FG
• Calculate DIH (Days Inventory Held)
– (Inventory / COGS) * 365 –Tells us how long inventory spends in
our warehouse before it is sold
– Prepaid Expenses/Other: payments made before
product given/service performed
• Simply % Sales
Net Working Capital
• CLs:
– Accounts Payable: amount company owes for
credit purchases
• Calculate DPO (Days Payable Outstanding)
– (AP / COGS) * 365
– Average number of days it takes to make payment on
outstanding purchases
– Accrued Liabilities: ie wages payable, rent,
interest, taxes
• Simply % Sales
Projecting an Account
• We Project these by either holding the
DSO/DIH/%Sales constant through time (or
growing/shrinking it a little each year) and
calculating what the account will look like
based on our sales predictions.
Projecting an Account
If Days Sales Outstanding has been about 45 days for the past few years, we can be fairly
confident it will remain 45.
Accounts Receivable * 365
We projected
revenue will go
from 100M to
110M next year
DSO =
Sales
So we know DSO (because we held it
constant at 45 after some research), and
sales (based on our revenue growth rates)
so we can calculate A/R
Accounts Receivable * 365
45 =
= 13.5M
110M
Projecting Accounts
• We do the same with the rest of the current
liabilities and assets
• With percentages, we expect the assets value to
be a % of revenue (or other account) so just look
at that year’s projected account and take the
percentage to find what the new current account
value is.
• Look at the year-over-year change value and take
(sum of current asset changes) – (sum of current
liabilities changes) to find the change in NWC.
Check for Understanding
Inventory Level this year: $100M
Cost of Goods Sold this Year: $450M
What is Days Inventory Held?
DIH = (Inventory/COGS)*365
DIH = (100/450)* 365
DIH= 81
Check for Understanding
If we forecasted $500M in COGS in 2013 and
expected DIH to grow by 1 day each year, what
will our inventory be in 2013?
DIH = (Inventory/COGS)*365
82 = (Inventory/500)* 365
Inventory = $112.35M
So change in inventory =
112.35M – 100M = 12.35M
What is the change in Net Working
Capital?
Inventory grew from 2012 to 2013 by 12M
Accounts Receivable decreased by 4M
Prepaid Expenses grew by 1M
Accrued Liabilities grew by 8M
Accounts Payable grew by 13M
(12+4+1) - (8+13)
17-20
-3M
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?
Weighted Average Cost of Capital
• What is it?
• Essentially the weighted average rate a
company expects to pay out to its financing
sources (both debt and equity holders)
• We use this rate as a discount rate for the cash
flows.
Weighted Average Cost of Capital
Equation:
WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity
Essentially:
How much return all of our financiers get =
How much return the equity holders demand * weighting of equity +
How much return the debt holders demand/get * weighting of debt
Cost of Debt
In order to find what the company pays to its debt holders, we
should find what the weighted average interest rate for their debt
is (on the 10-K)
We then weight the average interest rate they pay (by
multiplying it by what percentage of their capital comes from
debt capital) then multiply it again by (1-tax rate) to adjust for
the tax deductibility of interest expense.
(Average Interest Rate * %debt) * (1-tax Rate)
Check for Understanding
• So what is the cost of debt for a company that
has all of its money from equity holders?
0! If we don’t have any
debt, then we don’t care
about debt financing
costs.
(Average Interest Rate * %debt) * (1-tax Rate)
Check for Understanding
• If a company’s credit rating goes down, what
happens to its cost of debt?
(Average Interest Rate * %debt) * (1-tax Rate)
HINT: a decrease in credit rating will drive up your
average interest rate
Cost of debt will increase
Cost of Equity
Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)
Essentially how
much an extra
return an investor
gets for taking on
equity risk.
Can take a 5-20 year
average of S&P or
DOW’s returns or just a
1 year.
10- Year
Treasury Yield
(Market Premium * Beta) + Risk-Free Rate = Cost of Equity
Adjusting the
equity returns
for risk
Typically a long
term beta
Check for Understanding
• If the returns in the equity market increases,
what happens to a company’s cost of equity?
Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)
(Market Premium * Beta) + Risk-Free Rate = Cost of Equity
It increases, since now in order
to compete for financing dollars
through equity, the company
must effectively yield more
returns to entice investors.
WACC
So what is the calculation for it?
(Cost of Debt * % of capital that comes from
debt) * (1-tax Rate)
+Cost of Equity * % of capital from equity
Weighted Average Cost of Capital
• What influences it?
– Market Interest Rates
– Company Volatility (beta)
– Equity market returns
– Risk-free rates
– Tax rates
STOP!
• We just learned how to calculate WACC, the
value we will be using for our discount rate.
• IT IS IMPERATIVE YOU YELL AT ME AND ASK
QUESTIONS!
Discounting
We use the PV equation to discount each cash
flow back to its present value.
Remember:
PV = (FV/ (1+ Discount Rate) ^ years away)
Discounting
• We’re still missing part of the value of the
company, the company wont stop functioning
after 5 years, technically we need to do this
for the entire life of the company to find what
the company is worth.
• We call the estimation of a company’s cash
flows from t=5 to t= infinity its “terminal
value”
Critical Thinking
• If we’re taking the PV of an infinite number of
years’ cash flows, shouldn’t the PV end up
being infinity?
No- as you get further and further into the
future, a dollar becomes worth less and less
until it eventually becomes worth nothing.
Terminal Value
• 2 ways to calculate this:
– Exit Multiple Approach
– Long-term growth rate approach
Terminal Value: The Exit Multiple
Approach
• We can multiply the 5th year’s cash flow by a
multiple of EV/EBITDA we plan to sell the
company at in the future, then discount it
back at year 5.
Terminal Value = 5th Year Cash Flow * Projceted (EV/EBITDA)
Terminal Value: The Exit Multiple
Approach
• We discount this terminal value back to the
present value using year=5, not infinity.
Calculated FV Terminal Value
PV Terminal Value =
(1+Discount Rate) ^5
Terminal Value: The Long-Term Rate
• We can also calculate terminal value by
figuring out the “long-term growth rate” of a
company- essentially the amount we expect a
company to grow consistently in the future
once it has matured. Typically this number is
just slightly larger than US or world GDP
growth.
5th Year Cash Flow * (1+LT Rate)
Terminal Value =
Discount Rate – LT Rate
Enterprise Value
• Stepping aside, we need to discuss another
way to measure the size of a company.
• Previously we said market cap was a way to
size a company (Price * shares outstanding)
• But this had the issue of not taking into
account the debt that was used to fund a
company.
• We adjust for this problem by calculating
Enterprise Value
Enterprise Value
• EV is essentially the amount of money you
would have to pay to “take over” a company,
buying all of its debt and equity.
EV = Market Cap + Debt – Cash +Preferred Shares + Minority Interest
We take out cash
because when we
buyout a company,
we are paying cash
for cash, which
cancels out.
Here we are taking
into account nonequity shares we
have to buyout
Getting to Enterprise Value from Cash
Flows
After discounting the terminal value and the
FCF’s from the 5 projected years, we add them
all up to reach our implied Enterprise Value.
From this, we solve for market cap by taking out
debt, preferred shares, and minority interest,
leaving us with Market Cap + Cash. We divide
this value by the shares outstanding to find the
implied price per share.