Discounted Cash Flow (DCF)
Tutorial Part II
Wednesday, February 7th, 2007
Recap from Last Week
• Basic Underlying Principles
– Time Value of Money (A dollar today is worth more than a dollar
tomorrow)
– Present/Future Value
• PV=FV/(1-i)^n
• FV=PV(1+i)^n
– Opportunity Cost
• What is a business worth?
– A business is worth the present value of the expected future cash flows
of the business.
– Ex. Target Corp (TGT):
$60 Share Price
x 858.89 Shares Outstanding (mm)
= $51,533 Market Capitalization or Market Value of Equity
Recap cont.
• What is Free Cash Flow?
Net Income
Add: Depreciation
Less: Capital Expenditures (CAPEX)
= Free Cash Flow to Equity
• Basics of DCF Analysis
– Compostion
– Computation
– Forecasting
Tonight's Objectives
•
•
•
•
Screening for companies
Where do you find the financial data
Introduction to the DCF Model
Example of ‘how to use’ the model
– Dell Inc.
– Currently trading at $23.90/share, with a
52.42b Market Cap
Screening for Companies
• Web-site to use: Yahoo Finance
– Web Address: finance.yahoo.com
– On the left margin click on ‘Stock Research ->
Screener’
• Initial Screen Criteria
– Price to Earnings (P/E) ratio no greater than 20
– The Company’s Return on Equity (ROE) should
be greater than or equal to 10%
Where to find the data?
• On-line
– Edgar
• (http://www.sec.gov/edgar/searchedgar/companysearch.html)
– Yahoo Finance, or Reuters
• File Looking for?
– 10-K: Annual Filing
– 10-Q: Quarterly Filing
• Important Sections
– Part I: (Business/Risk Factors)
– Part II:
• Management Discussion and Analysis of Financial Condition
• Consolidated Statements of Financial Position
Introduction to the DCF Model
•
Four main sections of the DCF Model
1.
2.
3.
4.
•
Historical Values
Future Projections
Discount Rate & Perpetuity Growth
Comparison of the Fair Value to the Current Market
Price
Variables to change within the Model
–
–
‘Blue’ cells change
‘Black’ cells DO NOT change
Example: ‘How to use’ the Model
•
Six Step Process
1.
2.
3.
4.
Screen for the company
Find the financial data
Input the historical data into the model
Make future projections based upon research and
information within the 10-K/10-Q
5. Apply the Discount Rate & Perpetuity Growth
6. Compare the Fair Value to the Current Market
Price
Step 1: Screen for the Company
• Go to Yahoo Finance
– Website: finance.yahoo.com
– On the left margin click on ‘Stock Research ->
Screener’
– Screen initially for:
• Price to Earnings (P/E) ratio no greater than 20
• The Company’s Return on Equity (ROE) should be
greater than or equal to 10%
– Secondary Screen
• Price to Book less than 1.5 – 2.0
• Debt to Equity Ratio less than 1.5 – 2.0
• Current Ratio greater or equal to 1.0
Step 2: Find the Financial Data
• Use:
– Edgar
• (http://www.sec.gov/edgar/searchedgar/companysearch.
html)
– Yahoo Finance, or Reuters
• Search for the 10-K/Annual Data
• 10-K
– Financial data found in Part II of ‘Consolidated
Statements of Financial Position’
Step 3: Input Historical Data into the
Model
• Want to input historical data for the past five
years
• Historical Data that we are looking for:
– Revenues
– Net Income
– Depreciation
– Capital Expenditures (CAPEX)
Note: Revenues and Net Income will be found on the Income Statement
and Depreciation and CAPEX will be found on the Cash Flow
Statement
Step 4: Make Projections
• Need to forecast in the areas of (blue text):
– Revenue Growth Rate
– Net Income Margin
– Depreciation as a % of Sales
– CAPEX as a % of Sales
Step 4: Projections (cont.)
• Dell Example
– Revenue Projection facts to consider
• Historical Revenue Growth: 5 year average of 15.8%
– Too high to use for a five year forecast?
• 41% of sales in 2006 came from outside the U.S.
• In 2007 are looking to expand their sales outside U.S.
• Desktop PC sales growth continues to decline, as a result of
cheaper laptop prices, while mobility products sales are increasing
as a percentage of sales
• ‘Servers’ business continues to grow as a percentage of sales
• As they expand outside the U.S. ‘enhanced services’ business may
increase sales
• Michael Dell will take the position of CEO once again
– Will he realign the company back to their core business?
• Is the industry saturated from a domestic and international
perspective?
– Growth rates based off of sectors of Dell’s business
• Generally assumed that Revenues would grow for the next two years, then slowly
decrease
Step 4: Projections (cont.)
• Net Income Margin
– Assumed that over time Dell will keep their
margin in line with their historical average
– Used the historical five year average of 5.8%
• Depreciation as a % of Sales
– Used the historical five year average of 0.7%
• CAPEX as a % of Sales
– Used the historical five year average of 1.3%
• Question: Why forecast Depreciation and
CAPEX as a % of Sales?
Step 5: Apply a Discount Rate and
Perpetuity Growth
• Discount Rate:
– Will assume a 10% Discount Rate as the
opportunity cost of my money
• Perpetuity Growth
– Assumed the company is a ‘Going Concern’
– Use a rate at or below the rate of inflation
– Used: 2.5%
Step 6: Compare the Fair Value to the
Current Market Price
Discount Rate
10.0%
PV of Projected Cash Flows
PV of Terminal Value CF
$15,604.3
$42,690.4
Fair Value
Shs. Outstanding (millions)
Per Share Fair Value
$58,294.7
2,230
$26.14
Current Share Price
Margin %
$23.52
11.1%
*Note: This tells you that according the DCF Model, we can buy
1 share of Dell for $23.52 today, while the NPV of their future
cash flows are valued at $26.14 per share.
Results from Dell Inc. DCF
SIA Discounted Cash Flow (DCF) Worksheet - Dell Inc.
2002
2003
2004
2005
2006
1
2007E
2
2008E
3
2009E
4
2010E
5
2011E
Revenues
% Growth
$31,168.0
$35,404.0
13.6%
$41,444.0
17.1%
$49,205.0
18.7%
$55,908.0
13.6%
$63,735.1
14.0%
$72,658.0
14.0%
$82,103.6
13.0%
$91,135.0
11.0%
$97,514.4
7.0%
$99,952.3
2.5%
Net Income
% Margin
1,246.0
4.0%
2,122.0
6.0%
2,645.0
6.4%
3,043.0
6.2%
3,572.0
6.4%
3,689.9
5.8%
4,206.4
5.8%
4,753.3
5.8%
5,276.1
5.8%
5,645.5
5.8%
5,786.6
5.8%
Add: Depreciation
% of Sales
239.0
0.8%
211.0
0.6%
263.0
0.6%
334.0
0.7%
393.0
0.7%
430.7
0.7%
491.0
0.7%
554.9
0.7%
615.9
0.7%
659.0
0.7%
675.5
0.7%
Less: Capital Expenditures
% of Sales
303.0
1.0%
305.0
0.9%
965.0
2.3%
525.0
1.1%
728.0
1.3%
832.5
1.3%
949.1
1.3%
1,072.5
1.3%
1,190.4
1.3%
1,273.8
1.3%
1,305.6
1.3%
Free Cash Flow to Equity
$1,182.0
$2,028.0
$1,943.0
$2,852.0
$3,237.0
$3,288.1
$3,748.4
$4,235.7
$4,701.6
$5,030.7
$5,156.5
Discount Rate
10.0%
$2,989.2
$3,097.9
$3,182.3
$3,211.3
$3,123.7
$3,201.8
PV of Projected Cash Flows
PV of Terminal Value CF
$15,604.3
$42,690.4
Fair Value
Shs. Outstanding (millions)
Per Share Fair Value
$58,294.7
2,230
$26.14
Current Share Price
Margin %
$23.52
11.1%
Discounted Cash Flows:
Perpetuity
What We’ve Covered Tonight
•
•
•
•
Screening for companies
Where do you find the financial data
Introduction to the DCF Model
Example of ‘how to use’ the model
– Dell Inc.
– 6 Step Process