DCF MODEL
Discount Cash Flow (DCF)
Valuation
• An important concept in valuing assets
– Not just companies
• Basis of Fundamental Analysis
– Intrinsic value of a company
•
•
•
•
•
Cash flows
Time value of money
Opportunity cost
Financial statement analysis
Change the way you look at things in life?
Who uses DCF?
Career/Job Category
To do what?
Investment Banking
Advise sellers, buyers in M&A deals
Equity (e.g. IPO)
Debt issuance
Investment Management
Stock picks, shape and execute
investment strategies (e.g. Long
short equities)
Research
Equity research (Buy/Sell/Hold)
Fixed income trading
Price bonds
But who does what?
• An equity analyst work is to find the real
value of a firm, then DCF is the work
model!
• An portfolio manager job is to invest in the
”best” company, why relative valuation is
more important tool!
Discounted Cash Flow Valuation - DCF
• What is it: In discounted cash flow valuation, the value of an
asset is the present value of the expected cash flow on the asset.
• Philosophical basis: Every asset has an intrinsic value that can
be estimated, based upon its characteristics in terms of cash
flows, growth and risk.
• Information needed: To use DSF valuation, you need
– To estimate the life of the asset
– To estimate the cash flow during the life of the asset
– To estimate the discount rate to apply to these cash flows to get
present value
• Market inefficiency: Markets are assumed to make mistakes in
pricing assets across time, and are assumed to correct
themselves over time, as new information comes out about
assets.
Advantages of DCF valuation
• Since DCF valuation, done right, is based upon an
asset’s fundamentals, it should be less exposed to
market moods and perceptions.
• If good investors buy businesses, rather than stocks,
discounted cash flow valuation is the right way to think
about what you are getting when you buy asset.
• DCF valuation forces you to think about the underlying
characteristics of the firm, and understand its business. If
nothing else, it brings you face to face with the
assumptions you are making when you pay a given price
for an asset.
Disadvantages of DCF valuation
• Since it is an attempt to estimate intrinsic value, it
requires far more inputs and information than other
valuation approaches.
• These inputs and information are not only noisy (and
difficult to estimate), but can be manipulated by savvy
analyst to provide the conclusion he or she wants.
• In an intrinsic valuation model, there is no guarantee
that anything will emerge as under or over valued.
Thus, it is possible in a DCF valuation model, to find
every stock in a market to be over valued . This can be
a problem for
– Equity research analysts, whose job it is to follow sectors and
make recommendations on the most under and over valued
stocks
– Equity portfolio managers, who have to be fully (or close to
fully) invested in equities.
When DCF valuation works best
• This approach is designed for use for assets
(firms) that derive their value from their
capacity to generate cash flows in the future. It
does make your job easier, if the company has
a history that can be used in estimating future
cash flows. It works best for investors who
either
– have a long time horizon, allowing the market time
to correct its valuation mistakes and for price to
revert to “true” value or
– are capable of providing the catalyst needed to
move price to value, as would be the case if you
were an activist investor or a potential acquirer of
the whole firm.
Merits of the DCF
Strengths:
• Captures the time value of money and opportunity cost
• Scientific
• Widely used
• Based on cashflow
Weaknesses:
• Almost always results in overvaluation. Why?
• Can we ever predict the future?
– “Forecasts may tell you a great deal about the forecaster; they
tell you nothing about the future.” Warren Buffett
• Based on many assumptions
– Which assumptions are the most critical?
– 5 years vs. 10 years estimation
Valuing a company using a DCF
model
Steps:
1. Understand the business of the company you are valuing
2. Find Inputs:
a)
Calculate the Discount Rate
–
b)
Build Future (Pro forma) Cash Flow and find the PV of these cash flow
–
c)
Weighted Average Cost of Capital (WACC)
Free Cash Flow (FCF)
Calculate Terminal Value
–
EBITDA Multiple
3. Analyze Outputs:
a)
b)
c)
Enterprise value (EV)
Equity (share price)
Perform Sensitivity Analysis
–
•
Range vs. Point Estimate
There are many correct answers and many variations on methods and
which numbers to use (academics vs. practitioners).
Pro Forma Cash Flow
•
•
•
Estimate the future cash flow of a company (horizon is 5 to 10 years)
An EBITDA world (Earnings Before Interest, Tax, Depreciation and Amortization), but
EBITDA is not cash
Need Free Cash Flow (FCF), estimated by
–
FCF = EBIT * (1-Tc) + D&A – Change in net working capital – Capital Expenditure (CAPEX)
Where to find the stuff?
• EBIT
• D&A
• Net working capital (current asset – current liabilities)
• Capex
•
•
Find the PV of FCF (remember C/(1+r)n)
How do we estimate future cash flow?
–
–
–
–
–
•
(I/S)
(C/S)
(B/S)
(C/S, B/S)
Probably the toughest task in the entire DCF valuation exercise
First thing is to get a better understanding of the business and the industry as a whole. Start with the 10-K
Estimate future growth profile from company filings. Is past history a good indication of the future? We want
to predict the trends.
Leverage analyst reports (ibankers)
Talk to management (research analysts)
Start with the income statement. In real-life you often have to pro forma (at least parts of)
all three financial statements but there are shortcuts
Terminal value
• The 5 to 10 year pro forma cash flow
attempts to capture foreseeable changes
in earnings
• The terminal value estimates the
company’s value after it has entered
“steady state”
Structure of a DCF model
Input:
Output:
Cash Flow
Value (Enterprise Value)
Industry standard:
5 to 10 yr horizon
Year
2007
2008
2009
2010
2011
2012
……..
Period
0
1
2
3
4
5
……..
C1
C2
C3
C4
C5
……..
FCF
Year 1 to 5: Capture changes and volatility in the
business (cash flow)
Terminal
value
(TV)
PV (CF)
Sum of
PV(CF)
C1/
(1+r)1
EV
C1/
(1+r)1
C1/
(1+r)1
EV of the company as of the
end of year 2007
C1/
(1+r)1
(C1+TV)
/(1+r)1
……..
Company
enters
steady
state
Example: Kraft (NYSE: KFT)
• Kraft Foods
• Remember, before we jump into Excel:
– What does Kraft do?
– Market position (market share, revenue, etc)?
– Established or emerging industry?
– Level of competition?
– Growth opportunities?
– Quality management?
• Excel demonstration
VALUING A FIRM
Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF
Value of Operating Assets
+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value= FCFF n+1 /(r-gn)
FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Cost of Equity
Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows
Expected Growth
Reinvestment Rate
* Return on Capital
+
Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)
Beta
- Measures market risk
Type of
Business
Operating
Leverage
X
Weights
Based on Market Value
Risk Premium
- Premium for average
risk investment
Financial
Leverage
Base Equity
Premium
Country Risk
Premium
Revenue (Group)
Q3
FY2006
Consensus
Reported
Consensus
Contributors: 15
Rep. date:2006-11-22
Contributors: 12
1022,64
842
3844,88
EBIT (Group)
71,91
40
217,13
Pre-tax Profit
59,98
25
158,48
Net profit
42,53
18
113,03
0,23
0,1
0,61
Dividend per share
0
0
0
Total global demand (MW)
0
0
11515
1015
0
5488,33
Vestas global market share
0
0
26,58
Non-recurring items
0
0
0
Recommendation
0
0
EPS
Vestas total volume (MW)
0
Daily Q/ V WS.C O [B ar, MA 20, V OL]
[Professional]
8/15/2006 - 12/1/2006 (GMT)
P rice
DKK
Q/VWS.CO, Last Trade, Bar
11/29/2006 217.00 220.00 215.75 219.00
Q/VWS.CO, Close(Last Trade), MA 20
11/29/2006 185.38
220
215
210
205
200
195
190
185
180
175
170
165
160
155
150
Vo l
Q/VWS.CO, Last Trade, VOL
11/29/2006 20,579
12M
8M
4M
0
21
28
A ug 06
04
11
18
S ep 0 6
25
02
09
16
23
Oct 0 6
30
06
13
20
No v 0 6
27
Industry Implications
• Everyone in the industry knows how to do a DCF
• Every bank, every analyst uses , uses similar
assumptions, studies the same theories in
school, but bankers and analysts come up with
extremely different values and recommendations
(Buy/Sell/Hold) for the same company
• Interesting trends
• The industry always comes back to two
questions:
– What percentage of a banker/analyst’s performance is
due to luck vs. skills
– Is past performance a good indicator of future
performance?
So is it all just a crapshoot?
• Experience leads to better valuation
• Valuation is an art, not a science
– The key is to develop your own framework and style
• Understanding of the business is the key
• Wall Street often gets it wrong?
Discounted Cash Flow Valuation
• DCF is the cornerstone of valuations and is the "analytically most correct"
way
– In reality: several "fudge-factors" and disagreement between practitioners
• Robust in valuing anything that gives cash-flow in the future given
assumptions
– Bonds, derivatives, companies, etc.
• Valuation of future cash that the investor will get from holding the firm. At the
end of the day:
"Cash is King"
"Cash is fact – profit is an opinion"
"Earnings do not pay the bills"
• Used when significant information is available on company and its prospects
• Also used to select between internal projects and to price the impact of
various scenarios e.g. during negotiations
Fundamentals of any Discounted Cash Flow Valuation
CF3
CF1
CF2
CF4
Value 



 ...
1
2
3
4
(1  r ) (1  r ) (1  r ) (1  r )
Year
Expected
cashflow
Discount rate
• Expected cashflow in each period
• Divided by the appropriate discount factor that reflects the riskiness of
the estimated cashflows
• Example: How much is an infinite stream of ISK 15 million/year worth?
Assuming a 10% discount rate:
Value 
15
15
15
15
15
15
15
15




...




 ...  150
1
2
3
4
(1  .1) (1  .1) (1  .1) (1  .1)
1.10 1.21 1.33 1.46
Discounted Cash Flow Valuation
in 4 Steps
• Step 1 Compile information
– Historical accounts (last 2-3 years). Review
sales, margins, CAPEX, WC ratios, notes etc.
– Research business, strategy, products,
customers, markets, competition etc.
– Industry and environment forecasts (official
forecasts, KB research, news etc.)
– Discuss main risk factors
– Look up information on similar companies
Discounted Cash Flow Valuation
• Key Drivers of Cashflow
– Sales growth rates
• Market, strategic considerations, pricing, economy, competition
– EBITDA margin
• Cost development, fixed vs. floating costs etc.
– Capital expenditure (CAPEX)
• Maintenance and investment CAPEX
– Working capital requirement
• Must support current operations and strategy (inventories,
receivables & payables)
– Cash tax rate
• A specialist area (legislation, relief from previous tax loss, deferred
tax)
• Model also highly sensitive to
– Discount factor
– Terminal value growth
År
1997
Resultaträkning:
Nettoomsättning:
Övriga intäkter
Rörelsens kostnader:
Bruttoresultat:
Avskrivningar:
Rörelseresultat(EBIT)
Finansiella intäkter:
Finansiella kostnader:
Resultat e fin poster:
Övriga avsättningar:
Resultat före skatt:
Skatt:
118,955
6,349
110,018
15,286
2,756
12,530
1,022
211
13,341
13,341
3,916
Resultat:
1998
1999
2000
2,001
2,002
2,003
426,310
359,321
66,989
6,841
60,148
4,607
3,354
61,401
142
61,543
21,113
503,418
419,849
83,569
6,849
76,720
9,253
7,051
78,922
96
79,018
25,703
162,521
13,973
155,205
21,289
3,696
17,593
984
270
18,307
18,307
5,151
182,923
960
159,624
24,259
3,491
20,768
1,456
465
21,759
21,759
4,929
191,567
21,039
180,371
32,235
6,184
26,051
2,489
880
27,660
3,574
24,086
7,886
291,643
80
246,558
45,165
6,335
38,830
2,137
1,628
39,339
39,339
11,601
9,425
13,156
16,830
16,200
27,738
40,430
53,315
Balansräkningen:
Omsättningstillgångar:
Kassa, bank
Kundfordringar
Varulager
Övriga OT
Totala OT
-
13,151
23,436
4,096
27,564
68,247
32,916
63,340
5,351
19,305
120,912
42,450
60,096
3,639
38,317
144,502
87,401
85,270
15,909
18,252
206,832
130,439
138,004
16,393
11,363
296,199
170,479
154,999
11,719
26,437
363,634
Anläggningstillgångar:
Maskiner o inventarier
Övriga AT
Totala AT
Totala tillgångar
-
9,198
664
9,862
78,109
11,422
671
12,093
133,005
11,580
18,834
30,414
174,916
13,925
28,089
42,014
248,846
17,442
47,827
65,269
361,468
14,352
94,542
108,894
472,528
Kortfristiga sk ulder
Leverantörsskulder
Skatteskulder
Räntebärande KS
Övriga KS
Totala KS
-
6,311
3,480
2,380
9,733
21,904
11,395
2,704
21,148
11,838
47,085
6,926
5,186
16,183
21,006
49,301
21,256
6,030
9,004
31,447
67,737
34,301
7,748
19,818
55,412
117,279
14,260
13,100
47,955
118,126
193,441
Långfristiga sk ulder
Checkkredit
Räntebärande lån
Övriga LS
Totala LS
-
2,701
2,701
1,902
1,842
315
4,059
718
2,956
5,460
9,134
1,601
3,379
32,987
37,967
22,721
45,310
68,031
57,626
57,626
Obesk attade reserver
Totala OR
-
2,973
4,623
6,558
8,440
11,610
15,389
Eget k apital
Aktiekapital
Bundna reserver
Balanserad resultat
Årets resultat
Totalt EK
Totala sk ulder/EK
-
20,801
11,538
5,324
12,868
50,531
78,109
26,250
24,037
10,481
16,470
77,238
133,005
27,301
48,184
18,238
16,200
109,923
174,916
32,761
52,059
22,144
27,738
134,702
248,846
32,761
59,568
31,901
40,430
164,660
361,580
33,077
63,583
56,055
53,315
206,030
472,486
-
-
Discounted Cash Flow Valuation
• Step 2 Estimate the appropriate discount factor weighted average cost of
capital (WACC)
E
D
WACC  K e * (
)  Kd (
)
DE
DE
Components of WACC are:
1) Cost of Debt (Kd)
K d  (Risk Free Rate  Credit Risk Premium) * (1  tax %)
– Risk Free Rate (e.g. 10 year government bond) Nominal or real – must
harmonize with forecasts
– Appropriate Credit Risk Premium
2) Cost of Equity (Ke) (CAPM)
K e  Risk Free Rate  β(Beta) * Equity Market Premium
– Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most
common
– Equity risk premium is an estimate of the premium investors require in excess of riskfree assets for owning equities (4-7% most typically used)
– Beta is a measurement of firm's/similar firms volatility compared to the
β levered
market (if higher than 1 company/sector is riskier than market in average). β unlevered  
D 
1

(1
tax)(
)
When compiling and averaging betas it is necessary to take into account

E 
different company leverage
CAPM
• Re = Rf + βe * Rm
Symbol
What is it
Where to find it
Rf
Use a long-term treasury rate (e.g.
10 year)
Bloomberg web
(http://www.bloomberg.co
m/markets/rates/index.ht
ml)
βe
Equity beta (levered), “risk” (how
the company’s share price moves
compared to the market1)
Bloomberg terminal,
Google Finance
Rm
Market risk premium (excess
return of market over Rf)
Use rule of thumb (e.g.
6%)
1E.g.
The “market” can be the S&P 500
Discount Rate (WACC)
Symbol
What is it
Where to find it
Re
cost of equity
Calculated (via CAPM)
Rd
cost of debt
Company’s borrowing
rate (Corp bonds)
E
market value of the firm's equity
10-K
(Balance Sheet)
D
market value of the firm's debt (long- 10-K
term interest bearing debt)
(Balance Sheet)
V
D+E
Calculated
Tc
Corporate tax rate
10-K / Estimate
Discounted Cash Flow Valuation
• Step 2 cont.
– WACC calculation example (typical Icelandic firm)
Discounted Cash Flow Valuation
• Step 3 Prepare a "visible" forecast period (5-10 years and longer for some
industries)
– Forecast Sales, margins, capital expenditure, working capital requirement
– And derive Free Cash Flow to Firm
2004
2005
2006
2007
2008
2009
2010
1,106,009
940,108
36,498
129,403
28%
93,170
36,498
44,240
63,808
21,620
1,437,812
1,236,518
46,010
155,284
28%
111,804
46,010
60,388
79,633
17,793
1,869,156
1,626,166
57,944
185,046
28%
133,233
57,944
82,243
99,209
9,725
2,429,903
2,114,015
72,897
242,990
28%
174,953
72,897
97,196
123,364
27,290
3,158,873
2,716,631
91,607
350,635
28%
252,457
91,607
110,561
160,374
73,130
2011
2012
2013
Kassaflödet
Omsättningen
- rörelsekostnad
- avskrivningar
EBIT
Skattesats
EBIT (1-skatt)
+ Avskrivningar
- Förändringar i AT
- Förändringar i RöK
= FCFF
654,443
549,732
22,906
81,805
28%
58,900
22,906
22,906
40,777
18,123
850,776
714,652
28,926
107,198
28%
77,182
28,926
32,330
51,047
22,733
3,917,003
3,368,622
109,676
438,704
28%
315,867
109,676
137,095
166,789
121,660
4,778,744
4,157,507
129,026
492,211
28%
354,392
129,026
143,362
189,583
150,472
5,734,492
4,989,008
149,097
596,387
28%
429,399
149,097
172,035
210,265
196,196
Historical analysis of Sectra
Year
1997
1998
1999
2000
2001
2002
Revenue
118955
162521
182923
191567
291643
426310
Aritmetric
Geometric
% change in revenue
EPS
% change in EPS
36,6%
12,6%
4,7%
52,2%
46,2%
0,56
0,51
0,85
1,23
-8,9%
66,7%
44,7%
Based on revenue
30,5%
29,1%
Based on EPS
34,1%
30,0%
Regression: Revenue = 35708 + 55222 * Revenue
Regression s lösningen
55222

 24,1%
Genomsnitt lig omsättning
228986
Different models – different
outcome?
Year
Aritmetric
Geometric
2003
2004
2005
556,3 Mkr
726,0 Mkr
947,5 Mkr
550,4 Mkr
710,5 Mkr
917,3 Mkr
Regression
solution
529,1 Mkr
656,6 Mkr
814,8 Mkr
Analysts
forecast
552 Mkr
675 Mkr
811 Mkr
Sectras
own
forecast
554,2 Mkr
720,5 Mkr
936,6 Mkr
Actual numbers: 2003: 503, 2004: 495, 2005: 455
Analysts mainly focus on
• Information from companies, press release, meetings
etc.
• Macro information important for the company –
airliner/oil
• Information from other companies in the same industry
Nokia/Ericsson
• Other sector specific analysts – Gartner Group
Do equity analysts forecast well?
• Old studies show they no more than – bad! But
we can see a shift about 1995 – why?
• Resent research in Sweden show that
newspaper/magazines: Affärsvärlden, Veckan
Affärer and Aktiespararna all are over optimistic.
• In the period 1987 to 2002 analysts are 11 %
over optimistic in there p/s forecast but with
changing spread due to volatility.
Discounted Cash Flow Valuation
* Forecasts should trend downwards to
achieve long run growth rates
.
• Step 3 cont
* Assumptions should be reviewed for
consistency with past performance and
business model
* COGS & SG&A include Depreciation so
it needs to be subtracted (non-cash item)
* Depreciation should harmonize
with CAPEX & the value of
property, plant and equipment
(PP&E) in the long run
Discounted Cash Flow Valuation
• Step 3 cont.
* Helpful to create a balance sheet and
model the difference in inventories,
receivables and payables between years.
* Tax relief from debt is
included in the discount factor
* CAPEX needs to be sufficient to
fund the strategy (e.g. the
opening of new stores)
Discounted Cash Flow Valuation
• Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to
Firm with the WACC
– Deal properly with Terminal Values
• Beyond the visible cashflow period, the value of the company is captured
using a terminal value calculation (using either a DCF to perpetuity or comps
calculation)
1
DF 
(1  WACC) Year
* Equity Value
calculated from EV
* 30-70% split is a
rough guide for
mature companies
TV 
FCF(final forecast year) * (1  g)
WACC - g
* 0..5% often
used for
perpetual
growth
Betavärdet
Cost of equity
Andelen equity
Efterskatt lån
Andelen lån
Cost of capital
Kumultativ WACC
2004
1.2
11.0%
66%
4.8%
34%
8.9%
1.0888
2005
1.2
11.0%
66%
4.8%
34%
8.9%
1.186
2006
1.2
11.0%
68%
4.8%
32%
9.0%
1.292
2007
1.2
11.0%
70%
4.8%
30%
9.1%
1.410
2008
1.2
11.0%
70%
4.8%
30%
9.1%
1.539
2009
1.18
10.9%
72%
4.8%
28%
9.2%
1.680
2010
1.16
10.8%
72%
4.8%
28%
9.1%
1.833
2011
1.14
10.7%
74%
4.8%
26%
9.2%
2.001
2012
1.12
10.6%
74%
4.8%
26%
9.1%
2.183
2013
1.1
10.5%
74%
4.8%
26%
9.0%
2.380
Kassaflödet
Omsättningen
- rörelsekostnad
- avskrivningar
EBIT
Skattesats
EBIT (1-skatt)
+ Avskrivningar
- Förändringar i AT
- Förändringar i RöK
= FCFF
DCF
654,443
549,732
22,906
81,805
28%
58,900
22,906
22,906
40,777
18,123
850,776
714,652
28,926
107,198
28%
77,182
28,926
32,330
51,047
22,733
1,106,009
940,108
36,498
129,403
28%
93,170
36,498
44,240
63,808
21,620
1,437,812
1,236,518
46,010
155,284
28%
111,804
46,010
60,388
79,633
17,793
1,869,156
1,626,166
57,944
185,046
28%
133,233
57,944
82,243
99,209
9,725
2,429,903
2,114,015
72,897
242,990
28%
174,953
72,897
97,196
123,364
27,290
3,158,873
2,716,631
91,607
350,635
28%
252,457
91,607
110,561
160,374
73,130
3,917,003
3,368,622
109,676
438,704
28%
315,867
109,676
137,095
166,789
121,660
4,778,744
4,157,507
129,026
492,211
28%
354,392
129,026
143,362
189,583
150,472
5,734,492
4,989,008
149,097
596,387
28%
429,399
149,097
172,035
210,265
196,196
16,645
19,175
16,730
12,617
6,319
16,241
39,889
60,791
68,927
82,441
Discounted Cash Flow – Presenting the
Results
•
The Ultimate Answer to the Great Question of Life, the Universe and Everything
-Hitchhiker's guide to the Galaxy
All diligent valuations are presented as sensitivity tables
– Demonstrate the link between assumptions and the final value
– Allow the reader, which probably disagrees with some assumptions, to use the
analysis