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ulSCCun1Lu CASP lLCW: CCnCL1 Anu MCuLL

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SLock's currenL prlce reecLs Lhe LoLal value of Lhe company forever
ro[ecL Lhe fuLure free cash ows
- Cash LhaL company generaLes aer Lhe money requlred for lLs operauons and asseL base
- Allows company Lo pursue opporLunlues Lo enhance shareholder value
ulscounL Lhese cash ows by Lhe welghed average cosL of caplLal - Lhe cosL of nanclng Lhe company
key concepLs covered ln lecLure : lree Cash llows, CaplLal SLrucLure, CAM, WACC, 1ermlnal value
DCF Analysis
($ in millions of US dollars) Historical
Projected
Fiscal Year Ending: 12/31 2004 2005 2006 2007 2008 2009 2010 2011 2012
Operating Income $8.0 $7.0 $100.3 $214.7 $303.9 $298.4 $298.7 $286.6 $261.6
Taxes (1.0) (0.9) (4.8) (7.7) (9.1) (11.9) (11.9) (11.5) (10.5)
Depreciation and Amortization 12.0 14.5 56.6 127.2 193.4 182.4 191.6 194.9 197.6
Decreases (Increases) in Working Capital (1.0) (1.8) (40.0) (74.5) (134.2) - (0.6) (0.5) (0.4)
Capital Expenditures (110.0) (121.6) (828.9) (2,321.2) (331.5) (27.6) (281.8) (252.2) (220.9)
Free Cash Flows (92.0) (102.9) (716.8) (2,061.5) 22.5 441.2 196.0 217.3 227.4
Free Cash Flows Already Received - - - - - - - - -
Discounted Free Cash Flows 20.9 381.8 157.8 162.8 158.5
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6#,, 7"89 6:3)
8epresenLs cash Lhe rm ls able Lo generaLe aer laylng ouL Lhe money requlred for lLs asseL base
Allows company Lo pursue ways Lo enhance shareholder value
Cash ls needed Lo develop producLs, make acqulsluons, pay dlvldends, reduce debL
Should be noLed LhaL negauve lCl ls noL necessarlly bad - could mean LhaL rm ls maklng large lnvesLmenLs, lf Lhese lnvesLmenLs earn a
hlgh reLurn Lhen Lhe rm's sLraLegy could pay o
1wo maln meLhods Lo calculaLe lCl:
- Worklng CaplLal meLhods
- SLaLemenL of Cash llows MeLhod
;3#*%&< 7"=%>":
neL lncome
+ u/A
- CaplLal LxpendlLures
- lncreases ln Worklng CaplLal
lCl
(>">,-,&> 3? 7"89 6:3)8
Cash llow lrom Cperauons
- CaplLal LxpendlLures
lCl
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8epresenLs operaung llquldlLy - Lhe caplLal avallable Lo run Lhe
buslness
osluve worklng caplLal ls requlred Lo ensure LhaL a rm ls able Lo
conunue operauons and sausfy debL obllgauons
ln general, companles wlLh more WC wlll be more successful slnce
Lhey wlll be able Lo fund and expand Lhelr operauons
7":$1:"23&
CurrenL AsseLs
- Cash
- S1 lnvesLmenLs
1oLal WC AsseLs
CurrenL Llablllues
- ShorL 1erm uebL
- CurrenL oruon Long 1erm uebL
1oLal WC Llablllues
1oLal WC AsseLs
- 1oLal WC Llablllues
Worklng CaplLal
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1he caplLal sLrucLure of a company ls essenual Lo calculaung WACC
Slnce WACC ls a welghLed average of Lhe cosLs of equlLy and debL,
knowlng whaL Lhe proporuons are ls necessary
ldeally, you are glven a LargeL caplLal sLrucLure LhaL you are almlng for,
unforLunaLely LhaL ls noL Lhe case ln 18C
1o nd caplLal sLrucLure we use Lhe book value of debL and Lhe markeL
value of equlLy - added Lhese make up Lhe LoLal caplLallzauon of Lhe rm.
uebL ls commonly vlewed as loans and bonds
1he caplLal sLrucLure ls Lhen [usL a measuremenL of whaL percenLage of
Lhe asseLs of a company where nanced Lhrough debL and whaL
percenLage Lhrough equlLy
738> 3? @,.>
1he cosL of debL ln Lhe 18C model ls based o Lhe rm's credlL
raung, as well as Lhe rlsk free raLe
1he credlL raung can be used as an lndlcaLor for Lhe cosL of debL by
provldlng a debL premlum over Lhe rlsk free raLe LhaL Lhe rm's
corporaLe bonds Lrade aL
ln reallLy, you would use a 8loomberg Lermlnal Lo pull Lhe relevanL
daLa on Lhe bonds wlLh Lhe longesL maLurlLy Lhe rm has
7"=%>": A88,> B#%$%&< !30,: C 738> 3? /D1%>E
1o deLermlne Lhe cosL of equlLy for Lhe rm - or Lhe cosL of
nanclng Lhe company Lhrough equlLy - we use CAM
1he lnpuLs lnclude Lhe rlsk free raLe, Lhe rm's observable beLa,
and Lhe expecLed reLurn for Lhe markeL
1he rlsk free raLe ls Lhe approprlaLe Lreasury bond (elLher o or _o
year)
1he rm's beLa ls pulled from any nanclal webslLe (alLhough lf lL
does noL make sense concepLually, lL should be recalculaLed)
LxpecLed markeL reLurn ls someLhlng LhaL ls pro[ecLed by Lhe
analysL based on hlsLorlcal markeL reLurns
;,%<9>,0 A5,#"<, 738> 3? 7"=%>":
1he end resulL of our eorLs - Lhe cosL of nanclng Lhe rm
Lhrough a comblnauon of debL and equlLy
We use Lhe cosL of debL and Lhe cosL of equlLy, welghLed
respecuvely by Lhelr proporuons ln caplLal sLrucLure, and
accounung for Lax
1hls nal value glves us Lhe cosL of Lhe rm's nanclng Lhe
underLaklng new pro[ecLs eLc
lL wlll also serve as Lhe dlscounL raLe for our fuLure cash ows
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1he raLe of reLurn on a sLock should be dependenL upon Lhe rlsk free raLe of reLurn, Lhe markeLs reLurn, and Lhe sLock's Lendency Lo follow
Lhe markeL
1hls ls Lo say LhaL equlLy lnvesLors expecL a raLe of reLurn on Lhelr lnvesLmenL Lo be a funcuon of how closely a sLock follows Lhe broader
markeL, Lhose wlLh hlgher beLas, should have hlgher raLes of reLurn
lor more lnLeresL, consulL papers by Sharpe & LlLner, and a revlsed CAM by llscher 8lack
CAM follows several maln assumpuons
- no Lransacuon cosLs
- AsseLs are all Lradable and lnnlLely dlvlslble
- no Laxes
- no lndlvldual can aecL securlLy prlces
- ueclslons are made solely ln Lerms of expecLed reLurns and varlances
- unllmlLed shorL sales and borrowlng and lendlng aL Lhe rlsk free raLe
- Pomogenous expecLauons - same vlews on expecLed reLurn and rlsk
Clven Lhese assumpuons, lL can be clear why CAM doesn'L hold up emplrlcally
lf Lhe model ls rlghL Lhere should be llnear relauonshlps beLween reLurns and beLas, and Lhe only varlable LhaL should explaln reLurn ls beLa
Powever, ln reallLy Lhe relauonshlp beLween reLurn and beLa ls weak, and LhaL oLher varlables (slze, prlce/book) explaln dlerences ln
reLurn beuer
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normally, Lhere ls a rlsk premlum LhaL you are glven as an analysL. lor our uCl valuauons ln 18C, we rely on uslng Lhe rlsk free raLe ln
comblnauon wlLh Lhe expecLed markeL reLurn Lo calculaLe our rlsk premlum.
As menuoned, Lhe beLa should be pulled from elLher ?ahoo! llnance, 8loomberg, or any oLher daLa slLe LhaL ls repuLable. lf Lhelr
calculauons or Lhe beLa doesn'L make sense (l.e. negauve beLa), conslder revaluaung Lhe compuLauon Lhrough elLher regresslon analysls or
Lhrough Lhe normally accepLed equauon for beLa
1he rlsk free raLe ls Lhe yleld on Lhe uS Lreasury bond. Powever, when evaluaung a forelgn company lL may be approprlaLe Lo use Lhe
represenLauve governmenL bond for LhaL counLry. Powever, Lhe rlsk wlll be hlgher, so Lhe raLe wlll be hlgher. 1hls ls because even 8ussla
defaulLed on lLs bonds, and caused Lhe hedge fund L1CM Lo lose money and Lhls, compounded wlLh oLher facLors, broughL Wall SLreeL Lo lLs
knees ln 8-
;A77
8elow ls Lhe WACC equauon, along wlLh Lhe necessary lnpuLs
1he book value of debL should be Lhe sum of ShorL 1erm uebL, CurrenL oruon of Long 1erm uebL, Long 1erm uebL, less Cash
Powever, Lhe 18C uCl LemplaLe wlll calculaLe Lhe book value based o Lhe lnpuL you glve lL
WACC=R
e
Market Value of Equity
Total Capital
!
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$
%
&
+ R
d
Book Value of Debt
Total Capital
!
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$
%
&
1' ( ( )
where: R
e
is the cost of equity
R
d
is the cost of debt
! is the effective tax rate

R
e
= r
f
+ ! E(r
m
) " r
f
( )
market risk premium
! " # $ #
where: r
f
is the risk free rate
! is the firms equity beta
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As prevlously menuoned, Lhe lCls are forecasLed ouL for each lndlvldual year for Lhe nexL ve years. Powever, Lhls ls noL enough Lo value
Lhe company, slnce lL wlll mosL llkely be exlsLenL for longer Lhan LhaL. lorecasung for each lndlvldual year for Lhe resL of Lhe rm's exlsLence
ls noL a vlable ldea elLher
1o accounL for Lhls we need Lo seL a Lermlnal growLh raLe, one LhaL Lhe rm's growLh wlll converge Lo and conunue for lnLo perpeLulLy. 1he
uCl valuauon ls very sensluve Lo Lhls gure.
1here are muluple ways Lo check your Lermlnal growLh raLe, Lwo are dlscussed here:
H":1, 3? B,#=,>1%>E G,:"25, >3 I3>": H":1,
Cne meLhod ls Lo see whaL Lhe resenL value of Lhe erpeLual
Cash llows (1ermlnal value) ls relauve Lo Lhe resenL value of 1oLal
Cash llows.
lf Lhls rauo of v(1v)/v(1oLal) ls above 6-;, your Lermlnal
growLh raLe should denlLely be reconsldered.
Plgh growLh companles (Lech, bloLech, eLc) mlghL lndeed have a
value for Lhls rauo LhaL ls qulLe hlgh. 1hls ls because Lhey do noL
have much lncomlng cash ow now, and lL ls expecLed LhaL Lhey
wlll ln Lhe fuLure as Lhelr producL Lakes o
73-="#%&< I#"0%&< !1:2=:,8
A commonly used meLhod for double-checklng growLh raLes used
on Lhe SLreeL ls comparlng Lhe Lradlng muluples ln Lhe fuLure, and
Lhe Lradlng muluples of Lhe company now
1o do Lhls we Lake Lhe lasL forecasLed L8l1uA and roll lL forward
one year by uslng Lhe Lermlnal growLh raLe
We Lhen dlvlde Lhe 1ermlnal value by Lhls rolled L8l1uA and nd
Lhe lmplled forward muluple
We Lhen compare Lo Lhe currenL muluple (llrm value/L8l1uA)
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1he commonly accepLed meLhod for deLermlnlng a growLh raLe ls Lo begln wlLh Lhe expecLed lnauon raLe, and alLer Lhls gure based on Lhe rm's
facLors, macroeconomlc facLors, lndusLry facLors, eLc. lor example, a rm LhaL speclallzes ln hardcopy yellow pages wlll mosL llkely have a negauve
Lermlnal growLh raLe as LhaL parucular lndusLry as a whole ln decllne.
AcLual or forecasLed nomlnal Cu wlll yleld a number LhaL ls Loo hlgh, slnce Cu lncludes producuvlLy, populauon, markeL share galns, along wlLh
lnauon. Powever, lf lCl are growlng and have grown aL Lhe raLe of nomlnal Cu ln Lhe pasL, and we belleve lL wlll conunue Lo do so ln Lhe fuLure, Lhls
mlghL be okay
CallbraLe for your buslness and lndusLry, wlll Lhe prlclng grow fasLer or slower Lhan lnauon o years ouL ln perpeLulLy?
?ou wlll Lyplcally have a z- number
Cne lnpuL Lo Lhlnk abouL ls Lhe !"#$%&' growLh raLe of earnlngs (or lf sLable: revenue) for Lhe lasL o years
We're seeklng a level of sLablllLy, where marglns, markeL share are sLable and producuvlLy galns are almosL zero
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EBITDA $ 459.18
Rolled $ 463.77
Terminal Value $ 4,934.37
Forward Multiple 10.64
2007 EBITDA $ 461.87
2007 Firm Value $ 3,169.36
Multiple 6.86
Present Value of Forecasted Cash Flows: $ 929.86
Present Value of Perpetual Cash Flows: $ 3,747.76
Present Value of Total Cash Flows $ 4,677.61
PV(Perpetuity)/PV(Total) 80.12%
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1he Lermlnal value glves us a value of Lhe company beyond Lhe years forecasLed ln Lhe model based on Lhe Lermlnal growLh raLe gure
1he denomlnaLor (WACC-g) dlscounLs Lhls fuLure value ln Lerms of dollars of Lhe lasL year forecasLed
1hls means Lhe 1v value wlll be dlscounLed by Lhe same facLor as Lhe lasL forecasLs
/D1"23&
TV=
FCF
last year
1+ g ( )
WACC-g
PV(TV)=
FCF
last year
1+ g ( )
WACC-g
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%
&
1+ WACC ( )
N
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We dlscounL cash ows because of Lhe nouon LhaL a dollar Loday ls noL Lhe same as a dollar Lomorrow
8ecause dlscounung ls compounded, Lhe cash ows furLher away from Lhe presenL, even lf Lhey are all equal, are worLh relauvely less ln
presenL Lerms
lnvesLmenLs LhaL have hlgher rlsk wlll also usually have hlgher dlscounL raLes. Slnce Lhe dlscounL raLe can be LhoughL of as Lhe requlred
reLurn Lo make Lhe lnvesLmenL auracuve (ln Lerms of ylelds on bonds), lnvesLors requlre a hlgher reLurn for Lhelr hlgher rlsk, hence Lhe
dlscounL raLe ends up belng hlgher
?our dlscounL raLe should never be bellow LhaL of r
f
slnce Lreasury bonds or bllls are consldered Lhe safesL lnvesLmenL LhaL could be made,
slnce as menuoned, lL ls unllkely LhaL Lhe u.S. CovernmenL wlll defaulL
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We use Lhe eecuve Lax raLe LhaL Lhe company provldes ln Lhe
noLes of lLs quarLerly and annual llngs
Someumes, Lhey forecasL expecLauons for whaL Lhelr Lax raLe ln
Lhe fuLure should be, Lhls should be Laken lnLo accounL for Lhe
valuauon - lL can someumes be found ln Lhe LranscrlpL for Lhelr
earnlngs calls
63#,$"82&<
We sLarL o wlLh growLh and Lhen Lallor lL down for each year unul
lL converges Lo a low number
Cen, a few years ouL wlll be forecasLed or released by Lhe
company ln an earnlngs call. lf Lhey have a solld Lrack record of
meeung Lhls, lL may be safe Lo use
I,#-%&": (9"#,8 41>8>"&0%&<
AmounL of shares Lhe company wlll have le ouLsLandlng aL Lhe
end of Lhe uCl's perlod
8ase Lhls o of Lhe rm's hlsLory wlLh share buybacks, and
secondary oerlngs Lo deLermlne Lhe ballpark for Lhls gure
lL wlll noL aecL Lhe presenL value of Lhe uCl, buL lL wlll aecL Lhe
prlce per share gure
K"8> I),:5, !3&>98 LKI!M
lound uslng Lhe laLesL reporL and Lhen plugglng lL lnLo Lhe sLub
and prevlous sLub columns
1hls calculaLes Lhe change ln Lhe prevlous Lwelve monLhs and ls
whaL we should be uslng Lo value Lhe company
ldeally, Lhese gures are whaL ls used for Lhe comparables analysls
as well - Lo compare apples Lo apples
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Aer approprlaLe forecasung and Lermlnal assumpuons, we dlscounL Lhe values of Lhe fuLure cash ows accordlngly wlLh WACC. We Lhen
sum Lhese values LogeLher Lo galn Lhe lnLrlnslc value of Lhe company
Slnce we are looklng for equlLy value we musL now subLracL Lhe rms debL (slnce bondholders have senlorlLy) and add back cash as Lhls ls
avallable Lo shareholders ( ln Lhe form of dlvldends or sLock repurchases)
We Lhen Lake Lhls LoLal value, and dlvlde by Lhe Lermlnal number of shares ouLsLandlng.
1hls provldes us wlLh an esumaLe of whaL Lhe Lrue sLock prlce of Lhe company should be. Cur uCl model provldes a range as well as Lhe
poLenual upslde and downslde muluples
8emember, Lhe uCl ls noL everyLhlng. 1radlng comparables are equally lmporLanL. ln Lhe lndusLry Lhere are muluple valuauon Lechnlques
lncludlng Lhe uCl, Lradlng comparables, and Lransacuon comparables
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