DISCOUNTED

CASH FLOW (DCF)

PRESENTED BY JANE SHUI

WHAT IS A DCF?

Fair Value: Valuing a company today based on estimates of

future cash flows

Parts of a DCF:
Projected Cash Flow

Future sales growth and profit margins

Discount rate (rw.a.c.c.)

Terminal Value
Other Factors:
Risks that its stocks face

PV of cash flows during

the forecasting period

TIME VALUE OF MONEY

REFRESHER
Perpetuity & Annuity

ILLUSTRATION
Future Value

Present Value

IMPORTANT FORMULAE
Perpetuity

Annuity

PROJECTED CASH FLOW

Company value during growth
1. Forecast Period
2. Growth Rate
3. Unlevered Free Cash Flow

1) FORECAST PERIOD
1. One Year
Slow growing company that operates in highly competitive
low-margin industry
2. Five Year
Solid company that operates with advantage such as strong
marketing channels, recognizable brand names, or regulatory
advantage
3. Ten Year
Outstanding growth company that operates with very high
barriers to entry, dominant with market position or prospects
Bottom Line: Aim to forecast cash flows until the firm is at a steady
state

2) GROWTH RATE: METHODS

1. Look at the past
Historical growth in EPS
2. Look at others
Analysts estimate growth in EPS for many firms. Use
them!!
3. Look at fundamentals
How much the firm is investing in new projects
What the new projects are making for the firm

3) UFCF OVERVIEW

UFCF (Unlevered Free Cash Flow)

Cash flow that is available to all investors (shareholders
& bondholders)
Cash flow before the effects of debt & equity financing:

Does NOT include cash flows from debt issuances or

retiring, dividends or equity issuance

Actual amount of cash that a company has left from its

operations that could be used to pursue opportunities
that enhance shareholders value

Develop new products

Pay dividends to investors
Do share buy backs

3) UFCF APPROACH A
Cash Flow to Firms

Equity Investors: Levered free cash flow or free cash flow to

equity (r s)

Debt Holders: Interest Expenses (1-TC) + Principle payments

New Debt Issues

Preferred Stockholders: Preferred Dividends

Firm = Equity Investors + debt holders + preferred stockholders

APPROACH A: ILLUSTRATION

3) UFCF APPROACH B
UFCF = EBIT * (1-TC) + D&A NWC CAPEX

D&A: part of non-cash expense

NWC:

NWC = (Current assets Cash & marketable securities) (Current

liabilities current portion of interest-bearing debt/notes)

NWC = NWC (current year) NWC (previous year)

Represents:

The amount of cash tied up in current assets

Less cash float from current liabilities

CAPEX: Capital expenditure that will be a significant part of

the cash flow
Expansionary vs. maintenance

APPROACH B: ILLUSTRATION
EBIT * (1-T)
- (CAPEX Depreciation & Amortization)
- Increases in WC (or + Net decreases in WC)
+ Other relevant CFs for an all equity firm
_________________________________________
= UFCF

APPROACH B: EXAMPLE

EBIT = $5,559 M
Tax Rate = 36%
Capital Spending = $1,746 M
Depreciation = $1,134 M
Working Capital Change = $477 M

What is the UFCF?

EXAMPLE IN REALITY

How can you find the UFCF from the 3 financial statements?
Balance Sheet, Income Statement, and Cash Flow
Statement
Using Facebook as an example http
://www.scmp.com/business/companies/article/1417348/facebo
ok-stocks-surge-us15-billion-2013-earnings-andrising

Pg. 70 75 of the 2012 Annual Reports

http://files.shareholder.com/downloads/AMDA-NJ5DZ/2929681
396x0x658233/46826077-D2FD-4E84-9BBE-C3F844B547A0/
FB_2012_10K.pdf

DISCOUNT RATE
Cost of capital (rw.a.c.c) = S/(B+S) (1-TC) (rB) + B/(B+S) (rS)

COST OF EQUITY
CAPM
R s = E(r j)= r f + B

j,M

(r

r f)

r f: Short term / long term government securities used

depending on the time horizon of your project

j,M

Method 1: Regression using excel of of stock returns over

market return
Method 2: from variances & covariance of the stock to
the market
r M r f: average of historical market risk premiums used

BETA METHOD 1
f(x) = 0.81x + 0.81

BETA METHOD 2

CovRj , RM

2
M

j , M j M
j

j ,M
2
M
M

A theoretical approach because most of the time Google

Finance would provide you with the Beta estimated from historical
data

EXAMPLE

The stock Aardvark Enterprises has a beta of 1.5 and that of

Zebra Enterprises has a beta of 0.7. The risk-free rate is 5
percent, and the difference between the expected return on
the market and the risk-free rate is 4.53 percent. What are the
expected return on the two securities?

COST OF DEBT

Bonds?
If firm has tradable bonds outstanding, the YTM of a longterm (typically 10 years) straight bonds can be used as
the interest rate
If the firm has no bond, then use the YTM of comparable
companies bond
Credit Ratings?
If firm is rated, apply the typical default spread on bonds
with that rating over the risk free rate to estimate the
cost of debt
If no credit rating, build a synthetic credit rating based
on the companys credit and liquidity ratios

W. A. C. C.

EXAMPLE

Levered Cost of Equity: 9.99%

Proportion in Equity: 70%
Before Tax Cost of Debt: 4%
Tax Rate: 40%
After Tax Cost of Debt: 2.4%
Proportion in Debt: 30%

TERMINAL VALUE
Gordon Growth Model & Exit Multiple

GORDON GROWTH MODEL

Assume perpetual constant slow growth rate of g after the maturity

of the firm
Discount the terminal value by r w. a. c. c. given the forecast high growth
period of t = n

EXIT MULTIPLE MODEL

The terminal value of the company is determined through a

multiplier of some income or cash flow measure:
Net Income
Net Operating Profit
EBITDA
Operating Cash Flow
Free Cash Flow
The multiple is determined by how the market values comparable
companies

Was there a recent sale of a similar company?

What is the standard industry valuation for a company at the same
stage of maturity?
Mostly used for companies in the blue-chip industry because we
assume that their company is more mature and therefore
experiencing less growth

COMBINING EVERYTHING
EV of the firm= PV of UFCFs + PV of Terminal Value

PV OF UFCFS

GORDON GROWTH MODEL

Assume perpetual constant slow growth rate of g after the maturity

of the firm
Discount the terminal value by r w. a. c. c. given the forecast high growth
period of t = n

PROS & CONS

Advantages & Disadvantages of Using the DCF

ADVANTAGES
Produces the closest thing to an intrinsic value of the business
Multiples are not useful if the entire industry is over or under
valued
Relies on FCF, a trustworthy measure that cuts through
arbitrariness in financial accounting reporting of earnings
Can apply DCF as a sanity check: can plug the current stock
price into the DCF model, working backwards, calculate how
quickly the company would have to grow its cash flows to
achieve the stock price
Help investors identify where the companys value is coming
from and whether or not its current share price is justified
Works the best when there is a high degree of confidence in the
market performance and future cash flows

ADVANTAGES

Only as good as the assumptions of its inputs: garbage in, garbage out
principle

Tricky when the companys operations lack visibility: it is difficult to predict

sales and cost trends with certainty

Investors need to be able to make good forward looking predictions

Valuation particularly sensitive to assumptions about the perpetuity growth

rates and discount rates

DCF is a moving target that require constant vigilance and modification:

never built in stone

The model is not suited for ST investing since DCF focuses on LT value
Cause you to miss ST price run ups that can be profitable
Focusing too much on the DCF may cause you to overlook unusual
opportunities

THANK YOU!
Questions?