 # CHRIS DELL’AMORE COLGATE FINANCE CLUB 2/12/11 Introduction to Discounted Cash Flow Analysis.

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CHRIS DELL’AMORE COLGATE FINANCE CLUB 2/12/11 Introduction to Discounted Cash Flow Analysis

What is a DCF? Value can be derived from the present value of its projected free cash flows Intrinsic Value ≠ Market Value Assumptions:  Growth rates (i.e. sales)  Profit margins  CAPEX  Net Working Capital requirements

When do we use a DCF? No “true” comparable companies Times of economic turmoil Flexibility in assumptions Fundamental approach

Process of a DCF 1. Analyze Target and Determine Drivers 2. Project the Free Cash Flow (FCFs) 3. Calculate Weighted Average Cost of Capital (WACC) Capital Asset Pricing Model (CAPM) 4. Calculate Terminal Value (TV) 5. Calculate Present Value (PV) Disclosure: This presentation will go over the basics of each step and will not analytically delve into the development of each calculation.

Target Analysis (Step 1) Public  SEC filings, earnings call transcripts, analyst research and Management Discussion and Analysis portion of the 10-K and 10-Q Private:  Confidential Information Memorandum (CIM), analyst research, trade journals and SEC filings Business model Financial profile End markets Competitors

Driver Analysis (Step 1) Sales Growth  Internal: new facilities, new products, capital efficiency improvements, costumer contract expansion  External: acquisitions, end market trends, regulatory changes consumer buying patterns Profitability  Management, brand, customer base, marketing, technology Free Cash Flow Generation  CAPEX (i.e. owning vs. leasing)

Projecting Free Cash Flows (Step 2) Historical Performance Projection Period Length (~5-10 years) Best Case, Base Case, Worst Case Projections:  Sales, COGS and SG&A, EBITDA, EBIT, Tax, D&A, CAPEX, NWC EBIAT /NOPAT= EBIT – Marginal tax rate (~35-40%) FCF= EBIAT + D&A - CAPEX - ΔNWC NWC = Current Assets – Current Liabilities

Calculating WACC (Step 3) Represents the weighted average of the required return on the invested capital  Debt and Equity have different risk and tax benefits/detriments Determine target capital structure  Debt-to-total capitalization [D/(D+E)]  Equity-to-total capitalization [E/(D+E)]

Calculating WACC (Step 3) (Cost of Equity) (Cost of Debt)

Calculating WACC (Step 3) Estimate Cost of Debt (r d )  Credit Profile at target capital structure  Bonds: current yield on all outstanding issues  Credit Facilities: analyzed by DCM team internally  Tax-effect your cost of debt by marginal tax rate Estimate Cost of Equity (r e ) – CAPM  Annual rate of return that equity investors expect to receive  Use CAPM to find this rate r e = r f + β L * (r m - r f ) Disclosure: Did not discuss process of unlevering and relevering beta for sake of simplicity

Calculating WACC (Step 3) WACC= ( E ) (r e )+ ( D ) (1-t)(r d ) (D+E) D = market value of debt E = market value of equity r D = discount rate for longterm debt r e = discount rate for equity (from CAPM)

Calculating Terminal Value (Step 4) Captures the value beyond the projected period Steady state; accounts for ~75% of valuation Exit Multiple Method (EMM)  Based on the current LTM trading multiples of comps  Must normalize to account for peaks and troughs in industry Perpetuity Growth Method (PGM)  Treats company’s terminal year FCF as a perpetuity growing at an assumed rate. (Must be cautious when choosing growth rate) TV = EBITDA n * Exit Multiple TV =FCF n * (1 + g) (r e -g)

Calculating Present Value (Step 5) Time value of money Discount Rate:  Fractional value representing the present value of a dollar received at a future date given an assumed discount rate (WACC) Discount Factor =1 (1 + WACC) n PV of FCF n = FCF n *Discount Factor

Final Valuation Enterprise Value  Discount and sum the present values of the FCF for each period and the TV Equity Value Share Price Implied Equity Value = Enterprise Value – (Net Debt + Preferred Stock + Non-controlling Interest) Implied Share Price = Implied Equity Value Fully Diluted Shares Outstanding

Works Cited Pearl, Joshua, and Joshua Rosenbaum. Investment Banking Valuation, Leveraged Buyouts and Mergers & Acquisitions. Hoboken: John Wiley & Sons, 2009. Print.

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