1. DCF MODEL

2. 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?

3. 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

4. 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!

5. 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.

6. 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.

7. 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.

8. 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.

9. 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

10. Valuing a company using a DCF model
Steps:
1. Understand the business of the company you are valuing
2. Find Inputs:
Calculate the Discount Rate
Weighted Average Cost of Capital (WACC)
Build Future (Pro forma) Cash Flow and find the PV of these cash flow
Free Cash Flow (FCF)
Calculate Terminal Value
EBITDA Multiple
3. Analyze Outputs:
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). 10

11. 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 (I/S)
D&A (C/S)
Net working capital (current asset – current liabilities) (B/S)
Capex (C/S, B/S)
Find the PV of FCF (remember C/(1+r)n)
How do we estimate future cash flow?
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 11

12. 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”

13. Structure of a DCF model
Input: Cash Flow
Output: Value (Enterprise Value)
Industry standard: 5 to 10 yr horizon
Year
2007
2008
2009
2010
2011
2012
……..
Period 1 2 3 4 5
FCF C1 C2 C3 C4 C5
Terminal value (TV)
PV (CF)
C1/ (1+r)1
(C1+TV)/(1+r)1
Sum of PV(CF) EV
Year 1 to 5: Capture changes and volatility in the business (cash flow)
Company enters steady state
EV of the company as of the end of year 2007

14. 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

15. VALUING A FIRM + Cashflow to Firm Expected Growth EBIT (1-t)
Reinvestment Rate
- (Cap Ex - Depr)
* Return on Capital
Firm is in stable growth:
- Change in WC
Grows at constant rate
= FCFF
forever
Terminal Value= FCFF
n+1
/(r-g n )
FCFF 1
FCFF 2
FCFF 3
FCFF 4
FCFF 5
FCFF n
Value of Operating Assets
+ Cash & Non-op Assets
Forever
= Value of Firm
Discount at
WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
- Value of Debt
= Value of Equity
Cost of Equity
Cost of Debt
Weights
(Riskfree Rate
Based on Market Value
When you discount cash flows to the firm, you start with operating income. Consequently, you value only the operating assets of the firm. To this you have to add the value of non-operating assets - cash and marketable securities and holdings in other firms. Subtracting out debt should yield the value of equity for a firm.
+ Default Spread) (1-t)
Riskfree Rate :
- No default risk
Risk Premium
- No reinvestment risk
Beta + X
- Premium for average
- In same currency and
- Measures market risk
risk investment
in same terms (real or
nominal as cash flows
Type of
Operating
Financial
Base Equity
Country Risk
Business
Leverage
Leverage
Premium
Premium

16. Q3 FY2006 Consensus Reported Contributors: 15 Rep. date:2006-11-22Q3
FY2006
Consensus
Reported
Contributors: 15
Rep. date:
Contributors: 12
Revenue (Group)
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
EPS
0,23
0,1
0,61
Dividend per share
Total global demand (MW)
11515
Vestas total volume (MW)
1015
5488,33
Vestas global market share
26,58
Non-recurring items
Recommendation

18. 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?

19. 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?

20. 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
Why cash and not profits – key considerations are ignored: earnings can be manipulated in terms of revenue and cost recognition, non recurring items and changes in accounting policies.

21. Fundamentals of any Discounted Cash Flow Valuation
Expected cashflow
Year
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:

22. 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

23. 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
The visible forecast period extends longer for utilities, mining and real estate firms
Argument for using terminal value: Don't have sufficient information to forecast & company will reach a certain stage of maturity

25. Discounted Cash Flow Valuation
Step 2 Estimate the appropriate discount factor weighted average cost of capital (WACC)
Components of WACC are:
1) Cost of Debt (Kd)
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)
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 risk-free assets for owning equities (4-7% most typically used)
Beta is a measurement of firm's/similar firms volatility compared to the market (if higher than 1 company/sector is riskier than market in average). When compiling and averaging betas it is necessary to take into account different company leverage
Market value of debt/equity (circularity)
risk free in Iceland (HFF24+2.5%) commonly used
Debt Credit premium .5..3% commonly used (despite being wrong currently)

26. 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 ( 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

27. 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-term interest bearing debt) V
D+E
Calculated Tc
Corporate tax rate
10-K / Estimate 27

28. Discounted Cash Flow Valuation
Step 2 cont.
WACC calculation example (typical Icelandic firm)
Or…
... as is very common: Present WACC as a figure (8..15%) and provide a sensitivity table

29. 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
The visible forecast period extends longer for utilities, mining and real estate firms
Argument for using terminal value: Don't have sufficient information to forecast & company will reach a certain stage of maturity

31. Historical analysis of Sectra

32. Different models – different outcome?
Actual numbers: 2003: 503, 2004: 495, 2005: 455

33. 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

34. 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.

35. 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
* Depreciation should harmonize with CAPEX & the value of property, plant and equipment (PP&E) in the long run
* COGS & SG&A include Depreciation so it needs to be subtracted (non-cash item)

36. Discounted Cash Flow Valuation
Step 3 cont.
* Helpful to create a balance sheet and model the difference in inventories, receivables and payables between years.
* CAPEX needs to be sufficient to fund the strategy (e.g. the opening of new stores)
* Tax relief from debt is included in the discount factor

37. 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)
* 0..5% often used for perpetual growth
* 30-70% split is a rough guide for mature companies
* Equity Value calculated from EV

39. 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
Douglas Adam's