Discounted Cash Flow Analysis Primary way to value a company Present value of the company’s free cash flow Known as the company’s intrinsic value vs. market value Free cash flow is equal to Revenues less expenses less capital investment less net working capital requirements Provides a check on market based valuation approaches

Discounted Cash Flow Analysis Discount rate used is the weighted average cost of capital (WACC) Given the fact that slight changes in the WACC and the terminal value have tremendous impact in the valuation a sensitivity analysis is performed based on various WACCs and terminal values

Steps Determine the company’s key performance drivers Project cash flow – 5 years Calculate the WACC Determine terminal value Calculate PV and Determine valuation

Determine Key Performance Drivers Know your industry Know the company Drivers a) Sales growth 1) New products 2) Opening of stores 3) New markets 4) Market trends 5) Government influences 6) M&A

Determine Key Performance Drivers b) Expense growth 1) Sales growth 2) M&A 3) Start-up costs c) Cap Expenditures d) Working capital requirements Want to make sure that year 5 of the projections is at a normal rate representative of the company’s normalized operations.

Determine Key Performance Drivers Make sure that there is a logic to the projection a) Higher sales mean greater expenses, higher cap exp. And higher working capital requirements. Operating expenses are usually based on historical operating margins. S,G &A is usually based on historical % of sales Expense margins are usually held constant unless there is something specific going on with the company

Free Cash Flow EBIT Less: Taxes at the Marginal Rate Equal EBIAT What we are trying to avoid is earnings that are benefitting from extraordinary low rates for that year. Want projections to be built based on taxes that are at a normalized rate. What is the marginal tax rate or the normalized rate? - Look at the historical tax rate

Free Cash Flow EBIAT Plus: Depreciation and amortization Less: Capex Less: (Increase or decrease in net working capital) Depreciation is usually estimated going forward as the existing level of depreciation plus a % of capex or of sales. Amortization usually lumped in with depreciation or estimated as a % of sales

Free Cash Flow Capital expenditures are shown on the cash flow statement a) Usually use the historical number and the historical growth rate b) May be adjusted if there are anticipated changes in the company’s strategy, etc. c) You usually revert back to the historical rates

Free Cash Flow Net working capital Current assets (accounts receivable, inventory, prepaid expenses and other) Less Current liabilities (accounts payable, accrued liabilities and other)

Free Cash Flow Growing company usually has working capital requirements – Sales growth causes increase in inventory and accounts receivable Can estimate net working capital as a whole but if possible the components of current assets and current liabilities are estimated and then put together

Free Cash Flow DSO (Days sales outstanding) = A/R / Sales x 365 Inventory Turns = COGS / Average Inventory Prepaid and other current assets projected as a % of sales DPO = Average A/P / COGS x 365 Other current liabilities and accrued liabilities projected as a % of sales

Weighted Average Cost of Capital Rd x (1- t) x (total debt / total capitalization) Re x (total equity / total capitalization) Cost of debt is equal the weighted average cost of each outstanding debt issuance. Where there are bond issues it the current yield to maturity of the bonds. t is the current tax rate

Cost of Equity Capital Asset Pricing Model Rf + Beta x (market risk premium) = Cost of Equity Market risk premium = 7.1% Beta found on financial web sites. It is dependent on the capital structure of the company. Rf is the yield to maturity of the 10 year US Treasury

Free Cash Flow Need to look at the debt to total capital of comparable companies. If it is similar then you can use the beta for the company. If it is not then you need to go through the calculation of the average unlevered beta.

Terminal Value Usually derived based on the comparable company approach. Most often EBITDA x (EBITDA multiple)

Determine the Value Calculate the PV of each projected cash flow Remember to add terminal value to the last period. The terminal multiple is multiplied times the last 12 months results. Add the PVs to get the value Divide by the fully diluted number of shares to get the value per share

Sensitivity Analysis Usually you create a chart of values with a number of different terminal values and WACCs Then you need to pick the value that makes the most sense.

Pros and Cons Pros Cash flow based. The value of a company is the PV of the future cash flows of the company. Independent of market and market conditions Flexibility – Ability to tailor projections to different scenarios

Pros and Cons Cons Dependence on financial projections Value significantly depends on the WACC and the terminal value Terminal value is based on market conditions Assumes a constant capital structure

Info for Projections Analyst reports Annual investor day presentations provided by the company Industry reports Historical trends and relationships a) Growth – step down rates for outer years b) Profit margins Usually look at the prior 3 years