Discounted Cash Flow Model Presentation Notes

Student Investment Association

Discounted Cash Flow Model Presentation Notes

Wednesday, September 26, 2007

Simon Yu:

Steve Kretz:

SIA Investment Criteria:

Return on Equity (SIA criteria: >3yr. average greater than industry average)
ROE = Net Income / Shareholder’s Equity
Measure of corp. profitability that reveals how much profit was generated with stockholder’s equity

Discounted Cash Flow (DCF) Model Tutorial:

Introduction to a DCF model
A valuation method used to estimate the attractiveness of an investment opportunity
Projection of company’s future cash flow and discounted it back to PV
If value is higher than the current cost of investment: the investment is undervalued and a good buy

What is a business worth?
A business is worth the PV of the expected future cash flows of the business = Reasoning behind DCF
Apple will not sell their company @ what it is worth today; it will factor in the possible cash flows of the future

Discount Rate
Interest Rate: the rate @ which you discount future cash flows of a company back to PV
Efficient Markets Hypothesis (EMH)
Finance theory that states that all stock market prices @ any given time reflect the accurate PV of future cash flows of a business
If true; you can never beat the market
Uses Capital Asset Pricing Model (CAPM) to establish the theoretical “cost” of equity
(Cost of Equity = CAPM) = RF + B * (Mkt –RF)
RF = Risk free rate
B = Beta = measure of volatility (risk) in comparison to the market as a whole
Mkt = Expected market return

Free Cash Flow – Equity (FCFE)
The cash that is left for shareholders after debt-holders have been paid and necessary reinvestment has been made
This is what you care about as an investor = what you are entitled to
Formula:

Net Income

Add: Depreciation (largest non-cash expense)

Less: Capital Expenditure (reinvestments back into the company)

Free Cash Flow to Equity (Shareholder’s entitlement)

Continuation of the Discounted Cash Flow (DCF) Model Tutorial:

Terminal Cash Flow
Going concern assumption: the business will operate and generate cash flows indefinitely

Forecasting Cash Flows
Use historical performance and company information/news to predict future performance of the company
Every projection should be backed by a rational argument

Introduction to the DCF Model
Four main sections of the DCF Model
Historical Values – Found in company’s 10-K
Future Projections – The artistic form of valuation – use historic performance and news (what do you think the company will do in the future)
Discount Rate & Perpetuity Growth – The cost of the investment
Comparison of the Fair Value to the Current Market Price – If Fair Value > Current Market Price = Possible good investment

*** Remember to change the blue cells and not the black cells

How to build the Model – Six Step Process
Screen for the company
Yahoo Finance:
Investing  Stocks  Research Tools  Stock Screener
Insert investment criteria – could add additional criteria for a more narrow screen
Additional Criteria:
Debt to Equity: < 1.5 – 2
Current Ratio (Liquidity Ratio): 1

Input Historical Data into the Model (Our model uses 5 years of historical data)
Revenues (Income Statement)
Net Income (Income Statement)
Depreciation (Statement of Cash Flows – Operating Activities)
Capital Expenditure (Statement of Cash Flows – Investing Activities)

Make Projections
Need to forecast the areas of blue text
Revenue growth rate
Net income margin
Depreciation as a % of sales
CAPEX as a % of sales
Future valuation of a company’s cash flow can be seen as an art and something very subjective. Make sure you have a rational and concrete explanation to support your valuation
Apply a Discount Rate and Perpetuity Growth
Discount rate: opportunity cost of money
Can use 10% for simplicity or use CAPM: cost of equity
Perpetuity Growth:
Assumed the company is a going concern
Use a rate @ or below GDP growth plus inflation

Student Investment Association – Analyst Program (Office BCC N120)

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