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DCF Model

The document provides an overview of discounted cash flow (DCF) valuation. It discusses that DCF values an asset based on the present value of expected future cash flows, discounted by the opportunity cost of capital. It also outlines the key steps in performing a DCF valuation, including estimating future cash flows, determining the terminal value and discount rate, and calculating the net present value. The document notes both advantages and disadvantages of the DCF approach, and that it works best for valuing assets that generate predictable cash flows over the long term.

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358 views

DCF Model

The document provides an overview of discounted cash flow (DCF) valuation. It discusses that DCF values an asset based on the present value of expected future cash flows, discounted by the opportunity cost of capital. It also outlines the key steps in performing a DCF valuation, including estimating future cash flows, determining the terminal value and discount rate, and calculating the net present value. The document notes both advantages and disadvantages of the DCF approach, and that it works best for valuing assets that generate predictable cash flows over the long term.

Uploaded by

Tera Byte
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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DCF MODEL

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?

Who uses DCF?


Career/Job Category Investment Banking To do what? Advise sellers, buyers in M&A deals Equity (e.g. IPO) Debt issuance Stock picks, shape and execute investment strategies (e.g. Long short equities) Equity research (Buy/Sell/Hold) Price bonds

Investment Management

Research Fixed income trading

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!

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.

Advantages of DCF valuation


Since DCF valuation, done right, is based upon an assets 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.

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.

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.

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

Valuing a company using a DCF model


Steps: 1. Understand the business of the company you are valuing 2. Find Inputs:
a) b) Calculate the Discount Rate
Weighted Average Cost of Capital (WACC) Free Cash Flow (FCF) EBITDA Multiple

Build Future (Pro forma) Cash Flow and find the PV of these cash flow

c)

Calculate Terminal Value

3. Analyze Outputs:
a) b) c) 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).

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 D&A Net working capital (current asset current liabilities) Capex (I/S) (C/S) (B/S) (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

Terminal value
The 5 to 10 year pro forma cash flow attempts to capture foreseeable changes in earnings The terminal value estimates the companys value after it has entered steady state

Structure of a DCF model


Input: Output:
Year Period FCF 2007 0

Industry standard: Cash Flow 5 to 10 yr horizon Value (Enterprise Value)


2008 1 C1 2009 2 C2 2010 3 C3 2011 4 C4 2012 5 C5 .. .. .. ..

Year 1 to 5: Capture changes and volatility in the business (cash flow)

Terminal value (TV)


PV (CF) Sum of PV(CF) EV C1/ (1+r)1 C1/ (1+r)1 C1/ (1+r)1 C1/ (1+r)1 (C1+TV) /(1+r)1

EV of the company as of the end of year 2007

Company enters steady state

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

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