Discounted Cash Flow DCF Tutorial Part II

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Discounted Cash Flow (DCF) Tutorial Part II
Wednesday, February 7th, 2007
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Recap from Last Week

• Basic Underlying Principles
• Time Value of Money (A dollar today is worth more
  than a dollar tomorrow)
• Present/Future Value
• PVFV/(1-i)n
• FVPV(1i)n
• Opportunity Cost
• What is a business worth?
• A business is worth the present value of the
  expected future cash flows of the business.
• Ex. Target Corp (TGT)
• 60 Share Price
• x 858.89 Shares Outstanding (mm)
• 51,533 Market Capitalization or Market Value
  of Equity

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Recap cont.

• What is Free Cash Flow?
• Net Income
• Add Depreciation
• Less Capital Expenditures (CAPEX)
• Free Cash Flow to Equity
• Basics of DCF Analysis
• Compostion
• Computation
• Forecasting

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Tonight's Objectives

• Screening for companies
• Where do you find the financial data
• Introduction to the DCF Model
• Example of how to use the model
• Dell Inc.
• Currently trading at 23.90/share, with a
• 52.42b Market Cap

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Screening for Companies

• Web-site to use Yahoo Finance
• Web Address finance.yahoo.com
• On the left margin click on Stock Research -
  Screener
• Initial Screen Criteria
• Price to Earnings (P/E) ratio no greater than 20
• The Companys Return on Equity (ROE) should be
  greater than or equal to 10

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Where to find the data?

• On-line
• Edgar
• (http//www.sec.gov/edgar/searchedgar/companysearc
  h.html)
• Yahoo Finance, or Reuters
• File Looking for?
• 10-K Annual Filing
• 10-Q Quarterly Filing
• Important Sections
• Part I (Business/Risk Factors)
• Part II
• Management Discussion and Analysis of Financial
  Condition
• Consolidated Statements of Financial Position

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Introduction to the DCF Model

• Four main sections of the DCF Model
• Historical Values
• Future Projections
• Discount Rate Perpetuity Growth
• Comparison of the Fair Value to the Current
  Market Price
• Variables to change within the Model
• Blue cells change
• Black cells DO NOT change

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Example How to use the Model

• Six Step Process
• Screen for the company
• Find the financial data
• Input the historical data into the model
• Make future projections based upon research and
  information within the 10-K/10-Q
• Apply the Discount Rate Perpetuity Growth
• Compare the Fair Value to the Current Market Price

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Step 1 Screen for the Company

• Go to Yahoo Finance
• Website finance.yahoo.com
• On the left margin click on Stock Research -
  Screener
• Screen initially for
• Price to Earnings (P/E) ratio no greater than 20
• The Companys Return on Equity (ROE) should be
  greater than or equal to 10
• Secondary Screen
• Price to Book less than 1.5 2.0
• Debt to Equity Ratio less than 1.5 2.0
• Current Ratio greater or equal to 1.0

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Step 2 Find the Financial Data

• Use
• Edgar
• (http//www.sec.gov/edgar/searchedgar/companysearc
  h.html)
• Yahoo Finance, or Reuters
• Search for the 10-K/Annual Data
• 10-K
• Financial data found in Part II of Consolidated
  Statements of Financial Position

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Step 3 Input Historical Data into the Model

• Want to input historical data for the past five
  years
• Historical Data that we are looking for
• Revenues
• Net Income
• Depreciation
• Capital Expenditures (CAPEX)
• Note Revenues and Net Income will be found on
  the Income Statement and Depreciation and CAPEX
  will be found on the Cash Flow Statement

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Step 4 Make Projections

• Need to forecast in the areas of (blue text)
• Revenue Growth Rate
• Net Income Margin
• Depreciation as a of Sales
• CAPEX as a of Sales

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Step 4 Projections (cont.)

• Dell Example
• Revenue Projection facts to consider
• Historical Revenue Growth 5 year average of
  15.8
• Too high to use for a five year forecast?
• 41 of sales in 2006 came from outside the U.S.
• In 2007 are looking to expand their sales outside
  U.S.
• Desktop PC sales growth continues to decline, as
  a result of
• cheaper laptop prices, while mobility products
  sales are increasing
• as a percentage of sales
• Servers business continues to grow as a
  percentage of sales
• As they expand outside the U.S. enhanced
  services business may
• increase sales
• Michael Dell will take the position of CEO once
  again
• Will he realign the company back to their core
  business?
• Is the industry saturated from a domestic and
  international
• perspective?
• Growth rates based off of sectors of Dells
  business
• Generally assumed that Revenues would grow for
  the next two years, then slowly
• decrease

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Step 4 Projections (cont.)

• Net Income Margin
• Assumed that over time Dell will keep their
  margin in line with their historical average
• Used the historical five year average of 5.8
• Depreciation as a of Sales
• Used the historical five year average of 0.7
• CAPEX as a of Sales
• Used the historical five year average of 1.3
• Question Why forecast Depreciation and CAPEX as
  a of Sales?

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Step 5 Apply a Discount Rate and Perpetuity
Growth

• Discount Rate
• Will assume a 10 Discount Rate as the
  opportunity cost of my money
• Perpetuity Growth
• Assumed the company is a Going Concern
• Use a rate at or below the rate of inflation
• Used 2.5

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Step 6 Compare the Fair Value to the Current
Market Price

• Note This tells you that according the DCF
  Model, we can buy 1 share of Dell for 23.52
  today, while the NPV of their future cash flows
  are valued at 26.14 per share.

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Results from Dell Inc. DCF
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What Weve Covered Tonight

• Screening for companies
• Where do you find the financial data
• Introduction to the DCF Model
• Example of how to use the model
• Dell Inc.
• 6 Step Process