Discounted Cash Flow (DCF) Tutorial

1
Presentation Procedure
By Phil Garrett
2
Overview

• Choosing a Company
• Evaluating a Company
• Presenting a Company
• Typical Mistakes

3
Choosing a Company

• The Student Investment Association is a value
  fund
• Your pitch should be focused around why this
  company is undervalued
• Look for companies that are trading with a low
  price/book ratio (P/B) and a low price/earnings
  ratio (P/E) relative to their peers
• Choose a small- to mid-cap company
• Market Capitalizations from 500 MM - 5 B
• Less analyst coverage
• The size effect

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Choosing a Company

• Benjamin Graham
• Investing with a Margin of Safety
• Invest in a company whose stock price is trading
  at a significant discount to its intrinsic value
• Look for unpopular or out-of-favor companies
• Mr. Market
• AAPL 52 wk range 196.89 - 364.90 Shares
  Outstanding 921.28 MM
• 154.8 B
• A low P/E and P/B ratio does not ALWAYS mean the
  company is undervalued
• Look for companies that have a high Return on
  Invested Capital

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Evaluating a Company

• Read through a companys financial statements
  (10-K,10-Q) and transcript from the earnings call
• Analyze the companys industry
• Porters 5 Forces
• Competition who are their competitor, how
  competitive is the industry
• New Entrants what are the barriers to entry, is
  it easy to enter the industry
• Substitutes What are the substitutes, is it for
  consumers to substitute their product
• Power of Suppliers Who are their suppliers, can
  they control the pricing
• Power of Buyers Who are their buyers, can they
  control the pricing
• What are other factors that affect the industry
• Government regulation
• Commodity prices
• Seasonality

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Evaluating a Company

• Assess the companys strategy
• What is their competitive advantage
• Low cost leaders, differentiation
• What is their plan for the future
• Is the company sustainable, why
• What risk and success factors they must manage
• Analyze the companys profitability and risk
• Use financial ratios and compare them over time
  and against competitors and the industry
• Use any industry specific measures
• Same store sales, FFO, EBITDAR

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Evaluating a Company

• Analyzing a companys profitability and risk
  contd
• Has the companys margins increase, decreased or
  maintain
• What is the companys ROA and ROE
• Is the ROE greater than the cost of equity
• What does their short-term liquidity look like
• Current/quick ratios, Days in Inventory, Days A/R
  outstanding, Days A/P outstanding
• What does their long-term liquidity look like
• Debt to Equity ratio, Interest Coverage ratio
• Compare these factors for the company over the
  past several year and currently against its
  competitors

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Evaluating a Company

• Forecasting future performance
• The information gather in prior steps
• Management guidance
• Use analyst reports to get ideas about how others
  think about the company.
• Dont use them as your own work
• Valuation
• SIA provides a sample Discounted Cash Flow model
  on the website
• Use that to input historical data and your
  forecasted projections to value the company
• Take a step back and think does this make sense?

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Discounted Cash Flow

• The value of any resource is the present value
  (PV) of the future payouts discounted at a rate
  reflective of the risk of the payouts
• Then to value the company, we project the future
  free cash flows to equity and discount them to
  present value.
• Its hard to project the free cash flows reliably
  after 5 years
• Use the terminal value method to capture the
  present value of the free cash flows into
  perpetuity
• Use the cost of equity as the discount rate
  because we are looking at the FCF to equity
• The cost of equity is calculated using CAPM

10
Discounted Cash Flow

• We project firm growth through revenue and the
  rest of the components in the DCF model are
  percentages of revenue.
• The terminal value is a large part of the
  companys value be conservative with estimate
• The long-term growth rate shouldnt grow faster
  than GDP
• When using CAPM it is better to use historical
  averages rather current values.
• Historical average risk-free rate 6
• Historical average market risk premium 5.6
• Be able to logically back each of your projections

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Presenting a Company

• Build your presentation around selling the 3 main
  reason, your investment thesis, we should invest
  in this company
• Try to boil down the information to relevant
  facts surrounding your company
• Present both the 3 main reason and 3 biggest
  risks to the company
• Try to anticipate possible questions surround
  your investment and risks reasons and cover them
  in the presentation

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Presenting a Company

• Investment overview (1 slide)
• Have your recommendation and 3 main reasons to
  invest
• Company overview
• Briefly cover how this company makes money
• Industry overview
• Cover key industry information relevant to your
  investment thesis
• What is the issue surrounding the company
• Why is the company trading at these low multiples
• Why is the company undervalued
• Why is the market wrong

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Presenting a Company

• What is going to make you investment thesis come
  true
• Why should we invest in this company
• What are risks to your investment thesis
• Why might the company no be undervalued
• Your valuation
• Briefly walk us through your projections and your
  thought process behind choosing these projections

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Typical Mistakes

• Presenting an overview of the company instead of
  focusing on the relevant facts regarding why we
  should invest
• Knowing who a companys management is and what is
  the revenue break down is important, but
  shouldnt be presented unless it affects your
  investment thesis
• Making a decision about a company before
  evaluating it
• Dont base the facts around your decision, base
  your decision around the facts.
• As you evaluate the company, if information
  doesnt look like you expected then change your
  decision or company.

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Typical Mistakes

• Just because its in the news doesnt mean it is
  relevant
• Unless the news story affects your investment
  thesis, it shouldnt be included
• Not explaining what key terms are
• If you werent comfortable using the term before
  you research the company then it probably should
  be explained
• Forgetting about the efficient market hypothesis
• The reason for buying or selling a stock
  shouldnt be based on an event
• The reason should be based on the markets under
  or over reaction to it

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Questions?
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Appendix
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Ratios

• Price to Earnings
• Current stock price / TTM EPS
• Price to Book
• Current stock price / (Total Assets Intangible
  assets Liabilities)
• Return on Invested Capital
• How well is the company using its money to
  generate returns
• (Net Income Dividends) / Total Capital
• Total Capital includes long-term debt, common and
  preferred shares, additional paid-in capital

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DCF Formulas

• Free Cash Flow to Equity
• FCFE NI D/A ?NWC Cap Ex
• FCFE CF from Operations Cap Ex
• Terminal Value
• Terminal FCFE / (Cost of Equity Growth Rate)
• CAPM
• Cost of Equity Risk-Free Beta Market Risk
  Premium