Introduction to Discounted Cash Flow Analysis

1. Introduction to Discounted Cash Flow Analysis Chris Dell’Amore Colgate Finance Club 2/12/11

2. What is a DCF? • Value can be derived from the present value of its projected free cash flows • Intrinsic Value ≠ Market Value • Assumptions: • Growth rates (i.e. sales) • Profit margins • CAPEX • Net Working Capital requirements

3. When do we use a DCF? No “true” comparable companies Times of economic turmoil Flexibility in assumptions Fundamental approach

4. Process of a DCF • Analyze Target and Determine Drivers • Project the Free Cash Flow (FCFs) • Calculate Weighted Average Cost of Capital (WACC) • Capital Asset Pricing Model (CAPM) • Calculate Terminal Value (TV) • Calculate Present Value (PV) Disclosure: This presentation will go over the basics of each step and will not analytically delve into thedevelopment of each calculation.

5. Target Analysis (Step 1) • Public • SEC filings, earnings call transcripts, analyst research and Management Discussion and Analysis portion of the 10-K and 10-Q • Private: • Confidential Information Memorandum (CIM), analyst research, trade journals and SEC filings • Business model • Financial profile • End markets • Competitors

6. Driver Analysis (Step 1) • Sales Growth • Internal: new facilities, new products, capital efficiency improvements, costumer contract expansion • External: acquisitions, end market trends, regulatory changes consumer buying patterns • Profitability • Management, brand, customer base, marketing, technology • Free Cash Flow Generation • CAPEX (i.e. owning vs. leasing)

7. Projecting Free Cash Flows (Step 2) • Historical Performance • Projection Period Length (~5-10 years) • Best Case, Base Case, Worst Case • Projections: • Sales, COGS and SG&A, EBITDA, EBIT, Tax, D&A, CAPEX, NWC

8. Calculating WACC (Step 3) • Represents the weighted average of the required return on the invested capital • Debt and Equity have different risk and tax benefits/detriments • Determine target capital structure • Debt-to-total capitalization [D/(D+E)] • Equity-to-total capitalization [E/(D+E)]

9. Calculating WACC (Step 3) (Cost of Equity) (Cost of Debt)

10. Calculating WACC (Step 3) • Estimate Cost of Debt (rd) • Credit Profile at target capital structure • Bonds: current yield on all outstanding issues • Credit Facilities: analyzed by DCM team internally • Tax-effect your cost of debt by marginal tax rate • Estimate Cost of Equity (re) – CAPM • Annual rate of return that equity investors expect to receive • Use CAPM to find this rate Disclosure: Did not discuss process of unlevering and relevering beta for sake of simplicity

11. Calculating WACC (Step 3)

12. Calculating Terminal Value (Step 4) • Captures the value beyond the projected period • Steady state; accounts for ~75% of valuation • Exit Multiple Method (EMM) • Based on the current LTM trading multiples of comps • Must normalize to account for peaks and troughs in industry • Perpetuity Growth Method (PGM) • Treats company’s terminal year FCF as a perpetuity growing at an assumed rate. (Must be cautious when choosing growth rate)

13. Calculating Present Value (Step 5) • Time value of money • Discount Rate: • Fractional value representing the present value of a dollar received at a future date given an assumed discount rate (WACC)

14. Final Valuation • Enterprise Value • Discount and sum the present values of the FCF for each period and the TV • Equity Value • Share Price

15. Works Cited Pearl, Joshua, and Joshua Rosenbaum. Investment Banking Valuation, Leveraged Buyouts and Mergers & Acquisitions. Hoboken: John Wiley & Sons, 2009. Print.