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Discounted Cash Flow (DCF) Tutorial

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Title: 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

4
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

5
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

6
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

7
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

8
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?

9
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

11
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

12
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

13
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

14
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.

15
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

16
Questions?
17
Appendix
18
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

19
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
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