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UIS WEEK 4 PT.1 DISCOUNTED CASH FLOW VALUATION & PT.2 EUROPEAN DEBACLE


Discounted Cash Flow Valuation  What is it?  Intrinsic valuation  Why use this?  Not susceptible to market error  Flexible to future changes – just apply different inputs.  No need for a peer group  What’s the limitation?  The accuracy (rather, inaccuracy) of assumptions of future. 



Very sensitive to changes in those assumptions

A Subjective process


Concept



Time ->



Bring this future $ to today + future lump sum (upon sale/revaluation) brought to today’s value



Let’s say today’s $100 will grow to $110 in 1 year. Then what is future $100 in 1 year worth today? Assuming the implied rate of 10%, $90.09




Process of DCF  1. Calculate weighted average cost of capital (WACC)  

Find out cost of debt Find out cost of equity using CAPM

 2. Select forecast period & period of steady state

condition  3. Calculate/project the firms’ Unlevered Free Cash Flow

(UFCF) from EBIDTA (just look up Morning star)  4. Discount each UFCF by WACC to the present value

and add them up.


Process of DCF  5. Calculate the firm’s terminal value (TV) & Discount to

present value  

Exit Multiple Method Perpetuity Growth Rate Method (or both) (personal choice)

 6. Derive Total Enterprise Value 

Tot. EV = Net present value of Future FCF + present value of TV

 7. Derive the firms Total Equity Value from Enterprise

Value 

Equity Val.=Enterprise Val. – debt – preferred stock – minority interest + cash & cash equivalents


Process of DCF  8. Create a range of values by running different

inputs & assumptions  9. Compare it to other valuation methods & see if the

DCF value is reasonable. If there’s a wild difference, figure out why.


1. Calculate WACC  WACC = Ke * (E/D+E) + Kd * (1-T) * (D/D+E)  Ke = Cost of equity (using Capital Asset Pricing Model) Ke = Rf + (β * (Rm – Rf))  Rf = Risk free rate (T-bill 10 yr. most commonly used)  Β = Volatility of the stock compared to the market (can be found in Yahoo! Finance, etc.)  Rm = Rate of Return in the market. This is SUBJECTIVE. May use S&P 500 average return. 

  

E = market value of equity = share price * diluted shares outstanding D = Market value of Debt = May use book value (caution!) or if debt is publicly traded, that price may be used. T = marginal tax rate


Calculate WACC  WACC = Ke * (E/D+E) + Kd * (1-T) * (D/D+E)  Kd = Cost of Debt The company’s debt footnote in its 10-k or annual report.  If there was a recent debt issuance, use that rate  If the debt is publicly traded, get a quote from there  All else fail, look for a comparable company with a similar risk/credit profile 

 WACC will be your discount rate  CAUTION: The risk free rate is currently heavily

skewed due to fed’s heavy involvement.


Calculate & predict FCF  Unlevered Free Cash Flow: Cash Flow independent of capital

structure (i.e. cash flow after covering cap ex, working cap, investment needs but before interest and dividends) 

No need to calculate this. Just look up in the internet

 Growth projections: may use the firm’s own projections or use

analysts’ consensus.

 What life cycle is it in? steady state, growth, or demise?  Use the rate to calculate each future years’ FCF  Discount it to present Value:  PV = CF1/(1+r)^1 + CF2/(1+r)^2 + …


Calculate Terminal Value  Exit Multiple method: Sell off concept 

Terminal Value = Multiple * Financial Metric n Multiple = total enterprise value / EBIDTA (current)  Financial Metric n = EBIDTA of year of ending forecast period 



Will the same multiple hold in the future?

 Perpetuity Growth Rate method: goes on forever 

TV = (FCF n * (1+g)) / (r-g) FCFn = predicted UFCF of future year n  g = steady growth rate (SUBJECTIVE!)  r = WACC 

 

Calculating r value and g value is a nightmarish undertaking in today’s market. Present Value both!!


Finally  PV of FCF + PV of TV = Enterprise Value  Equity Value = Enterprise Val. – debt, PFD, minority

int. + cash & equivalents  Equity Value per share = Equity Value / Diluted

Shares


EUROPE


Tracing the market


Quick summary  European leaders roll out a possibility of a possible

plan about hour before the us markets close.  Economic data, slow, but not recessionary.      

ADP nonfarm payroll 91k vs. 70k expected ISM non-manufacturing 53 vs. 53 expected Initial jobless (oct/6) 401k vs.411k expected GBP PPI 1.7% vs. 1.2% expected German Industrial Production -1% vs.-1.5% US nonfarm payroll (official, oct/7) 58k vs. 53k expected (the official number is 103k, but that includes verizon’s 45k workers returning to work after strike)


Data continued  Ohhh there’s just too much data…  http://www.forexpros.com/economic-calendar/


Back to European Special  (oct 15) G20 meeting says Europe has 1 week to come up

with a credible plan if they want our support. Basically, this weekend’s European summit at Cannes is a breakor-make.  Banks balk at greater loss possibility from Greece. Currently marked at ~20%. Talk is to increase that to 30~50%.  New leverage mechanism talked about: EFSF takes first 20~30% loss on all bonds. May x3 to x4 the funds.  Franco-German talk stalled, according to Sarkozy just before he flew to Frankfurt.


More News  According to a leak preliminary document, the inspectors

for the European Commission and ECB doesn’t believe that the second bailout will rescue Greece. (but should give them the money anyways to prevent immediate bankruptcy)  EFSF will be allowed to purchase bonds. (Only if the nation has long-term solvency & is fiscally responsible)   

If Greece was fiscally responsible, they wouldn’t be here in the first place. If bond purchase can fix, not just a stop-gap, the mess, why hasn’t ECB’s bond purchases worked? Greece is showing reform fatigue. You’ve seen the news of crazy protests.


Bottom Line  Some analysts say there’s a chance that nothing will

be resolved this weekend. (All official decisions will now come on Wednesday oct/26 on the second European meeting. Even that one has low expectations) 



Be careful. You never know what will happen with those politicians. Whichever way you bet, make sure you’re hedged. So what do YOU think will happen eventually?

DCF Valuation and a Euro Update  

Presented by the UCLA Undergraduate Investment Society

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