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?