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Strategic Capital Group

Workshop #7: DCFModeling

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Agenda

Forecasting Part 2

Projecting A Companys Lines

Finishing the Model

WACC

Calculating Terminal and Equity Value

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Previously, on SCG Workshop

We discussed ways to forecast revenue:

1.) Use past historical growth rates to predict future rates

Works well if you expect the company to remain stable at its

current levels, ineffective if company is changing.

2.) Use analyst estimates as a benchmark and adjust them slightly to

reflect the differences between your opinions

3.) Compute numbers yourself

We will work

on this today

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Previously, on SCG Workshop

We talked about how you can forecast revenue by taking analyst

estimates for the next 5 years, reading their report on why they

picked their numbers, then using your own opinion about the

company to adjust the projection accordingly.

Analyst Estimate: $50B

in revenue (10% growth

over 2011)

Analyst thinks

the product sell

decently this

year so picked10% growth

rate.

You think the

product will

grow faster

than theanalyst thinks,

so you go 12%

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We can also forecast revenues without

analyst benchmarks

The Pear Company makes only one

product, the qPhone. Currently the

qPhone has a 15% market share in a very

saturated smartphone market.

We believe the qPhone 2 that was just

announced will revolutionize

smartphones and drive all qPhone users

to upgrade. Since surveys show that 30%

of R2D2 Smartphone OS users would

consider moving to the qPhone 2, we

can make a projection about Pears top

line growth.

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We can also forecast revenues without

analyst benchmarks

SmartPhone Market-

$1T per year in sales

5M phones sold per year

Market Composition-

15% qPhone

25% BlueBerry

60% R2D2

10% Doors

If R2D2 will lose 30% of its market

share to us and we will keep our

15% renewing to the qPhone 2, we

can forecast out how much our

sales will increase over 5 years.

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COGS Forecasting

We need to figure out how much COGS will

change by as well.

To do this we need to ask ourselves some

questions.

Do we expect the direct inputs into the products to

decline in price or usage?

Management could be identifying cost cutting measures, oil

prices rising could drive up input prices and transportationcosts, better efficiency in the supply chain can drive down

costs

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COGS Forecasting

If we expect efficiency, cost-cutting measures, decline in input prices,

etc. then we should expect COGS to go down and Gross Margin to

increase.We do this by increasing our COGS

(through the growth rate) at a rate slower

than the growth rate of revenue. Onlyrarely do we give COGS a negative growth

rate- this would imply we can use less

inputs despite having to make more

products, almost impossible.

If we do not expect that there will be cost cutting measures put into place,

COGS should grow at the same rate that revenue does.

Will this make FCF shrink over the years? NO! We can still grow free cash

flow by increasing revenue, FCF just growsfasterwhen margin increases.

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SG&A Forecasting

SG&A forecasting works much in the same

way as COGS, however it deals with changes in

Selling, General, and Administrative expenses.

In the 10-K MD&A section, management will

typically discuss how they see SG&A moving.

SG&A and EBIT Margin doesnt normally change as

much as Gross Margin.

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Capital Expenditures

Lets look at MD&A for a good estimate for

Capital Expenditures (purchases of long-term

assets, found in the statement of cash flows

investing section). In non-time constrainedenvironments we would go back and check

Managements accuracy of predictions.

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Capital Expenditures

As a company matures, typically its Capital

Expenditures tails off

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Depreciation

Depreciation is tied to long-term assets, (long-termassets are the only assets that generate depreciationexpense, we dont depreciate cash or accountsreceivable).

We can look at a depreciation schedule in the 10k tofigure out how much depreciation will come due fromyear to year and forecast that way, or tie it to CapExgrowth (eventually D&A growth will tie to CapExgrowth).

We add depreciation back to Revenue in order toeliminate non-cash expenses and get to a moreaccurate Free Cash Flow

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So where are we?

Weve learned forecasting tools for revenues,

costs, and learned the general form of a DCFs

line items.

Weve gone over how depreciation and CapEx

are forecasted and how they affect free cash

flows.

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Change in Net Working Capital

Working Capital = Current Assets

Current Liabilities

We deal with non-cash current assets and non-interest bearingcurrent liabilities

Represents operating liquidity of the business.

We add/ subtract this from Revenue due to the involvement ofchanges in current assets and liabilities to cash We pay cash to increase current assets, and gain cash when current

assets are sold, the inverse applies to liabilities

So if the change in NWC is positive, then we added more assetsthan liabilities so we subtract this from Revenue. If change in NWC

was negative (more liabilities added than assets), this will increasethe amount of cash we received during the period

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Net Working Capital

Flip to the NWC page on the DCF Template

Here we forecast out changes in major current

assets:Accounts Receivable, Inventory,

Prepaid Expenses and current liabilities:

accrued liabilities and accounts payable

Not cash, want this to be independent of cash

flows generated.

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Net Working Capital

Current Assets:

Accounts Receivable: customers paid on credit

Calculate DSO (Days Sales Outstanding)

(AR / Sales) * 365 tells us how long it takes to collect a full A/R

account

Inventory: RM, WIP, FG

Calculate DIH (Days Inventory Held)

(Inventory / COGS) * 365Tells us how long inventory spends inour warehouse before it is sold

Prepaid Expenses/Other: payments made beforeproduct given/service performed Simply % Sales

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Net Working Capital

CLs:

Accounts Payable: amount company owes for

credit purchases

Calculate DPO (Days Payable Outstanding) (AP / COGS) * 365

Average number of days it takes to make payment on

outstanding purchases

Accrued Liabilities: ie wages payable, rent,interest, taxes

Simply % Sales

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Projecting an Account

We Project these by either holding the

DSO/DIH/%Sales constant through time (or

growing/shrinking it a little each year) and

calculating what the account will look likebased on our sales predictions.

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Projecting an Account

If Days Sales Outstanding has been about 45 days for the past few years, we can be fairly

confident it will remain 45.

We projected

revenue will go

from 100M to110M next year

DSO =Accounts Receivable * 365

Sales

So we know DSO (because we held it

constant at 45 after some research), and

sales (based on our revenue growth rates)

so we can calculate A/R

45 =Accounts Receivable * 365

110M

= 13.5M

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Projecting Accounts

We do the same with the rest of the currentliabilities and assets

With percentages, we expect the assets value to

be a % of revenue (or other account) so just lookat that years projected account and take thepercentage to find what the new current accountvalue is.

Look at the year-over-year change value and take(sum of current asset changes) (sum of currentliabilities changes) to find the change in NWC.

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Check for Understanding

Inventory Level this year: $100M

Cost of Goods Sold this Year: $450M

What is Days Inventory Held?DIH = (Inventory/COGS)*365

DIH = (100/450)* 365

DIH= 81

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If we forecasted $500M in COGS in 2013 and

expected DIH to grow by 1 day each year, what

will our inventory be in 2013?

DIH = (Inventory/COGS)*365

82 = (Inventory/500)* 365

Inventory = $112.35M

So change in inventory =

112.35M 100M = 12.35M

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What is the change in Net Working

Capital?

Inventory grew from 2012 to 2013 by 12M

Accounts Receivable decreased by 4M

Prepaid Expenses grew by 1MAccrued Liabilities grew by 8M

Accounts Payable grew by 13M

(12+4+1) - (8+13)

17-20

-3M

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So whats left?

We know what our revenue and costs will be over

the next 5 years, we know NWC and the

depreciation and CapEx.

Weve reached free cash flow, but we need tofigure out what the cash flows are worth today.

We need to discount them back to the future.

But what discount rate do we use? How do wefind an discount rate that reflects the diversity of

risk within our specific company?

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Weighted Average Cost of Capital

What is it?

Essentially the weighted average rate a

company expects to pay out to its financing

sources (both debt and equity holders)

We use this rate as a discount rate for the cash

flows.

It is also the long-term return we expect on

the investment

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Equation:

Essentially:

How much return all of our financiers get =

How much return the equity holders demand * weighting of equity +

How much return the debt holders demand/get * weighting of debt

WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity

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Cost of Debt

(Average Interest Rate * %debt) * (1-tax Rate)

In order to find what the company pays to its debt holders, we

should find what the weighted average interest rate for their debt

is (on the 10-K)

We then weight the average interest rate they pay (bymultiplying it by what percentage of their capital comes from

debt capital) then multiply it again by (1-tax rate) to adjust for

the tax deductibility of interest expense.

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So what is the cost of debt for a company that

has all of its money from equity holders?

0! If we dont have anydebt, then we dont care

about debt financing

costs.


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If a companys credit rating goes down, what

happens to its cost of debt?


HINT: a decrease in credit rating will drive up your

average interest rate

Cost of debt will increase

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Cost of Equity

Market Premium = Return in the Equity market (Rm) Risk-Free Rate (Rf)

10- YearTreasury Yield

Can take a 5-20 year

average of S&P or

DOWs returns or just a

1 year.

Essentially howmuch an extra

return an investor

gets for taking on

equity risk.

(Market Premium * Beta) + Risk-Free Rate = Cost of Equity

Adjusting the

equity returns

for risk

Typically a long

term beta

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If the returns in the equity market increases,

what happens to a companys cost of equity?

It increases, since now in order

to compete for financing dollars

through equity, the companymust effectively yield more

returns to entice investors.

(Market Premium * Beta) + Risk-Free Rate = Cost of EquityMarket Premium = Return in the Equity market (Rm) Risk-Free Rate (Rf)

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WACC

So what is the calculation for it?

(Cost of Debt * % of capital that comes fromdebt) * (1-tax Rate)

+Cost of Equity * % of capital from equity

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What influences it?

Market Interest Rates

Company Volatility (beta)

Equity market returns

Risk-free rates

Tax rates

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STOP!

We just learned how to calculate WACC, the

value we will be using for our discount rate.

IT IS IMPERATIVE YOU YELL AT ME AND ASK

QUESTIONS!

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Discounting

We use the PV equation to discount each cash

flow back to its present value.

Remember:

PV = (FV/ (1+ Discount Rate) ^ years away)

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Discounting

Were still missing part of the value of the

company, the company wont stop functioningafter 5 years, technically we need to do this

for the entire life of the company to find whatthe company is worth.

We call the estimation of a companys cash

flows from t=5 to t= infinity its terminalvalue

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Critical Thinking

If were taking the PV of an infinite number of

years cash flows, shouldnt the PV end up

being infinity?

No- as you get further and further into the

future, a dollar becomes worth less and less

until it eventually becomes worth nothing.

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Terminal Value

2 ways to calculate this:

Exit Multiple Approach

Long-term growth rate approach

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Terminal Value: The Exit Multiple

Approach

We can multiply the 5thyears cash flow by a

multiple of EV/EBITDA we plan to sell the

company at in the future, then discount it

back at year 5.

Terminal Value = 5th Year Cash Flow * Projceted (EV/EBITDA)

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Terminal Value: The Exit Multiple

Approach

We discount this terminal value back to the

present value using year=5, not infinity.

PV Terminal Value =Calculated FV Terminal Value

(1+Discount Rate) ^5

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Terminal Value: The Long-Term Rate

We can also calculate terminal value by

figuring out the long-term growth rate of a

company- essentially the amount we expect a

company to grow consistently in the futureonce it has matured. Typically this number is

just slightly larger than US or world GDP

growth.Terminal Value =

5th Year Cash Flow * (1+LT Rate)

Discount Rate LT Rate

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Enterprise Value

Stepping aside, we need to discuss anotherway to measure the size of a company.

Previously we said market cap was a way to

size a company (Price * shares outstanding) But this had the issue of not taking into

account the debt that was used to fund acompany.

We adjust for this problem by calculatingEnterprise Value

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Enterprise Value

EV is essentially the amount of money you

would have to pay to take over a company,

buying all of its debt and equity.

EV = Market Cap + Debt Cash +Preferred Shares + Minority Interest

We take out cashbecause when we

buyout a company,

we are paying cash

for cash, which

cancels out.

Here we are taking

into account non-

equity shares we

have to buyout

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Getting to Enterprise Value from Cash

Flows

After discounting the terminal value and the

FCFs from the 5 projected years, we add them

all up to reach our implied Enterprise Value.

From this, we solve for market cap by taking outdebt, preferred shares, and minority interest,

leaving us with Market Cap + Cash. We divide

this value by the shares outstanding to find theimplied price per share.

WS7-11.1.2012

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