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Lecture 22: Stocks (Part 4)

The Discounted Free Cash Flow Model

Overview

  • The Discounted Free Cash Flow (DCF) Model evaluates the total value of a firm’s productive assets for all investors (equity holders and debt holders).
  • Formula for Enterprise Value (EV):
    [ \text{EV} = \text{Market Value of Equity} + \text{Debt} - \text{Cash} ]

Valuing the Enterprise

  • To calculate a firm’s Enterprise Value, we determine the present value (PV) of its free cash flow (FCF) accessible to all investors.
  • Free Cash Flow Calculation Formula: [ FCF = \text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation} - \text{Capital Expenditures} - \text{Increase in Net Working Capital} ]
    • EBIT: Earnings Before Interest and Taxes

Discounting Future Cash Flows

  • The present value of future free cash flows is calculated using the Weighted Average Cost of Capital (WACC): [ V_0 = \text{PV(Future Free Cash Flow)} ]
    • ( V0 = \frac{FCF1}{(1 + r{wacc})^1} + \frac{FCF2}{(1 + r{wacc})^2} + … + \frac{FCFn}{(1 + r_{wacc})^n} ]

Key Term

  • Weighted Average Cost of Capital (WACC): This reflects the risk of the overall business, a combination of equity and debt risks.

Terminal Value Estimation

  • The Terminal Value accounts for cash flows that grow at a constant long-term growth rate ( g{FCF} ) beyond a forecast horizon: [ VN = \frac{FCF{N+1}}{r{wacc} - g} ]
    • ( g_{FCF} ) is often based on long-term revenue growth expectations.

Practical Example: Valuing Nike Stock

  1. Sales Forecast: Nike's sales were $36.397B in 2018, increasing at various rates culminating in a long-term growth of 5%.
  2. Assumption of EBIT: 13% of sales.
  3. Debt and Cash Position:
    • Cash: $5.25B
    • Debt: $3.8B
  4. Shares Outstanding: 1,626 million shares.
  5. Tax Rate: 25%; WACC: 9%.

Valuation Calculation Steps

  • Develop a pro forma statement for FCF predictions from 2019 to 2024.
  • Calculate Terminal Enterprise Value based on expected growth rates post-2024.

Connection to Capital Budgeting

  • Future free cash flows relate to the COE (Cost of Equity) and emerging projects:
    • The firm's overall value is determined by both ongoing and future investments.
    • Projects should be accepted if they positively influence the firm's share price (positive NPV).

Sensitivity Analysis

  • Changes in fundamental assumptions (like EBIT margins) significantly affect valuations.
  • Example: A 1% margin increase raised stock value by about 8%.
  • A sensitivity analysis helps assess how variable inputs alter end values.