Course Intro and Fundamental Valuation
1. Course Intro and Fundamental Valuation
Let's get started with the course. Discounted cash flow or DCF analysis is the name for a broad class of valuation approaches that determine the value today of cash flows that you expect to receive in the future.2. Time Value of Money
DCF analysis relies on the concept of time value of money. What is time value of money?3. Time Value of Money
Suppose you have a choice to receive $100 today or $100 a year from now, which one would you choose? Virtually everyone will choose to receive the money today.4. Time Value of Money
From a finance perspective, the reason for this choice is that receiving $100 today is certain while receiving $100 a year from now entails risk. We have to be compensated for taking on that risk of waiting one year. The higher the risk, the larger the compensation. Because of this, the value of $100 you expect to receive next year is worth less than $100 today.5. Present Value
Suppose you could have invested the $100 in a comparable investment and earn 10% between today and next year. This means that you would only need to put in $91 today at a 10% return to get $100 next year. To see how we get to $91 in R, let's look at the code on the slide. First, we take the future value 'fv' which is equal to $100 and then divide it by 1 plus r or 10%. This gets us to $91. You can check to see that if you invested $91 today at a rate of 10% or $91 times (1 plus 10%), you will get $100 next year. The same issue happens in two years, but now the value of $100 two years from now is even less than the value of $100 one year from now because, all else equal, the risk grows the longer you have to wait for the cash flow. Assume the future value two years from now 'fv' is equal to $100. To get to the present value today, we have to discount this $100 two periods. In other words, 'fv' divided by 1 plus 10% raised to 2 years, which gets us $83 today. So the farther out the cash flow is, the less the value of that cash flow is today. In other words, money today is worth more than money tomorrow.6. Discount Cash Flow valuation
There are two general kinds of DCF valuation approaches used in practice.7. FCFE vs. FCFF Models
We illustrate the difference between the two by looking at the market value balance sheet. Just like an accounting balance sheet, the market value of the assets of the firm must equal the the market value of the firm's debt and the market value of the firm's equity. The first approach focuses on a direct valuation of the equity piece. That's what we will do in this course. The second approach first values the assets of the firm and then subtracts the debt to get to the equity piece. There are two key inputs that are different under the two approaches. In the direct approach, we discount cash flows to shareholders at the cost of equity. In the indirect approach, to value the assets, we take the cash flows to the entire firm including cash flows to both bondholders and shareholders and discount those at the weighted-average cost of capital, which is a blended rate of the cost of equity and the cost of debt. In theory, both approaches should get you to the same value, so we focus on the free cash flow to equity model in this course.8. Let's practice!
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