I needed your help. I just passed my level 1 and have a task to work on equity research report and give a recommendation whether to buy, sell or hold the current position. I need the Level II guys to help me out with DCF analysis. Like i want to understand how to carry out the model and how can i forecast future CF and what growth rate to take. My industry is Luxury Automobiles and i am working on Ferrari (RACE:NYSE). Please help me out with a single answer on what is the process, how to do it and how to forecast it…
I’d recommend BUY on general principles: it’s FERRARI!
Forecasting is difficult, and quite subjective. You should look at as many years of historical data as you can get, and try to extrapolate those data to the future. Linear regression is one approach, but you have to look at the results and ask yourself if they’re reasonable. Look at the trends in sales, various cost elements (COGS, SG&A, and so on) and try to determine what they’re likely to do in the future.
A lot will depend on whether they can stop Mercedes’ domination of F1 this year.
I would recommend to first understand the automobile Industry, If you have access to Capital IQ etc, try to get an idea of
Revenue growth : In general the automobile is a low growth business and cyclic too.
Operating Margins : On a median basis, the margin was around 4.5% in 2015
Reinvestment needs of the industry, This is basically calculating the sales/capital ratio. This ratio measures how much incremental revenue you generate for each incremental dollar of reinvestment. Higher it is , more efficient is your company
Once you have the idea of the industry, you can then delve into Ferrari:
Revenues: Check revenue growth of ferrari in recent years and also compare it relative to overall market size and larger players in the sector. This will g ive you an idea what could be the revenue growth in the future. Lets say that you decide that the growth rate of revenue will be 8% in 2017, make sure you converge to risk free rate when you assume that Ferrari will reach stable stage and will calculate Terminal Value.
2.Operating Margin : Ferrari has comparatively very high operating margin (around 18% )than others because of its luxury brand and low production. YOu can maintain the operating margin as it is till it reaches stabel state
After getting Operating income, next is to find out the reinvestment needs in the form of capex and working capital. You can use Sales/capital ratio to get the reinvestment. YOu can calculate for the last year and make an assumption if your reinvestment will be higher or lower in the future, dpeending on Ferrari wants to maintain status quo or want to increase production. Also note that higher the sales to capital ratio, that implies more efficiently your company is growing.
Once you have the reinvestment, Subtracting reinvestment from After tax operating income will give you FCFF.
Now you have cash flows. Revenue growth will help you get all the other numbers.
Good luck and please let me know if I could be of further help.
Something else to consider when using linear regression is the validty of the model assumptions (especially if you’re working with time-series data). I’d recommend consulting a reputable applied regression text for diagnostic and remedy procedures. Conclusions aren’t always valid when the model is busted, even if it looks good.