Discounted Cash Flow

Question 1

Walk me through a DCF.

Answer 1

DCF values a company based on the PV of its CFs and its Terminal Value.

1. Project a company’s financials using assumptions for revenue growth, expenses and reinvestment.
2. Calculate FCF for each year, which you then discount to PV at WACC and sum to get PV(CFs).
3. Determine Terminal Value - Multiples Method or Gordon Growth Method, then discount back to NPV.
4. Sum the two = EV.

Question 2

Walk me through how you get from Revenue to FCF in the projections.

Answer 2

1. Revenue - COGS - OpEx = EBIT.

2. Unlevered FCF = EBIT (1-t) - (Capex + D&A) - Change to WC.

Question 3

Aside from starting with NI, what’s another way to calculate FCF?

Answer 3

Levered FCF = CFO - Capex

Unlevered FCF = Levered + Net Interest Expense

Question 4

Why do you use 5 or 10 years for DCF projections?

Answer 4

Hard to predict further into the future. Less than 5y would be too short, and more than 10y is too hard to predict.

Question 5

What do you usually use for the discount rate?

Answer 5

WACC

Question 6

How do you calculate the Cost of Equity?

Answer 6

Ke = Risk-free + (Beta x ERP)

• Beta can be regression or bottoms-up
• ERP can be pulled from Ibbotson’s, or implied

Question 7

How do you calculate Beta?

Answer 7

Take Bloomberg Betas for your comps, un-lever each, take the median of the unlevered betas and re-lever based on your company’s capital structure.

Question 8

Why do you have to un-lever and re-lever Beta?

Answer 8

We need our Beta to reflect our capital structure, not those of our comps. We must therefore first determine how risky a company is, being capital structure neutral, then re-lever.

Question 9

Would you expect a manufacturing company or a tech company to have a higher Beta?

Answer 9

Tech - riskier industry.

Question 10

If you use Levered FCF instead of Unlevered in your DCF, what’s the effect?

Answer 10

The resultant value will be Equity Value, not EV.

Question 11

If you use Levered FCF, what should your discount rate be?

Answer 11

Cost of equity

Question 12

How do you calculate Terminal Value?

Answer 12

Either:

1. Multiples Method, or
2. Gordon Growth Method (perpetuity)

Question 13

Why would you use GGM vs Multiples Method for TV?

Answer 13

SIMPLICITY - easier to get data on exit multiples (e.g., comps), whereas harder to pick a long-term growth rate.

GGM becomes appropriate if you lack comps or think exit multiples will change.

Question 14

What’s an appropriate growth rate to use when calculating TV?

Answer 14

AD - 10Y gov’t bond.

Otherwise, country’s long-term GDP growth rate, inflation rate or something similarly conservative.

Question 15

How do you select the appropriate exit multiple when calculating TV?

Answer 15

Look at comps and pick the median. Of course, show a range of exit multiples and the valuation implications.

Question 16

Which method of calculating TV will give you a higher valuation?

Answer 16

Hard to generalize due to assumption-dependency, but Multiples will be MORE VARIABLE since they span a wider range than do long-term growth rates.

Question 17

What’s the flaw with basing terminal multiples on what public comps are trading at?

Answer 17

Median multiples may change greatly in the next 5-10y so may no longer be appropriate. Hence, do sensitivity on a wide range of multiples.

Question 18

How do you know if your DCF is too dependent on future assumptions?

Answer 18

No hard rule, but if a lot more than 50% of EV (i.e., 80%-90%) comes from TV, may need to tweak.

Question 19

Should Cost of Equity be higher for a $5B or a $500M market cap company?

Answer 19

$500M - higher risk, higher Beta and higher Ke.

Question 20

Will WACC be higher for a $5B or $500M market cap company?

Answer 20

DEPENDS:

Assuming same capital structure, the $500M because of the higher Ke.

Question 21

What’s the relationship between debt and Cost of Equity?

Answer 21

By introducing a greater fixed cost (interest), debt makes your equity riskier. Debt increases beta, and therefore Ke.

Question 22

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company - but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 22

Dividend yield is baked into Beta, which describes returns in excess of the market, including dividends.

Question 23

Can we calculate Cost of Equity without the CAPM?

Answer 23

Ke = (Div. per share / share price) + Growth Rate of Dividends

May be used for companies where dividends are more important, or if Beta can’t be estimated.

Question 24

Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?

Answer 24

Depends on how much debt the levered company as. Unless the levered firm is beyond the optimal amount of leverage, the unlevered firm will have higher WACC.

Question 25

Which has a greater impact on a company’s DCF valuation - a 10% change in revenue or a 1% change in the discount rate?

Answer 25

It depends, but 10% is large enough that probably revenu, given effects throughout the projection period and TV.

Question 26

Greater effect on DCF valuation - 1% change in revenue vs. 1% change in discount rate?

Answer 26

Generally, the discount rate - affects NPV of free cash flows and TV.

Question 27

How do you calculate WACC for a private company?

Answer 27

Estimate based on auditors’ work or valuation specialists, or comps’ WACC. Could do bottom-up total beta..

Question 28

What should you do if you don’t believe management’s projections for a DCF model?

Answer 28

• Create your own projections
• Modify management’s projections downward to make more conservative
• Show separate cases: management vs base vs downside

Question 29

Why would you not use a DCF for a bank or other financial institution?

Answer 29

Banks don’t reinvest debt - it’s a raw input for them. Further, interest is a part of the model and changes toworking capital can exceed NI, so FCF isn’t as helpful.

Instead, use DDM or Residual Income Model.

Question 30

What types of sensitivity analyses would we look at in a DCF?

Answer 30

• Revenue Growth vs. Terminal Multiple
• EBIT(DA) Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

Question 31

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Answer 31

If looking at Unlevered Free Cash Flow, you don’t. If looking at Levered, then your interest expense will decline each year, and your repayments will reduce FCFE.

Question 32

Why would we use the mid-year convention in a DCF?

Answer 32

Because a company’s cash flow comes throughout the year, not all at the end.

Question 33

What discount period numbers would I use for the mid-year convention if I have a stub period (e.g., Q4 of Y1) in my DCF?

Answer 33

Divide the stub period by 2, then subtract 0.5 from “normal” discount periods for the future.

For Q4: 0.125 (Q4), 0.75 (Y1), 1.75 (Y2), 2.75 (Y3)

Question 34

How does the TV calculation change when we use the mid-year convention?

Answer 34

Depends on whether Multiples Method or GGM:

• Multiples: ADD 0.5 to final year discount number, assuming company gets sold at EOY
• GGM: use final year discount number as is.

Question 35

If I’m working with a public company in a DCF, how do I calculate its per-share value?

Answer 35

Equity value = EV + Cash - Debt - Preferred - Minority

Adjust for any options or dilutive securities, then divide by DSO.

Question 36

Walk me through a DDM for a financial institution.

Answer 36

Conceptually, the same: finding NPV of future dividends.

1. Project financials out, down to EPS
2. Assume a dividend payout ratio, then apply to derive projected DPS
3. Take NPV at Ke
4. Calculate TV based on final year P/BV and BV; take NPV at Ke.
5. Sum NPV(DPS) + NPV(TV).

Question 37

Assume a company has convertible debt, and you’re calculating WACC. Do you count this as debt in your Levered Beta calculation?

Answer 37

IFF converts are out-of-the-money, add face value to debt. If in-the-money, add dilution to equity value.

Question 38

A company plans to buy a factory for $100 in cash in Y4. Current PV of its EV, per DCF, is $200. How would the purchase affect our DCF and EV?

Answer 38

• Add capex of $100 to Y4 FCF, which reduces by that much

- EV decreases by PV of ($100) at WACC