DCF Basic

Question 1

1. Walk me through a DCF.

Answer 1

“A DCF values a company based on the Present Value of its Cash Flows and the Present
Value of its Terminal Value.
First, you project out a company’s financials using assumptions for revenue growth,
expenses and Working Capital; then you get down to Free Cash Flow for each year,
which you then sum up and discount to a Net Present Value, based on your discount
rate – usually the Weighted Average Cost of Capital.
Once you have the present value of the Cash Flows, you determine the company’s
Terminal Value, using either the Multiples Method or the Gordon Growth Method, and
then also discount that back to its Net Present Value using WACC.
Finally, you add the two together to determine the company’s Enterprise Value.”

Question 2

2. Walk me through how you get from Revenue to Free Cash Flow in the projections.

Answer 2

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then,
multiply by (1 – Tax Rate), add back Depreciation and other non-cash charges, and
subtract Capital Expenditures and the change in Working Capital.
Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than
EBT. You should confirm that this is what the interviewer is asking for.

Question 3

3. What’s an alternate way to calculate Free Cash Flow aside from taking Net Income,
   adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities
   and CapEx?

Answer 3

Take Cash Flow From Operations and subtract CapEx and mandatory debt repayments
– that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to
add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question 4

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

Answer 4

That’s usually about as far as you can reasonably predict into the future. Less than 5
years would be too short to be useful, and over 10 years is too difficult to predict for
most companies.

Question 5

5. What do you usually use for the discount rate?

Answer 5

Normally you use WACC (Weighted Average Cost of Capital), though you might also
use Cost of Equity depending on how you’ve set up the DCF.

Question 6

6. How do you calculate WACC?

Answer 6

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) +
Cost of Preferred * (% Preferred).
In all cases, the percentages refer to how much of the company’s capital structure is
taken up by each component.
For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM – see the next
question) and for the others you usually look at comparable companies/debt issuances
and the interest rates and yields issued by similar companies to get estimates

Question 7

7. How do you calculate the Cost of Equity?

Answer 7

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
The risk-free rate represents how much a 10-year or 20-year US Treasury should yield;
Beta is calculated based on the “riskiness” of Comparable Companies and the Equity
Risk Premium is the % by which stocks are expected to out-perform “risk-less” assets.
Normally you pull the Equity Risk Premium from a publication called Ibbotson’s.
Note: This formula does not tell the whole story. Depending on the bank and how
precise you want to be, you could also add in a “size premium” and “industry
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premium” to account for how much a company is expected to out-perform its peers is
according to its market cap or industry.
Small company stocks are expected to out-perform large company stocks and certain
industries are expected to out-perform others, and these premiums reflect these
expectations

Question 8

8. How do you get to Beta in the Cost of Equity calculation?

Answer 8

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever
each one, take the median of the set and then lever it based on your company’s capital
structure. Then you use this Levered Beta in the Cost of Equity calculation.
For your reference, the formulas for un-levering and re-levering Beta are below:
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 9

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

Answer 9

Again, keep in mind our “apples-to-apples” theme. When you look up the Betas on
Bloomberg (or from whatever source you’re using) they will be levered to reflect the
debt already assumed by each company.
But each company’s capital structure is different and we want to look at how “risky” a
company is regardless of what % debt or equity it has.
To get that, we need to un-lever Beta each time.
But at the end of the calculation, we need to re-lever it because we want the Beta used in
the Cost of Equity calculation to reflect the true risk of our company, taking into
account its capital structure this time.

Question 10

10. Would you expect a manufacturing company or a technology company to have a
    higher Beta?

Answer 10

A technology company, because technology is viewed as a “riskier” industry than
manufacturing.

Question 11

11. Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash
    Flow in your DCF – what is the effect?

Answer 11

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the
cash flow is only available to equity investors (debt investors have already been “paid”
with the interest payments).

Question 12

12. If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 12

You would use the Cost of Equity rather than WACC since we’re not concerned with
Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise
Value.

Question 13

13. How do you calculate the Terminal Value?

Answer 13

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free
Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate
its value based on its growth rate into perpetuity.
The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free
Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).

Question 14

14. Why would you use Gordon Growth rather than the Multiples Method to calculate
    the Terminal Value?

Answer 14

In banking, you almost always use the Multiples Method to calculate Terminal Value in
a DCF. It’s much easier to get appropriate data for exit multiples since they are based on
Comparable Companies – picking a long-term growth rate, by contrast, is always a shot
in the dark.
However, you might use Gordon Growth if you have no good Comparable Companies
or if you have reason to believe that multiples will change significantly in the industry
several years down the road. For example, if an industry is very cyclical you might be
better off using long-term growth rates rather than exit multiples.

Question 15

15. What’s an appropriate growth rate to use when calculating the Terminal Value?

Answer 15

Normally you use the country’s long-term GDP growth rate, the rate of inflation, or
something similarly conservative.
For companies in mature economies, a long-term growth rate over 5% would be quite
aggressive since most developed economies are growing at less than 5% per year.

Question 16

16. How do you select the appropriate exit multiple when calculating Terminal Value?

Answer 16

Normally you look at the Comparable Companies and pick the median of the set, or
something close to it.
As with almost anything else in finance, you always show a range of exit multiples and
what the Terminal Value looks like over that range rather than picking one specific
number.
So if the median EBITDA multiple of the set were 8x, you might show a range of values
using multiples from 6x to 10x.

Question 17

17. Which method of calculating Terminal Value will give you a higher valuation?

Answer 17

It’s hard to generalize because both are highly dependent on the assumptions you make.
In general, the Multiples Method will be more variable than the Gordon Growth method
because exit multiples tend to span a wider range than possible long-term growth rates.

Question 18

18. What’s the flaw with basing terminal multiples on what public company
    comparables are trading at?

Answer 18

The median multiples may change greatly in the next 5-10 years so it may no longer be
accurate by the end of the period you’re looking at. This is why you normally look at a
wide range of multiples and do a sensitivity to see how the valuation changes over that
range.
This method is particularly problematic with cyclical industries (e.g. semiconductors).

Question 19

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

Answer 19

The “standard” answer: if significantly more than 50% of the company’s Enterprise
Value comes from its Terminal Value, your DCF is probably too dependent on future
assumptions.

In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually
quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.
But when it gets to be in the 80-90% range, you know that you may need to re-think
your assumptions…

Question 20

20. Should Cost of Equity be higher for a $5 billion or $500 million market cap
    company?

Answer 20

It should be higher for the $500 million company, because all else being equal, smaller
companies are expected to outperform large companies in the stock market (and
therefore be “more risky”). Using a Size Premium in your calculation would also ensure
that Cost of Equity is higher for the $500 million company

Question 21

21. What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 21

This is a bit of a trick question because it depends on whether or not the capital structure
is the same for both companies. If the capital structure is the same in terms of
percentages and interest rates and such, then WACC should be higher for the $500
million company for the same reasons as mentioned above.
If the capital structure is not the same, then it could go either way depending on how
much debt/preferred stock each one has and what the interest rates are.

Question 22

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

Answer 22

More debt means that the company is more risky, so the company’s Levered Beta will be
higher – all else being equal, additional debt would raise the Cost of Equity, and less
debt would lower the Cost of Equity.

Question 23

23. 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 23

Trick question. Dividend yields are already factored into Beta, because Beta describes
returns in excess of the market as a whole – and those returns include dividends.

Question 24

24. How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 24

There is an alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the “standard” formula but sometimes you use it for
companies where dividends are more important or when you lack proper information
on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Question 25

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

Answer 25

The one without debt will generally have a higher WACC because debt is “less
expensive” than equity. Why?
• Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the
WACC formula).
• Debt is senior to equity in a company’s capital structure – debt holders would be
paid first in a liquidation or bankruptcy scenario.
• Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers
you see (usually over 10%). As a result, the Cost of Debt portion of WACC will
contribute less to the total figure than the Cost of Equity portion will.
Theoretically if the company had a lot of debt, the Cost of Debt might increase and
become greater than the Cost of Equity but that is extremely rare – the company without
debt has a higher WACC in 99% of all cases.

Question 26

26. 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 26

You should start by saying, “it depends” but most of the time the 10% difference in
revenue will have more of an impact. That change in revenue doesn’t affect only the
current year’s revenue, but also the revenue/EBITDA far into the future and even the
terminal value.

Question 27

27. What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 27

In this case the discount rate is likely to have a bigger impact on the valuation, though
the correct answer should start with, “It could go either way, but most of the time…”

Question 28

28. How do you calculate WACC for a private company?

Answer 28

This is problematic because private companies don’t have market caps or Betas. In this
case you would most likely just estimate WACC based on work done by auditors or
valuation specialists, or based on what WACC for comparable public companies is.

Question 29

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

Answer 29

You can take a few different approaches:
• You can create your own projections.
• You can modify management’s projections downward to make them more
conservative.
• You can show a sensitivity table based on different growth rates and margins and
show the values assuming managements’ projections and assuming a more
conservative set of numbers.
In reality, you’d probably do all of these if you had unrealistic projections.

Question 30

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

Answer 30

Banks use debt differently than other companies and do not re-invest it in the business –
they use it to create their “products” – loans – instead. Also, interest is a critical part of
banks’ business models and changes in working capital can be much larger than a
bank’s net income – so traditional measures of cash flow don’t tell you much.
For financial institutions, it’s more common to use a Dividend Discount Model or
Residual Income Model instead of a DCF.

Question 31

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

Answer 31

Example sensitivities:
• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate,
which would make no sense).

Question 32

32. 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 32

Trick question. You don’t account for this at all in an Unlevered DCF, because paying off
debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but
we only take into account EBIT * (1 – Tax Rate), and then a few items from Cash Flow
from Operations, and then subtract Capital Expenditures to get to Unlevered Free Cash
Flow.
If we were looking at Levered Free Cash Flow, then our interest expense would decline
in future years due to the principal being paid off – the mandatory debt repayments
would also reduce Levered Free Cash Flow (note: some people define Levered FCF
differently, but if you think about it, repaying debt really does reduce the cash flow that
can go to equity investors so it should be subtracted out here).