BIWS Valuation and DCF Analysis Flashcards

Question

What’s the proper tax rate to use when calculating FCF – the effective tax rate, the statutory tax rate, or the cash tax rate?

Answer 1

The company’s Free Cash Flows should reflect the cash taxes it pays. So it doesn’t matter which rate you use as long as the cash taxes are correct. For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income), and then factor in Deferred Taxes within the non-cash adjustments. So if a company pays more or less in taxes than what it has recorded on its Income Statement, you could adjust afterward. Or you could calculate the company’s “cash tax rate” and skip the Deferred Tax adjustments. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes. It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.

Answer 2

Just like the company’s Free Cash Flow growth rate should decline over the explicit forecast period, the company’s CapEx and Depreciation should also decline. High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from “growth” to “maintenance.” If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end. If the company’s FCF is growing, CapEx should never EQUAL Depreciation. That’s partially due to inflation (capital assets purchased 5-10 years ago cost less back then), and partially because if you’re assuming FCF growth in the Terminal Period, Net PP&E needs to keep growing to support it. If you’re assuming that the company’s FCF declines or stagnates, then you might use different assumptions.

Answer 3

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you reflect inflation, then you also need to forecast inflation far into the future and adjust all figures in your analysis. This extra effort is probably not worth it because of the uncertainty and extra work.

Answer 4

You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt Repayments will change over time. It won’t show up explicitly in Unlevered FCF, but you will still reflect it in the analysis by changing the Discount Rate over time – WACC changes as the company’s Debt and Equity levels change. And in a Levered FCF, Cost of Equity will change because additional Debt increases the Cost of Equity and less Debt reduces it.

Answer 5

If you include an income or expense in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you include). For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher. This rule also explains why, in an Unlevered DCF analysis, you have to factor in Cash and Debt when moving to the Implied Equity Value: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

Answer 6

You could set up an NOL schedule and use them to reduce the company’s cash taxes, also factoring in accruals if the company ever records negative Pre-Tax Income. If you do this, then you don’t need to count them in the Implied Enterprise Value 􀃆 Implied Equity Value calculation at the end. However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end. Beyond the extra work, one problem with the first approach is that you may not use all the NOLs by the end of the explicit forecast period!

Answer 7

There are several different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments. Most of those count as operating expenses and should be reflected in the company’s Free Cash Flow. In an Unlevered DCF, you should exclude the Interest Expense and Expected Return on Plan Assets within the Pension Expense and then subtract the Unfunded portion of the Pension Obligation when moving from Implied Enterprise Value to Implied Equity Value. Some companies embed these items within Operating Expenses on the Income Statement, so you may have to review the filings to calculate EBIT properly. You may have to multiply the Unfunded Pension by (1 – Tax Rate) as well, though the treatment differs under U.S. GAAP and IFRS and in different countries.

Answer 8

For the most part, no. You certainly shouldn’t make speculative projections for these items – they are all non-recurring, so it’s not correct to forecast them as if they were recurring, predictable items. If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year. And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or received, and you’ll have to change the company’s revenue and expenses in future periods.

Answer 9

It tells you the percentage a company’s stock “should” return each year, over the very long term, also factoring in dividends and stock repurchases. In a valuation, it represents the percentage an Equity investor might earn each year. To a company, Cost of Equity represents the cost of funding its operations by issuing shares to new investors. The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting existing investors (and thereby giving more stock appreciation potential to others).

Answer 10

WACC is similar to Cost of Equity, but it’s the expected annual return percentage if you invest proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock, etc. To a company, WACC represents the cost of funding its operations by using all its sources of capital. Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Answer 11

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta The Risk-Free Rate represents what you would earn on "risk-free" government bonds denominated in the same currency as the company’s cash flows. You usually use 10-year or 20- year bonds to match the explicit forecast period of the DCF. Levered Beta represents how volatile this stock is relative to the market as a whole, factoring in both its intrinsic risk and the risk from leverage. And the Equity Risk Premium represents how much the stock market in the company’s country will return above the “risk-free” government bond. The idea is to say: “Stocks are riskier and have higher potential returns than government bonds. So let’s take the rate of return on those government bonds, add the extra returns you could get from the stock market, and then adjust for this company’s specific risk/return.”

Answer 12

You should use the rate on the government bonds that match the currency of the company’s cash flows. So if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if it reports them in EUR or GBP, you might use the rate on 10-year notes issued by the Bank of England or the European Central Bank.

Answer 13

One option is to take the Risk-Free Rate in a country that is assumed to be “risk-free,” like the U.S. or U.K., and then add a default spread based on your country’s credit rating. For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a spread of 11.2% for Greece based on its current credit rating. That rate of 13.7% represents how yields are much higher in Greece due to the significant chance of the government defaulting on its bonds.

Answer 14

There is almost no agreement on how to do it because stock-market returns differ based on the period and whether you use an arithmetic mean, a geometric mean, or other approaches. Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for companies of different sizes in different industries each year. You could also take the historical data for the U.S. stock market and add a premium based on the default spread of your country/market. For example, if the historical U.S. premium is 7%, you might add 3% if your country’s credit rating is Ba2 and that rating corresponds to a 3% spread. Finally, some groups just use a “standard” number for each market, such as 6-7%.

Answer 15

You might take the percentage revenue from each country, multiply it by the ERP in that market, and then add everything up to get a weighted average. The ERP in each market might be based on anything described above, but the “Historical U.S. stock market returns + default spread” approach is common.

Answer 16

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both the intrinsic business risk and the risk from leverage (i.e., Debt). If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%. If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%. Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

Answer 17

Yes, it’s possible. The company’s stock price has to move in the opposite direction of the market as a whole for Beta to be negative. Gold is commonly cited as an Asset that has a negative Beta because it often performs better when the stock market declines. However, negative Betas for companies are quite rare and usually revert to positive figures, even if they’re negative for short periods.

Answer 18

You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical Beta, i.e. its own Levered Beta, and skip this step. But in a valuation, you’re estimating the company’s Implied Value – what it should be worth. If you use the historical Beta, that corresponds more closely to the company’s Current Value – what the market says it’s worth today. By un-levering Beta for each comparable company, you isolate each company’s inherent business risk. Each company might have a different capital structure, so it’s important to isolate that risk and remove the risk from leverage. You then take the median Unlevered Beta from these companies and re-lever it based on the targeted capital structure of the company you’re valuing. You do this because, in reality, there will always be business risk and risk from leverage, and so you need to reflect both for the company you’re valuing. You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s targeted capital structure.”

Answer 19

Assuming the company has only Equity and Debt: Unlevered Beta = Levered Beta / (1 + Debt/Equity Ratio * (1 – Tax Rate)) Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 – Tax Rate)) If the company has Preferred Stock, you add another term for the Preferred/Equity Ratio. You use a “1 +” in front of Debt/Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta. And you multiply the Debt/Equity Ratio by (1 – Tax Rate) because the tax-deductibility of interest reduces the risk of Debt. The formulas reduce Levered Beta to represent the removal of risk from leverage, but they increase Unlevered Beta to represent the addition of risk from leverage.

Answer 20

Yes, this is one drawback of this approach. However: 1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with high Debt / Equity ratios tend to have higher interest rates as well. 2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.” 4x higher interest might barely change a large company’s financial profile, but it might make a much bigger difference for a smaller company.

Answer 21

Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF. A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and relever Beta regardless of the type of cash flow in your analysis.

Answer 22

Some people argue that you should use Predicted Beta instead of Historical Beta because Cost of Equity relates to expected future returns. If you do use historical data, you could use the company’s own Historical Beta or the re-levered Beta based on the historical performance of comparable companies. And if you re-lever Beta, you could do it based on the company’s current capital structure or its targeted or “optimal” capital structure. Most of these methods will produce similar results, and you always use a range of values when calculating Cost of Equity and WACC.

Answer 23

This question tests your ability to make a guesstimate based on common sense and your knowledge of current market rates. You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.” The numbers will change based on market conditions, but that’s the idea.

Answer 24

The formula for WACC is simple: WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock But it’s tricky to calculate because there’s ambiguity with many of these items: 1. Cost of Debt: Do you use the weighted average coupon rate on the company’s bonds? Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies? 2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company’s current capital structure, “optimal” structure, or targeted structure? 3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the Equity Risk Premium.

Answer 25

That’s not the best way to think about this concept. Think of Unlevered FCF as “Free Cash Flow to Firm,” or FCFF, instead (as that is the alternate name for it). And think of the relationship as: “Unlevered FCF, or FCFF, is available to ALL investors, and WACC represents ALL investors.” No Discount Rate can be capital structure-neutral since each part of a company’s capital structure affects the other parts. So “capital structure neutrality” is a property of Free Cash Flow and its variants.

Answer 26

A company’s “optimal” capital structure is the one that minimizes WACC. But there’s no way to calculate it because you can’t tell in advance how the Costs of Equity and Debt will change as the capital structure changes. So in practice, you’ll often use the median capital structure percentages from the comparable public companies as a proxy for the “optimal” capital structure. The logic is the same as the logic for un-levering and re-levering Beta: You want to capture what this company’s capital structure should be, not what it is right now. It’s better to use this expected capital structure because the company’s Implied Value in a DCF is based on its expected, future cash flows.

Answer 27

Some textbooks claim that you should use Equity Value + Debt + Preferred Stock – Cash for the denominator of the capital structure percentages in the WACC formula rather than Equity Value + Debt + Preferred Stock. However, we disagree with this approach for several reasons: 1) Cash Does Not “Offset” Debt – For example, many forms of Debt do not allow for early repayment or penalize the company for early repayment. So a high Cash balance doesn’t necessarily reduce the risk of Debt. 2) You May Get Nonsensical Results with High Cash Balances – For example, if the company’s Cash balance exceeds its Debt balance, Debt as a Percentage of Total Capital will be far too low. This will artificially inflate the Discount Rate since Equity is more expensive than Debt for most companies.

Answer 28

Because it offers higher risk and higher potential returns. Expected stock market returns exceed the interest rates on Debt in most cases, which already makes the Cost of Equity higher. But interest on Debt is also tax-deductible, which further reduces its cost. In developed markets like the U.S., the average annual stock market return is around 10-11%. So a company with a Beta of 1.0 will have a Cost of Equity in that range. For Cost of Debt to be higher, the Pre-Tax Cost would have to be ~17-18% at a 40% tax rate. And hardly any Debt has interest rates that high.

Answer 29

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity. That’s because the coupon rates on Preferred Stock tend to be higher than the interest rates on Debt, and Preferred Dividends are not tax-deductible. But these rates are still lower than expected stock market returns, and the risk is also lower since Preferred Stock investors have a higher claim on the company’s Assets than Common Stock investors.

Answer 30

These Costs represent the marginal rates a company would pay if it issued additional Debt or Preferred Stock. There is no way to observe these rates, but you can estimate them. One simple method is to calculate the weighted average coupon rate on the company’s existing Debt or Preferred Stock or to calculate the median coupon rate on the outstanding issuances of comparable companies. You could also use the Yield to Maturity (YTM) instead, which reflects the market prices of the bonds (a bond with a coupon rate of 5% that’s trading at a discount to par value will have a YTM higher than 5%). You could also take the Risk-Free Rate in the country and add a default spread based on the company’s expected credit rating if it issues more Debt or Preferred Stock (e.g., if you think its credit rating will go from BB+ to BB after issuing Debt, you’d calculate the average spread for BB+-rated companies and add it to the Risk-Free Rate).

Answer 31

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula. If not – i.e., the bonds are not currently convertible – you count them as Debt and use the coupon rate (or YTM, or another method above) to calculate their Cost. Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt is lower than the Cost of Equity, and the coupon rates on convertible bonds are even lower than the rates on traditional bonds. NOTE: This answer assumes that you’re calculating WACC based on the company’s current capital structure. If you’re using the optimal or targeted structure, the company’s convertible bonds won’t factor in.

Answer 32

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors. As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt. However, the exact impact depends on where you are on that curve. If the company already has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt, WACC is more likely to decrease with more Debt.

Answer 33

The Cost of Equity and Cost of Debt decrease for the reasons stated above: Less Debt means a lower risk of bankruptcy and, therefore, less risk for all investors. WACC could go either way depending on where you are on the curve. If the company already has a very high level of Debt, WACC will likely decrease with less Debt; if its Debt level is much lower, WACC will likely increase with less Debt.

Answer 34

It depends on how you’re calculating WACC. If you’re using the company’s current capital structure, WACC will most likely increase because 20% Debt is a fairly low level. At that level, less Debt will most likely increase WACC. But if you’re using the targeted, optimal, or median capital structure from the comparable companies, this change won’t affect WACC because you’re not using the company’s current capital structure at all.

Answer 35

Yes, sometimes it makes sense to use different Discount Rates. For example, if a company is growing quickly right now, but it’s expected to mature and grow more slowly in the future, you might use decreasing Discount Rates. So if the company’s current WACC is between 11% and 13%, and WACC for mature companies in the industry is between 8% and 9%, you might start out at 12% and then reduce it by 0.5% in each year of the explicit forecast period until it reaches 8.5% at the end. It makes less sense to do this if the company is already stable and mature and it’s not expected to change much over time.

Answer 36

The company’s Free Cash Flow growth rate, and possibly its Discount Rate, change over time in the explicit forecast period since you forecast cash flow in each year. But in the Terminal Period, you assume the company remains in a “steady state”: Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

Answer 37

The typical formula is: Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal FCF Growth Rate) But it’s more intuitive to think of it as: Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate) The intuition is that a company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher. For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has $100 in FCF in the first year of the Terminal Period. You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay $100 / 20%, or $500. That’s because the company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere. Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay $100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d be willing to pay $100 / (10% – 5%), or $2,000, for it. Higher growth lets you achieve the same targeted return even when you pay more.

Answer 38

The answer is: “Neither one – you just use them as starting points in the analysis, and then you adjust once you see the Terminal FCF Growth Rates that the selected multiples imply.” It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don’t want to reflect the control premium inherent in Precedent Transactions. The company doesn’t necessarily “get sold” at the end of the forecast period; the Terminal Multiple is just an abbreviated way of expressing its valuation. Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, you adjust it up or down as necessary.

Answer 39

This growth rate should be below the country’s long-term GDP growth rate and in-line with other macroeconomic variables like the rate of inflation. For example, if you’re in a developed country where the long-term expected GDP growth is 3%, you might use numbers ranging from 1.5% to 2.5% for the range of Terminal Growth Rates. You should NOT pick a rate above the country’s long-term GDP growth rate because the company will become bigger than the economy as a whole after a certain point!

Answer 40

Because the Terminal Value represents the Present Value of the company’s cash flows from the very end of the explicit forecast period into perpetuity. In other words, it represents the company’s value IN a future period AT a point in the future. Valuation tells you what a company is worth TODAY, so any “future value” must always be discounted back to its Present Value. If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Value because you’d be acting as if its Year 6, 11, or 16 cash flows arrived next year.

Answer 41

No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it’s the Present Value as of the very end of Year 10. You would use 11 for the discount period only if your explicit forecast period went to Year 11 and the Terminal Period started in Year 12.

Answer 42

If you’re building a Levered DCF analysis, you’re almost done because this summation gives you the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity Value by its diluted share count to get its Implied Share Price (if the company is public). In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows = Implied Enterprise Value, so you have to “back into” the company’s Implied Equity Value and then calculate its Implied Share Price. You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting Liability and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling Interests, etc.). Then, you divide by the company’s diluted share count to get its Implied Share Price.

Answer 43

In theory, yes. Some academics and professors such as Damodaran use Black-Scholes to value these out-of-the-money options, and then subtract the value of those options to determine its true Implied Equity Value. In practice, banks rarely include out-of-the-money options in a DCF. There are several reasons why, including the fact that these options tend to make a very small impact and the fact that the valuation of options gets tricky and requires inputs that you may or may not have.

Answer 44

It’s an iterative process: You start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by seeing what Growth Rates or Multiples they imply. If it seems wrong, then you adjust the range of Terminal Multiples or Terminal FCF Growth Rates up or down until you get more reasonable results. Example: You start by picking 10x EV / EBITDA for the Terminal Multiple. At a Discount Rate of 12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high. So you reduce it to 6x EV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to 1%, which is too low. So you guess 8x EV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more reasonable since it’s below the expected long-term GDP growth rate. This 8x figure might be your “Baseline Terminal Multiple,” so you start there and then go slightly above and below it in sensitivity tables.

Answer 45

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if one multiple is similar for both of them. You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those present other issues, such as less comparability across peer companies. This problem is one reason why the Gordon Growth Method is still the “real” way to calculate Terminal Value.

Answer 46

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, you might assume that the company’s cash flows eventually decline to 0. A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually. A negative Terminal FCF Growth Rate doesn’t make the company “worthless”; it just means that the Terminal Value will be much lower.

Answer 47

The same variables are important in any DCF: The Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the revenue growth and margin assumptions. It doesn’t make sense to sensitize much else – assumptions for CapEx and Working Capital, for example, make a very small difference. There may also be industry-specific assumptions that are worth sensitizing (e.g., the patent expiration date for a drug in biotech/pharmaceuticals).

Answer 48

You use it because a company’s cash flow does not arrive 100% at the end of each year – it’s generated throughout each year. Using 1, 2, 3, 4, etc. for the discount periods implies that the first cash flow arrives after one entire year has passed. But if you use 0.5, 1.5, 2.5, 3.5, etc. instead, you assume that only half a year passes before the first cash flow is generated, which is a better approximation for real life.

Answer 49

A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower. As a result, a formula like this: Present Value = $100 / ((1 + 10%) ^ Year#) Will produce higher values because the Year # of the first period would be 1 without the midyear convention, but 0.5 with the mid-year convention.

Answer 50

You include a “stub period” if you’re valuing a company midway through the year, and it has already reported some of its financial results. A DCF is based on expected future cash flow, so you should exclude these previously reported results and adjust the discount periods as well. For example, maybe it’s September 30th and the company’s fiscal year ends on December 31st. The company’s future cash flow for this year will be generated between September 30th and December 31st. It’s incorrect to include the cash flow from January 1st to September 30th since that part of the year has already passed. So for the first year in the analysis, you include only the expected FCF from September 30th to the end of the year. To discount the FCF in that 3-month period, you use 0.25 for the discount period since 3 months is 25% of the year. You then use 1.25 for the discount period of the next year, 2.25 of the year after that, and so on.

Answer 51

For the FCF, you exclude everything generated between January 1st and April 30th and include only the projected amount to be generated between April 30th and December 31st. Since most companies report only quarterly results, you’ll most likely be excluding the first quarter, not exactly the first 4 months. If you include both the stub period and the mid-year convention, you divide the stub period of the first year by 2. And then in each year after that, you subtract 0.5 from the “normal” discount period. In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the “normal” stub discount period is 0.67. Since you’re using the mid-year convention, you divide that by 2 to get 0.34. You then use that period to discount the company’s FCF from April 30th to December 31st. The “normal” discount period of the next year would be 0.67 + 1.00, or 1.67. So you take the 1.67 and subtract 0.50 to get 1.17. For the next year after that, the “normal” discount period is 0.67 + 2.00, or 2.67, so you subtract 0.50 and get 2.17. You continue that for the rest of the years.

Answer 52

It depends on how you calculate the Terminal Value. With the Multiples Method, the Terminal Value calculation stays the same since it’s based on the company’s EBITDA (or other metric) in the final projection year times an appropriate multiple. When you discount the Terminal Value, the stub period affects the discount period, but the mid-year convention does not because the Terminal Value is as of the END of the last projection year. So if the valuation date is April 30th, and there are 10 years in the projection period, you use 9.67 for the discount period to calculate the PV of the Terminal Value. With the Gordon Growth method, if you’re using the mid-year convention, you must adjust the Terminal Value by multiplying it by (1 + Discount Rate)^0.5. You have to do this because the normal formula, FCF in Year 1 of Terminal Period / (Discount Rate – Terminal Growth Rate), gives you the Present Value at Year 10.5 if you’re using the midyear convention. When you multiply by (1 + Discount Rate)^0.5, you “move the Terminal Value back” to the end of Year 10. Discounting the Terminal Value works the same way as it does with the Multiples Method: Only the stub period affects it. So you use also 9.67 for the discount period.

Answer 53

Yes, you could discount the Terminal Value to its Present Value by using a different discount period instead. However, the Terminal Values calculated via both methods should be directly comparable. In other words, BOTH Terminal Values should be as of the end of Year 10 in a 10-year analysis. If you do not adjust the Terminal Value from the Gordon Growth Method, and you’re using the mid-year convention, you can’t compare it to the Terminal Value from the Multiples Method because one TV is as of Year 10, and the other is as of Year 10.5.

Answer 54

You might create a Normalized Terminal Year if something about the company’s revenue growth, margins, or CapEx is expected to change in a major way in the Terminal Period. As a result of this change, multiplying FCF in the final projection year by (1 + Terminal FCF Growth Rate) won’t produce accurate results in the Terminal Value formula. For example, a key patent might expire in Year 9 or 10, or the company might have a huge Intangibles balance that gets completely amortized in Year 10. You use the FCF in this Normalized Year for the Terminal Value calculation rather than multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).

Answer 55

Technically, it could go either way, but in most cases, the Normalized Terminal Year will reduce a company’s Implied Value because you often adjust down the company’s growth rates and margins in this year.

Answer 56

The Discount Rate and Terminal Value make the biggest impact on the DCF output. That’s because the Discount Rate affects the PV of everything and because the PV of the Terminal Value often represents 50%+ of the company’s Implied Value. The assumptions for revenue growth and operating margins also make a significant impact, but less so than the ones above. Other items, such as CapEx, Working Capital, and non-cash adjustments, make a much smaller impact.

Answer 57

Assuming that both companies have the same capital structure percentages, Cost of Equity and WACC should both be higher for the $500 million company. All else being equal, smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains why Cost of Equity will be higher. Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt (and Preferred) also tends to be higher. And since all the Costs tend to be higher for smaller companies, WACC must be higher, assuming the same capital structure percentages.

Answer 58

The Discount Rate increase will make a bigger impact. Increasing revenue growth from 9% to 10% will barely impact FCF and the Terminal Value, but the Discount Rate will affect the Present Value of everything.

Answer 59

It’s harder to tell here. More than doubling a company’s revenue growth could make a bigger impact than changing the Discount Rate by 1%, but when the changes are this different, you’d have to run the numbers to tell for sure. These operational changes make a bigger impact over longer projection periods than they do over shorter ones, so you would see more of a difference for a 10-year DCF than a 5-year one.

Answer 60

This is a bit of a trick question because it depends on what you count toward the Implied Value. If it’s just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: The cash flows arrive earlier on, so they’re worth more. However, Company B will almost certainly have a much higher Terminal Value because it has higher FCF in Year 10. So if the Terminal Value comprises a big portion of the Implied Value, and you count it in the analysis, it’s a good bet that Company B will have the higher Implied Value.

Answer 61

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rates don’t matter because there’s no tax benefit to interest paid on Debt. Assuming there’s some Debt, a higher tax rate will reduce Cost of Equity, Cost of Debt, and WACC. It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher rate always reduces the after-tax cost. But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower. However, the Implied Value from a DCF will be lower because the higher tax rate reduces FCF and, therefore, the company’s Terminal Value. Those changes tend to outweigh a lower WACC. The opposite happens with lower taxes: Higher Costs of Equity and Debt, higher WACC, and a higher Implied Value from the DCF.

Answer 62

First, you select the companies and transactions based on criteria such as industry, size, and geography. Then, you determine the appropriate metrics and multiples for each set – for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples – and you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply those numbers to the financial metrics of the company you’re analyzing to estimate its Implied Value. For example, if the company you’re valuing has $100 million in EBITDA and the median EBITDA multiple of a set of comparable companies is 7x, its implied Enterprise Value is $700 million based on that. You then calculate its Implied Value for all the other multiples to get a range of values.

Answer 63

Because the comparable companies and transactions should have similar Discount Rates. Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate. If the companies in your set all have similar Discount Rates, it’s easier to conclude that one company has a higher multiple because its expected growth rate is higher. If they don’t have similar Discount Rates, it’s harder to draw meaningful conclusions.

Answer 64

You screen based on geography, industry, and size, and also time for Precedent Transactions. The most important factor is industry – you’ll always use that because it makes no sense to compare a mobile gaming company to a steel manufacturing company. Here are a few example screens: 􀁸 Comparable Company Screen: U.S.-based steel manufacturing companies with over $500 million in revenue. 􀁸 Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA. 􀁸 Precedent Transaction Screen: Latin American M&A transactions over the past 3 years involving consumer/retail sellers with over $1 billion USD in revenue. 􀁸 Precedent Transaction Screen: Australian M&A transactions over the past 2 years involving infrastructure sellers with over $200 million AUD in revenue.

Answer 65

You should avoid screening by both financial metrics and Equity Value or Enterprise Value. For example, you should NOT use this screen: “Companies with revenue under $1 billion and Enterprise Values above $2 billion.” If you do that, you’re artificially constraining the multiples because EV / Revenue must be above 2x for every company in the set.

Answer 66

The idea is similar – you use Current valuation multiples from similar companies or deals to value a company – but the execution is different. Here are the differences for Precedent Transactions: 􀁸 Screening Criteria: In addition to industry, size, and geography, you also use time because you only want transactions from the past few years. You might also use Transaction Size, and you might use broader screening criteria in general. 􀁸 Metrics and Multiples: You focus more on historical metrics and multiples, especially LTM revenue and EBITDA as of the announcement date. 􀁸 Calculations: All the multiples are based on the purchase price as of the announcement date of the deal. 􀁸 Output: The multiples produced tend to be higher than the multiples from Public Comps because of the control premium. But the multiples also tend to span wider ranges because deals can be done for many different reasons.

Answer 67

You start by finding each company’s most recent annual and interim (quarterly or half-year) filing. You calculate its diluted share count and Current Equity Value and Current Enterprise Value based on the information there and its most recent Balance Sheet. Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent annual results, adding the results from the most recent partial period, and subtracting the results from the same partial period the last year. For the projected figures, you look in equity research or find consensus figures on Bloomberg. And then you calculate all the multiples by dividing Current Equity Value or Current Enterprise Value by the appropriate metric.

Answer 68

You find the acquired company’s filings from just before the deal was announced, and you calculate the LTM financial metrics in the same way using those. To calculate the company’s Equity Value and Enterprise Value, you use the purchase price the acquirer paid, and you move from Equity Value to Enterprise Value in the same way you usually do, using the company’s most recent Balance Sheet as of the announcement date. You calculate all valuation multiples in the same way, using Transaction Equity Value or Transaction Enterprise Value as appropriate.

Answer 69

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitabilitybased metrics and multiples. For example, you might use Revenue, EBITDA, and Net Income, and the corresponding multiples: EV / Revenue, EV / EBITDA, and P / E. You do this because you want to value a company in relation to how much it sells and to how much it keeps of those sales. Sometimes, you’ll drop the sales-based multiples and focus on profitability or cash flow-based ones (e.g., EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Answer 70

Historical metrics are useful because they’re based on what actually happened, but they can also be deceptive if there were non-recurring items or if the company made acquisitions or divestitures. Projected metrics are useful because they assume the company will operate in a “steady state,” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because they’re based on predictions of the future.

Answer 71

No, you always use the Current Equity Value or Current Enterprise Value. NEVER “project” either one. A company’s share price, and, therefore, both of these metrics, is based on past performance and future expectations. So to “project” these metrics, you’d have to jump into the future and see what future expectations are at that point, which doesn’t make sense.

Answer 72

You have to “calendarize” by adjusting the companies’ fiscal years so that they match up. For example, to make everything match a December 31st year-end date, you take each company with a June 30th fiscal-year end and do the following: 􀁸 Start with the company’s full June 30th fiscal-year results. 􀁸 Add the June 30th – December 31st results from this year. 􀁸 Subtract the June 30th – December 31st results from the previous year. Normally, you calendarize to match the fiscal year of the company you’re valuing. But you might pick another date if, for example, all the comparable companies have December 31st fiscal years but your company’s ends on June 30th.

Answer 73

The interpretation depends on how the growth rates and margins of your company compare to those of the comparable companies. Public Comps are most meaningful when the growth rates and margins are similar, but the multiples are different. This could mean that the company you’re valuing is mispriced and that there’s an opportunity to invest and make money. For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15- 20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these ranges. However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable companies all trade at multiples of 10x to 12x. That could indicate that your company is undervalued since its multiples are lower, but its growth rates, margins, industry, and size are all comparable. If the growth rates and margins are very different, it’s harder to draw conclusions since companies growing at different rates are expected to trade at different multiples.

Answer 74

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed yet, the simple announcement of the deal reflects what one company believes another is worth. Note that you base all the metrics and multiples on the financial information as of the announcement dates.

Answer 75

The problem is that the circumstances surrounding each deal might be very different. For example, one company might have sold itself because it was distressed and about to enter bankruptcy. But another company might have sold itself because the acquirer desperately needed it and was willing to pay a high price. Some deals are competitive and include multiple acquirers bidding against each other, whereas others are more targeted and do not involve competitive bidding. All these factors mean that the multiples tend to vary widely, more so than the multiples for Public Comps.

Answer 76

You generally don’t factor in expected synergies because they’re so speculative. If you do include them, you might increase the sellers’ projected revenue or EBITDA figures so that the valuation multiples end up being lower. Opinions differ on earn-outs, but you could assume that they have a 50% chance of being paid out, multiply the earn-out amounts by 50%, and add them to the purchase prices. Other people ignore earn-outs or add the full earn-out amounts to the purchase prices.

Answer 77

Ideally, your set of Precedent Transactions will include only 100% acquisition deals. However, you may need to go beyond that and also include majority-stake deals (ones where the acquirer buys more than 50% but less than 100% of the seller). You can include those because the dynamics are similar, but you should not include minoritystake deals because acquiring 10% or 20% of a company is quite different. Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically include all deals regardless of the form of consideration. You may note whether each deal was cash, stock, or a mix of both.

Answer 78

The multiples are always based on 100% of the seller’s value. So if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value would be $500 million / 80% = $625 million. And then you would calculate the Purchase Enterprise Value based on that figure plus the usual adjustments. You would then calculate the valuation multiples based on those figures and the financial stats for 100% of the seller.

Answer 79

Median multiples are better than average multiples because of outliers. If there are 5 companies in your set, and the multiples are 8x, 10x, 9x, 8x, and 25x, you don’t want the 25x multiple to push up the average when it’s clearly an outlier. However, there’s no “rule” that you have to use the median rather than other percentiles. So you could make an argument for using the 25th percentile or 75th percentile. For example, you could argue that your company’s growth rates and margins are in-line with companies in the 75th percentile of your set and that the multiples of those companies are, therefore, most applicable to your company.

Answer 80

In a Liquidation Valuation, you value a company by determining the market values of all its Assets, adding them up, and subtracting the market values of all its Liabilities. It gives you the company’s Implied Equity Value because you’re valuing all the company’s Assets rather than just its core-business Assets. This methodology is useful for distressed companies because it tells you how much they might be worth if they have to liquidate and shut down. It’s less useful for healthy, growing companies because it tends to undervalue them grossly. A growing company is worth a lot more than what’s on its Balance Sheet because its cash flows will grow far into the future.

Answer 81

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually based on a percentage of Net Income. You then discount the Dividends to their Present Value using the Cost of Equity and add them up. To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E (or the Gordon Growth Method), and then you discount it to its Present Value using the Cost of Equity. You get the company’s Implied Equity Value at the end rather than its Implied Enterprise Value, so you can divide by its diluted share count to get its Implied Share Price. The DDM is essential in some industries, such as commercial banks and insurance, useful for other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so useful for most others.

Answer 82

The M&A Premiums analysis applies only to public companies because you look at acquisitions of similar public companies and calculate the “premium” each buyer paid for each seller. For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00 per share, that is a 25% premium. You take the median for a set of transactions and then use that to value your company. So if the median premium is 20%, and your company’s share price is $10.00, it’s worth $12.00 per share. This analysis is useful when Precedent Transactions give nonsensical or useless results, and you want to use something other than traditional multiples to value your company. For example, if the precedent transactions were all done at EV / EBITDA multiples between 6x and 8x, and your company is currently at trading at 10x, the results don’t make sense: A public company can’t sell for less than its current multiples. So you could look at the M&A premiums instead. If the median premium is 25%, you might apply that to your company’s share price and say that a buyer might have to pay that much to do the deal.

Answer 83

You take the median historical multiple from the Public Comps, often the P / E multiple, and apply it to the future metric of the company you’re valuing (Net Income or EPS with the P / E multiple). So you assume that in 1 or 2 years, the company will be trading at the median multiple the comparable companies are currently trading at. For example, if the median P / E is 15x and the company’s Year 1 projected EPS is $1.00, you would say the company’s expected “future share price” is 15x * $1.00 = $15.00. Then, you discount this future share price to its Present Value by using a range of values for the company’s Cost of Equity. For Enterprise Value-based multiples, you have to back into the Implied Equity Value and Implied Share Price in the future years and then discount that share price.

Answer 84

The Sum-of-the-Parts methodology, where you value each division of a company separately and add them up to determine the company’s Implied Value, works well for conglomerates like General Electric that have very different divisions. The divisions operate in such different industries that it would be meaningless to value the company as a whole – no other company would be truly comparable. But Sum of the Parts also takes far more time and effort to set up because you have to find comparable companies and transactions for each division, build a separate DCF for each division, and so on. Also, you may not have enough information to do it – companies sometimes don’t disclose EBIT or CapEx by division, and they may not disclose the corporate overhead expenses that you must factor in at the end of the analysis.

Answer 85

You set up the LBO valuation by creating a leveraged buyout model where a private equity firm acquires a company for a certain price, using Debt and Equity, holds it for several years, and then sells it for a certain multiple of EBITDA. Since most private equity firms target an internal rate of return (IRR) in a specific range, you work backward and determine the purchase price required to achieve this IRR. You use the Goal Seek function in Excel to determine the maximum purchase price the PE firm could pay if it wants to realize a 20% 5-year IRR on a company that it sells for 10x EV / EBITDA. This methodology is useful for setting a floor on a company’s valuation – you’re constraining the price because of the IRR requirement. It’s also useful for estimating what a private equity firm, rather than a normal company, might be willing to pay for a company.

BIWS Valuation and DCF Analysis Flashcards

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