DCF

Question 1

Walk me through a DCF.

Answer 1

Calculates EV using PV of all future CFs that are available to all investors. You calculate FCF for 5 years and discount using WACC. Afterwards you take TV e.g., with Gordon Growth Model or a multiple and also discount it. Sum of all gives you EV.

Question 2

How do you get to FCF to Firm in DCF?

Answer 2

EBITDA
- D&A
= EBIT
* (1 – Tax Rate)
= NOPAT
- Capex
- Working Capital
\+ D&A
\+ Any other non-cash items from P&L
- Any other cash items not included in P&L

This Unlevered FCF is fictional and only used for DCF as NOPAT is no real value. If you’re asked about FCF in general, talk about FCF used in LBO (via NI).

Question 3

What are pros and cons of a DCF?

Answer 3

Pros:
- Few assumptions beyond Business Plan
- Perfect method in theory. If all inputs are “true” output is true
- Simple concept
- Quick
- Helpful for companies with few comparables
- Good for cross-checking a LBO as this is also cash focused
Cons:
- Very sensitive
- Therefore, very manipulative
- Used less than multiple (more of a support function)
- WACC is static and doesn’t allow dynamic capital structure over time
- Less important if TV is large

Question 4

What’s an alternate way to calculate FCF aside from taking NI and adjusting for D&A, Capex and WC?

Answer 4

Take CF from Operations and subtract Capex. That gets you to LCF. You need to add back the tax adj. interest expense and subtract tax adj. interest income.

Question 5

What do you use as discount rate?

Answer 5

WACC (or COE depending how you’ve set up the DCF)

Question 6

How do you calculate COE?

Answer 6

COE = rf + β * risk premium

You can also add betas for size, value, etc.

Question 7

How do you get β in COE calculation?

Answer 7

You get β for comparables from Bloomberg, unlever each one take the median of the set and then lever it based on your company’s capital structure. Then you use this levered β in your calculation (see Formula section)

Question 8

Why do you have to unlever and relever β?

Answer 8

Because the βs you get from Bloomberg etc. already reflect cap structure of company and therefore are not comparable. We want to look at how risky a company is regardless of what % debt it has. At the end of the calculation you relever it to take into account your company’s cap structure.

Question 9

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

Answer 9

Tech company because tech is viewed as riskier

Question 10

Let’s say you use LFCF instead of UFCF in a DCF. What is the effect?

Answer 10

LFCF gives you Equity Value rather than EV since the CF is only available to equity investors.

Question 11

If you use LFCF what should you use as discount rate?

Answer 11

COE rather than WACC since you’re only looking at Equity Value not EV.

Question 12

How do you calculate the TV?

Answer 12

Either apply exit multiple to Year 5 EBITDA, EBIT or FCF (Multiple method) or you can use the Gordon Growth method to estimate its value based on growth into perpetuity:
TV = Y5 FCF * (1 + growth rate) / (discount rate – growth rate)

Question 13

Why would you use Gordon Growth method?

Answer 13

In banking you most often use multiples method as you can get multiples from comps, whereas GGM you have to guess. However, you use GGM if you have no good comps or if you have reason to believe that multiples will change significantly in the industry (e.g. cyclical,…)

Question 14

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

Answer 14

Normally you use the country’s long-term GDP growth rate, inflation rate or something similarly conservative. More would be very aggressive for dev. countries.

Question 15

How do you select exit multiples when calculating TV?

Answer 15

Normally you look at the comparable companies and pick the median or something close. As with everything you look at a range rather than one single value.

Question 16

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

Answer 16

Multiples will generally have a bigger range than GGM but other than that hard to generalize.

Question 17

What’s a flaw with basing TV multiples on what public comps are trading at?

Answer 17

Multiples may change drastically in next 5 to 10 years

Question 18

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

Answer 18

If more than ~50% of EV comes from TV. In reality almost all DCFs are too dependent on future assumptions. Actually it’s quite rare to see TVs that make up less than 50% of EV. 80%-90% definitely too high.

Question 19

Should COE be higher for a $5b or $500m market cap company?

Answer 19

$500m because all else being equal, smaller companies are expected to outperform large ones (size premium).

Question 20

What about WACC?

Answer 20

Trick question. COE will be higher for $500 and COD as well assuming same cap structure (less negotiation power etc.) but if you don’t know about cap structure it can also be the other way around (e.g. if the bigger company is much more levered)

Question 21

What’s the relationship between debt and COE?

Answer 21

More debt means company is more risky so levered β will be higher. More debt therefore raises COE.

Question 22

COE tells what return an equity investor expects but what about dividends?

Answer 22

Dividends are already factored into β so we account for them in COE.

Question 23

How do we calculate COE w/o using CAPM?

Answer 23

Alternate formula but rarely used:

COE = dividends per share / share price + growth rate of dividends = dividend yield + growth rate of dividends

Question 24

Two companies are the same but one has debt and other doesn’t - which one will have higher WACC?

Answer 24

The one without debt (if the other doesn’t have too much debt); debt cheaper than equity so up to some point WACC will be lower with debt, before default risk gets too high (U-shape ~Modigliani Miller Theorem)

Question 25

What has a greater impact in DCF – 10% chg. In revenue or 1% chg. In discount rate?

Answer 25

It depends but usually the 10% chg. In revenue

Question 26

What about 1% chg. In rev. vs. 1% chg. In discount rate?

Answer 26

It depends again but probably discount rate has higher impact

Question 27

How do you calculate WACC for private company?

Answer 27

Estimate based on work done by auditors or take it from comps

Question 28

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

Answer 28

• Create own projections
• Modify management projections
• Sensitivity tables

Question 29

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

Answer 29

Banks use debt differently than other companies and do not reinvest it in the business – they use it to create products instead. Also, interest is a critical part of a banks’ business model and WC takes up huge part of their BS so DCF would not make sense. Therefore it’s more common to use a dividend discount model for valuation purposes.

Question 30

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

Answer 30

• Revenue growth vs. Terminal Multiple
• EBITDA margin vs. Terminal Multiple
• Terminal Mult. vs. Disccount Rate
• Long-term growth rate vs. discount rate

Question 31

A company has high debt and is paying off a significant part each year. How do you account for this in a DCF?

Answer 31

You don’t account for this at all in a DCF because paying off debt principal shows up in CF from Financing on the CFS but we only get down to CF from Operations and subtract Capex to get to FCF.

If we would look a LFCF then our interest expense would decline in future years due to principal being paid off but we still wouldn’t count the principal repayments themselves anywhere.

Question 32

Why would you use a mid-year convention in a DCF?

Answer 32

To represent that not 100% of the CF comes at end of each year. (You therefore use 0.5 instead of 1, 1.5 instead of 2, etc.)

Question 33

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

Answer 33

Mutliples method: you add 0.5 to the final year discount number because you usually sell after 5 years instead of 4.5 etc.
GGM: You use the final discount number as is, because you are assuming the CF grows into perpetuity and that they are still received throughout the year rather than just at the end.

Question 34

How do you calculate the per share value of a public company in a DCF?

Answer 34

Once you get EV, add cash and subtract debt, pref. stock and minority interest (and any other debt-like items) to get to Equity Value. Then you need to use a circular calculation that takes into account basic shares outstanding, options, warrants, convertibles and other dilutives. Dilution depends on the share price but share price depends on number of outstanding shares so you have to use an interative calculator from Excel or similar

Question 35

Walk me through Dividend Discount Model (DDM) that you would use instead of a DCF for financial institutions.

Answer 35

Same mechanism but dividends rather than FCF:

• Project earnings down to EPS
• Assume payout ratio and calculate dividends for next 5 or 10 years
• Discount using COE
• Calculate TV based on P/E and EPS and discount based on COE
• Sum PVs to get company’s net present per-share value

Question 36

Do you count convertible debt as debt or equity in a WACC calculation?

Answer 36

If it’s in-the-money (dilutive effect) it contributes to equity. If it’s out-of-the-money you count it as debt and use the interest rate on the convertible for COD.

Question 37

DCF for company to buy a factory for $100 in cash only in Year 4. Currently the PV of its EV according to DCF is $200. How would we change DCF to account for factory purchase and what would new EV be?

Answer 37

Capex would be $100 higher in year 4 which would reduce FCF for year 4 by $100. EV would decrease by PV of these $100.

Question 38

What would be the effect of using LFCF rather than UFCF in your DCF model?

Answer 38

You would end up with Equity Value rather than EV.