DCF

Question 1

What’s the point of valuation? WHY do you value a company?

Answer 1

You value a company to determine it implied value based on your views. It this value is bigger than what the current market value then it is probably a good idea to buy it yourself or advise the client on what price it should sell its company.

Question 2

But public companies already have Market Caps and share prices. Why bother valuing them?

Answer 2

Because that is only the current value and the market could be wrong. You value it to see if the market information is correct or wrong.

Question 3

What are the advantages and disadvantages of the 3 main valuation methodologies?

Answer 3

Public Comparables: they are easy to calculate, show real current market data, and they don’t project far in the future data.

There may not be enough companies in the industry, some companies are too volatile, and it may devalue the true long-term potential of the company you are valuating.

Precedent Transactions: They are based on real prices that was actually paid for companies and it can reveal the market trends that are occurring more than public comps.

But the transactions can be overpaid and misleading, there may not be enough data, and the hidden deal information can inflate the multiples.

DCF: is considered the most accurate valuation method; its not affected by market volatility, you can input specific factors that affect it and the long term trends.

But it is very dependent on those long-term assumptions and it can be tricky to calculate cost of equity and WACC.

Question 4

Which of the 3 main methodologies will produce the highest Implied Values?

Answer 4

Precedent transaction generally produces the higher implied value than public comparable because of the control premium that buyers pay. But a DCF is more dependent on your assumptions that lead to a more variable output.

Question 5

When is a DCF more useful than Public Comps or Precedent Transactions?

Answer 5

Typically, any situation when evaluating a company. But it is especially useful when looking at mature companies that produce reliable cash flows.

Question 6

When are Public Comps or Precedent Transactions more useful than the DCF?

Answer 6

When the company you are valuating is still in its early stages and it doesn’t have a consistent cash flow, then it is appropriate to look into other methodologies.

And you can go to it when you have issues with the DCF you can’t calculate the discount rate or when the cash flows fluctuate wildly.

Question 7

Which should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?
Assume the growth rates, margins, and all other financial stats are the same.

Answer 7

Although I would need more information to make an assumption. Just going of what you said, healthcare is less heavy than industrials. So that means the CapEx and working capital are going to be lower which makes cash flow as a result higher.

Question 8

How do you value an apple tree?

Answer 8

The same way you would value a company. You use a DCF and comparables. You look what cash flow the tree can generate from the apples, what other trees have traded and solded for.

You would then discount the cash flows of the tree, discount its terminal value and add it all up to come up with its implied value.

Your discount would be what you could from other trees around it that you can invest in.

Question 9

People say the DCF is an intrinsic valuation methodology, whereas Public Comps and Precedent Transactions are relative. But is that correct?

Answer 9

You can say the DCF Is more relative than others but that is not correct.

DCF projects the cash flows more than it is about its intrinsic value. DCF uses the discount rate which is linked to market data and there is also the multiples that can be used as well where it is linked to peer companies.

So DCF is less linked to the market than other methodologies, but it still has some link to it.

Question 10

Why do you build a DCF analysis to value a company?

Answer 10

Because the company’s worth is based on its present value of the future cash flow value. If the company doesn’t generate cash in the future, then it is not worth buying.

And the way you value a company is by dividing the cash flow by what the discount rate minus the cash flow growth rate is.

But that discount rate and cash flow growth rate changes over time so you need to build a DCF to forecast the cash flow in two periods. One where the rates change and one where the rates stay the same forever, the terminal period.

You take those two together and discount them to their present value to get the implied value and you compare it to the seller’s asking price to see if it worth purchasing for.

Question 11

Walk me through a DCF analysis.

Answer 11

A DCF projects the values of a company’s cash flows and terminal period and then discounts it to get the company value.

You begin by projecting the free cash flows of the first 5-10 years by making assumptions of the revenue growth rate, margins, working capital, and capex.

Then you discount those cash flows to its present value using the WACC.

Then you look at the terminal period next. You calculate those cash flows using the Gordon Growth Method or the multiples method; which represents the company’s value after those first 5-10 years. And then you discount it as well and add the two discounted periods together to get the implied value of the company.

You then look at the current value of the company using the enterprise value of the company. And you might calculate the implied price as well and compare those figures with the current share price.

Question 12

How do you move from Revenue to Free Cash Flow in a DCF?

Answer 12

Is it Unlevered Free Cash Flow? Calm. So you subtract the operating costs and COGS to get the EBIT.

Then you take the tax rate and subtract it and back the D&A.

Then you subtract the CapEx, and add the change in working capital. And then you will get the unlevered FCF figure.

But if it is Levered FCF, then you have to subtract the Net Interest Expense before the tax rate and then you factor in any changes to the debt principle.

Question 13

What does the Discount Rate mean?

Answer 13

The discount rate represents that opportunity costs that investors have in investing in similar companies in the industry.

If the discount rate is higher, that means the investors have higher potential and higher risks, and vice versa if its lower.

And as the discount rate goes up, the company becomes worth less because that means they have better investments elsewhere.

Question 14

How do you calculate Terminal Value in a DCF, and which method is best?

Answer 14

You can either use the multiples method or the Gordon Growth method.

The multiples method, you basically assume the terminal multiple of the final year. So if the EV/EBITDA is 10x and the final year EBITDA is 500 then the terminal value is going to be 5000.

With the Gordon Growth method, you actually assume the terminal growth rate on the cash flows at which it grows forever.

Terminal value would be the final year FCF x (1 + terminal growth rate / (Discount rate - terminal growth rate)

The Gordon Growth method is better because growth always slows down to under the GDP rate so it accurately captures that.

Multiples method is used because it is easier but it would imply a higher growth rate.

Question 15

What are some signs that you might be using the incorrect assumptions in a DCF?

Answer 15

If the PV of the terminal value is too high where it represents something huge like 90% of implied value. It should be close to 50%.

If the terminal growth rate is higher than the GDP.

You are double counting items that shouldn’t be. Like when you count an expense or income line into the FCF, then that shouldn’t also be counted into the enterprise value to equity value bridge.

Your final year FCF is way too high than the terminal period, like 15%. Then there is something not right about the assumptions and it needs to be adjusted to decline more over time in the explicit forecast period.

Question 16

If your DCF seems off, what are the easiest ways to fix it?

Answer 16

You can extend the forecast period to 10-15 years and adjust the growth rate accordingly as it becomes closer to the terminal period.

To avoid double counting, just be extra sure of what you are calculating.

And you can fix the terminal if its too high by simply lowering the terminal multiple or the terminal growth rate.

Question 17

How do you interpret the results of a DCF?

Answer 17

You compare the implied enterprise and equity value as well as the share price to those current market values and see if it is under or overvalued.

But you do so over a range because investing is based on probability and so you want to create a sensitivity analysis to make sure.

So for example if your implied value is between 15-20 and the current value 8 than it is pretty safe to say that it is undervalued. But if the current value is 17, then it might be value appropriately.

Question 18

Does a DCF ever make sense for a company with negative cash flows?

Answer 18

If the company is expecting positive cash flows, then yes, it is still useful to project it. But if it is not then it is better to rely on other valuations like precedent transactions and comparable analysis.

Question 19

How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from the Unlevered DCF?

Answer 19

In a levered DCF, everything is equity value based; meaning that you use levered FCF, Cost of Equity for discount rate, you use multiples like P / E to calculate the terminal value. And you don’t need to bridge back to equity value because the analysis already produces it.

APV analysis is the same thing as a unlevered DCF but it just takes interest tax shield away and values it separately and adds it to the present value at the end. And you have to use the unlevered cost of equity for discount rate instead. Which is risk-free rate + equity risk premium * median unlevered beta from public companies). You then project the interest tax shield like a forecasted FCF, discount it, do the same for its terminal value, discount that and everything up.

Question 20

Will you get the same results from an Unlevered DCF and a Levered DCF?

Answer 20

No levered DCF calculates debt principal and interest payments so levered would probably be different than unlevered DCF.

Question 21

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

Answer 21

Unlevered DCF is easier to explain and it produces consistent results. While other methods require you to project, cash and debt balances, interest expense, debt principal. And because of that, Levered DCF can spike up and produce odd results because the principal payments make it spike up in certain years.

APV doesn’t factor in the increased chances of bankruptcy because of debt while a unlevered DCF does because it uses the WACC. Which when debt increases at first, WACC goes down but then it increases past a certain point, reflecting the company’s debt danger level.

Question 22

Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?

Answer 22

You calculate it like that because unlevered FCF is a enterprise value metric where you include only the financial metrics that are relevant to all the shareholders of the business. So, if there is an item that doesn’t represent all shareholders, not part of the core business, or not reoccurring, you don’t include it.

Net interest expense - only available to debt investors
Other income / expense - Non-core assets
Most non-cash adjustments except D&A - Nonreoccurring
Items on Cash From Financing - Available to only certain investors
Most of Cash Flow from Financing - Only CapEx is reoccurring core item

Question 23

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company’s business model?

Answer 23

The change in working capital defines the business model of how it fuels its growth. It projects either that it will generate more cash than expected or how much cash it needs to grow.

And this is directly related to the company’s business model of how it records revenue. Whether it collects deferred revenue first like a software company or it records expenses before collecting the cash like a retail company.

Which is why retail companies have negative working capital because of the initial inventory paid while software companies don’t inventory and receive deferred revenue so they have positive working capital.

Overall, the working capital either increases or decreases the free cash flow but it barely makes a noticeable difference and it doesn’t matter for most companies.

Question 24

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a non-cash add-back on the Cash Flow Statement.

Answer 24

No, its seen as a cash expense not a cash add-back based because it creates additional share. Whereas D&A it’s just a timing difference where the payment is being recognized later.

It’s a non-cash add back in the context of accounting not valuation. So, if you are going to count it in, you need to factor in the diluted shares to the implied share price and increase the amount of shares.

Question 25

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 25

It doesn't matter which rate you use as long as the FCF reflects the correct cash taxes it pays. You could straight up calculate the cash tax rate and use that. You could use statuary tax rate and adjust for state/local taxes to get to cash rate. But the most common way is to simply use the effective tax rate and adjust based on deferred taxes.

Question 26

How should CapEx and Depreciation change within the explicit forecast period?

Answer 26

They should both decline in the explicit period. High growth companies spend more on capital expenditure to support the company's growth, but it stops once it switches to company maintenance stage. If the FCF is growing, then capital expenditure should never equal to and always exceed depreciation, even in the terminal period. And that is because assets are always cheaper than they are today and net PP&E always has to increase to keep FCF growing in the terminal period. But of course, if you have different assumptions on the company, then the assumptions overrule this concept.

Question 27

Should you reflect inflation in the FCF projections?

Answer 27

No you shouldn't because investors think in nominal terms when it comes to investing decisions, even the salary and price assumptions are nominal figures. But if you wanted to do so, you would need to forecast into the far into the future period but we don't know if inflation is even dropping in the next few months so how would we know inflation in the next few years.

Question 28

If the company’s capital structure is expected to change, how do you reflect it in FCF?

Answer 28

In a levered DCF, the net interest payments and debt principal will be reflected onto the FCF directly. And the cost of equity will reflect the change over time. In a unlevered DCF though, it won't show up right onto the FCF, but it will be reflected onto the WACC eventually as more debt is issued.

Question 29

What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

Answer 29

If you include an income or expense line item on income statement, you have to exclude it from the EV to Equity Value bridge and vice versa. If you excluded items on the income statement like the interest income and expense, then you have to factor in cash and debt when moving to implied equity value in an unlevered DCF.

Question 30

How do Net Operating Losses (NOLs) factor into Free Cash Flow?

Answer 30

You could either setup a NOL schedule which can rollover if a company generates a negative pre-tax income and reduces the company's cash taxes. Doing means you don't count NOL into the EV - equity value bridge. Or you can simply add NOLs as a non-core business asset at the end which is easier.

Question 31

How does the Pension Expense factor into Free Cash Flow?

Answer 31

There are many components to a pension expense including service cost, interest expense, expected rate on plan assets, amortization of gains and losses. Service cost is an operating expense that should be included in the FCF. In an unlevered DCF, you exclude the interest expense, expected rates, and any amortization, and then you subtract unfunded portion of the pension obligation when bridging between EV and equity value. These line item can be found in the income statement.

Question 32

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

Answer 32

You shouldn't speculate about future projections especially since they are non-reoccurring. But if they made an announcement of an acquisition in the near future then you do so for that year's FCF. And you have to make assumptions on the cash balance after on what was spent or will continuously be received.

Question 33

What does the Cost of Equity mean intuitively?

Answer 33

It tells you how much a company may return over the long run and how much an investor might earn each year, factoring in all the dividends and stock repurchases. For a company, cost of equity is how much it costs for them to fund their operations if they wanted to issue new shares. The company would then pay for shares through the dividends and diluting the existing investors.

Question 34

What does WACC mean intuitively?

Answer 34

Its the expected annual percentage if you invest in all parts of the company's capital structure; the debt, equity, preferred stock. Representing the cost of funding of all its sources of capital. An investor might invest into the company if the IRR exceeds the WACC.

Question 35

How do you calculate Cost of Equity?

Answer 35

Risk-Free Rate + Equity Risk Premium * Levered Beta The Risk-Free Rate represents how much you would earn if you invested in a more trust worth 20-year government bond. Levered Beta represents how volatile a stock is, factoring in its intrinsic value and risk from leverage. And Equity Risk Premium represent the average stock market return in the country above the risk-free rate. The whole idea behind is that stocks are riskier and have higher potential return than government bonds. So, you add the extra returns you get from the market, and you adjust for this investment's risk and return.

Question 36

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

Answer 36

Use the country that matches the company's exchange rate on the company's cash flows.

Question 37

What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?

Answer 37

You could take the risk free rate of a stable country like he US and add a default spread based on your country's credit rating. For example take 2.5% from the US and then you determined that the spread of Argentina is 11%, so the rate is now 13.5% accounting for the increased risk and yield of default from the country.

Question 38

How do you calculate the Equity Risk Premium?

Answer 38

There is no agreed way on how to do it but some ways are you can use the Ibotta report which gives the risk premium of the stock market. You could take a country like US's stock market average and add the default spread rate to it. So, if the US stock market is 7%, and you estimate the spread to be 3% extra then it is going to be 10%. And some people use 6-7% as a general rule and that's it.

Question 39

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

Answer 39

You can take revenue of each country and multiply it by the ERP in that market and add everything to get a weighted average. The historical US stock market returns + the default spread also works.

Question 40

What does Beta mean intuitively?

Answer 40

Levered tells how volatile a company comparative to the stock market based on its intrinsic business risk and risk from leverage. So if beta is 1 and the stock market goes down by ten percent then the company goes down by 10 percent. But if the beta is 2 and the stock market goes down by 10 percent, then beta goes down by a whopping 20%. Unlevered beta excludes risk from leverage and reflects only the intrinsic business risk, so it is always less than or equal to levered beta.

Question 41

Could Beta ever be negative?

Answer 41

Yes its possible the stock market to move at the opposite direction the company's stock performance. For example, gold performs well in recessions since it has a negative beta and so people tend to buy up a lot of gold in economic downturns. However, this is rare for companies, and it usually comes back to positive after a short period.

Question 42

Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?

Answer 42

You don't have to do that; you could simply use the company's historical levered beta. But this is a current value calculation that is based on the market. In a valuation, you are estimating the implied value of the company - what it should be worth. By unlevering the beta, you are separating the capital structure of different companies, and you are locating what the average company's intrinsic risk should be worth. You do so because your company's capital structure is different and can be calculated. You then take the median unlevered beta and relever it based on your implied capital structure of your company. You do so because there is risk from leveraging debt. You can think of re-levered beta as what is volatility of the company comparative to the market based on its current capital structure and its peer's business risk.

Question 43

What are the formulas for un-levering and re-levering Beta, and what do they mean?

Answer 43

Unlevered Beta = Levered Beta / (1 + Debt/Equity Ratio * (1 – Tax Rate)) Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 – Tax Rate)) You use a 1 + to ensure that Unlevered Beta is always less than or equal to Levered Beta. And you use the 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.

Question 44

In those formulas, you’re not factoring in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.

Answer 44

Not really. If a company with has a high debt/equity ratio then they typically have higher interest rates. And risk isn't even directly proportional to interest rates. Big companies can have larger interest rates, but it wouldn't affect well established companies, whereas smaller companies are going to definitely be affected.

Question 45

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

Answer 45

Yes, unlevered and levered beta has nothing to do with unlevered and levered FCF. Capital structure is required in both cost of equity and WACC, so Levered beta is needed regardless.

Question 46

What are some different ways to calculate Beta in the Cost of Equity calculation?

Answer 46

You could either use predicted beta or historical beta. Historical beta being the previous beta that the company has been using or of comparable companies. And if you do predicted beta and relever beta, then you can base it on the company's targeted capital structure. But of these methods will produce similar results and it should be used together when calculating WACC and Cost of Equity.

Question 47

How would you estimate the Cost of Equity for a U.S.-based technology company?

Answer 47

Guestimate and I get the idea so say it.

Question 48

How do you calculate WACC, and what makes it tricky?

Answer 48

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.

Question 49

WACC reflects the company’s entire capital structure, so why do you pair it with Unlevered FCF? It’s not capital structure-neutral!

Answer 49

Well unlevered FCF means cash flow that is available to all investors and WACC calculates all the investors of the capital structure. All discount rates affect all investors so there isn't really neutrality when each part of a capital structure affects other parts.

Question 50

Should you use the company’s current capital structure or optimal capital structure to calculate WACC?

Answer 50

You want to capture what the company's capital structure and worth is going to be in the future not what it is right now. So, it is better to choose optimal because the DCF is based on the company's implied value on its future cash flows. You will be using median percentages from comparable companies as proxy.

Question 51

Should you use Total Debt or Net Debt to determine the capital structure percentages in the WACC calculation?

Answer 51

Its better to use total debt because 1) Cash does not always offset debt as sometimes it is not possible to pay your debt off early or there will be a penalty. 2) And if you have a high cash balance as a company, you would get results that doesn't make sense since you now have negative debt after subtracting the cash from it. Capital structure percentage of WACC = Equity Value + Debt + Preferred Stock

Question 52

Why is Equity more expensive than Debt?

Answer 52

Because the expected returns are higher on equity than debt. Companies usually have a beta of 1 or higher which is 10-11% potential return based on stock market. And on top of that debt is tax deductible so whatever percentage interest rate you receive will be lower. For a company to have more expensive debt than equity, debt would have to be at around 17% at a 40% tax rate, but that is not possible just yet.

Question 53

How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?

Answer 53

Preferred stock is more expensive than debt and less expensive than equity because it produces higher coupon rates than debt and less than equity. Although preferred dividends not tax-deductible, they get paid first for the company's assets before common stock investors do.

Question 54

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC calculation, and what do they mean?

Answer 54

The costs represent marginal rates of how it would cost if a company issued additional debt or preferred stock. You can calculate this by taking the weighted average coupon rate of company's current issuances of debt and preferred stock. Or you could use the market value of the company's bond which is the Yield to Maturity. You could also take the risk-free rate and add the default spread of a company based on what you think the credit rating will be after it issues more debt.

Question 55

How do convertible bonds factor into the WACC calculation?

Answer 55

If the company's share price exceeds the set convertible bond rate, then the bond is converted into equity resulting more diluted shares and in equity value increasing and the WACC increasing as a result since equity is more expensive than debt. But if it doesn't meet the strike price, then it will remain as debt for the firm and use the coupon rate to calculate it, to which it will decrease WACC since debt is cheaper. Convertible bonds almost always reduce WACC since they represent debt for that time period and the coupon rates on them are cheaper than regular debt. But this is for current capital structure, you can't factor in convertible bonds on implied assumptions.

Question 56

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

Answer 56

Well Cost of Equity and Cost of Debt are both going to always increase as result because the increased chance of bankruptcy affects all investors. But WACC will initially decrease because of the tax savings but as more debt is issued it will curve and start to increase because the increased chance of bankruptcy will start to heighten.

Question 57

How do those figures change as the company uses less Debt?

Answer 57

The Cost of Equity and Cost of Debt since less debt means less chance of bankruptcy for all investors. If the debt was already high, then the WACC would go lower but if debt was low than WACC would go higher.

Question 58

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect its WACC?

Answer 58

It is going to be higher since 20% is fairly low for debt. But if you are using targeted, not current capital structure than this change won't affect WACC since the calculation is dependent on comparable companies.

Question 59

Should you ever use *different* Discount Rates for different years in a DCF?

Answer 59

If a company is not mature yet and it is going to be growing for the next few years and stabilize, then yes discount rate can start at a certain number and change by half a percent each year in explicit forecast period until it matures. But it wouldn't make sense to do it for companies that are already mature, and their discount rate doesn't change much.

Question 60

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

Answer 60

In the explicit period, everything changes year over year; the discount rate, the cash flow growth rate. In the terminal period, they stay the same and assume the company stays in a steady state.

Question 61

What’s the intuition behind the Gordon Growth formula for Terminal Value?

Answer 61

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 company is worth less if the discount rate is higher and worth more if the terminal FCF growth rate is higher. Example: 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.

Question 62

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions?

Answer 62

Neither you use both as starting points for your analysis and then you adjust as you see the reasonable FCF Growth Rates are forecasted. It's better to start off with Public Comps since Precedent Transactions has paid premiums within the multiples. And then you adjust multiple until you find a reasonable Terminal FCF Growth Rate.

Question 63

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?

Answer 63

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!

Question 64

Why do you need to discount the Terminal Value back to its Present Value?

Answer 64

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.

Question 65

When you discount the Terminal Value, why do you use the number of the last year in the forecast period for the discount period (for example, 10 for a 10-year forecast)? Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?

Answer 65

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.

Question 66

What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?

Answer 66

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.

Question 67

The diluted share count includes dilution from the company’s in-the-money options. But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?

Answer 67

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.

Question 68

How can you check whether or not your Terminal Value estimate is reasonable?

Answer 68

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.

Question 69

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

Answer 69

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.

Question 70

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Answer 70

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.

Question 71

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

Answer 71

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).

Question 72

Which assumptions make the biggest impact on a DCF?

Answer 72

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.

Question 73

Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?

Answer 73

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.

Question 74

Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?

Answer 74

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.

Question 75

Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase the Discount Rate from 9% to 10%?

Answer 75

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.

Question 76

Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in every year. Which company will have the higher Implied Value in a DCF?

Answer 76

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.

Question 77

How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

Answer 77

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.

Question 78

Can you walk me through how you use Public Comps and Precedent Transactions in a valuation?

Answer 78

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.

Question 79

Why is it important to select Public Comps and Precedent Transactions that are similar?

Answer 79

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.

Question 80

How do you select Comparable Companies and Precedent Transactions?

Answer 80

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: x Comparable Company Screen: U.S.-based steel manufacturing companies with over $500 million in revenue. x Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA. x Precedent Transaction Screen: Latin American M&A transactions over the past 3 years involving consumer/retail sellers with over $1 billion USD in revenue. x Precedent Transaction Screen: Australian M&A transactions over the past 2 years involving infrastructure sellers with over $200 million AUD in revenue.

Question 81

Are there any screens you should AVOID when selecting Comparable Companies and Precedent Transactions?

Answer 81

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.

Question 82

Both Public Comps and Precedent Transactions seem similar. What are the main differences?

Answer 82

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: x 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. x Metrics and Multiples: You focus more on historical metrics and multiples, especially LTM revenue and EBITDA as of the announcement date. x Calculations: All the multiples are based on the purchase price as of the announcement date of the deal. x 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.

Question 83

Can you walk me through the process of finding market and financial information for the Public Comps?

Answer 83

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.

Question 84

Can you walk me through the process of finding market and financial information for the Precedent Transactions?

Answer 84

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.

Question 85

How do you decide which metrics and multiples to use in these methodologies?

Answer 85

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability-based 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.).

Question 86

Why do you look at BOTH historical and projected metrics and multiples in these methodologies?

Answer 86

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.

Question 87

When you calculate forward multiples for the comparable companies, should you use each company’s Current Equity Value or Current Enterprise Value, or should you project them to get the Year 1 or Year 2 values?

Answer 87

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.

Question 88

What should you do if some companies in your set of Public Comps have fiscal years that end on June 30th and others have fiscal years that end on December 31st?

Answer 88

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: x Start with the company’s full June 30th fiscal-year results. x Add the June 30th – December 31st results from this year. x 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.

Question 89

How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you’re valuing?

Answer 89

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.

Question 90

Is it valid to include both announced and closed deals in your set of Precedent Transactions?

Answer 90

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.

Question 91

Why do Precedent Transactions often result in more “random” data than Public Comps?

Answer 91

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.

Question 92

How do you factor in earn-outs and expected synergies in Precedent Transactions?

Answer 92

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.

Question 93

Are there any rules about filtering out deals for less than 100% of companies or about stock vs. cash deals in Precedent Transactions?

Answer 93

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 minority-stake 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.

Question 94

If there’s a Precedent Transaction where the buyer acquired 80% of the seller, how do you calculate the valuation multiples?

Answer 94

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.

Question 95

Why do you use median multiples rather than average multiples or other percentiles?

Answer 95

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.