DCF Flashcards
What’s the point of valuation? WHY do you value a company?
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.
But public companies already have Market Caps and share prices. Why bother valuing them?
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.
What are the advantages and disadvantages of the 3 main valuation methodologies?
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.
Which of the 3 main methodologies will produce the highest Implied Values?
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.
When is a DCF more useful than Public Comps or Precedent Transactions?
Typically, any situation when evaluating a company. But it is especially useful when looking at mature companies that produce reliable cash flows.
When are Public Comps or Precedent Transactions more useful than the DCF?
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.
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.
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.
How do you value an apple tree?
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.
People say the DCF is an intrinsic valuation methodology, whereas Public Comps and Precedent Transactions are relative. But is that correct?
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.
Why do you build a DCF analysis to value a company?
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.
Walk me through a DCF analysis.
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.
How do you move from Revenue to Free Cash Flow in a DCF?
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.
What does the Discount Rate mean?
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.
How do you calculate Terminal Value in a DCF, and which method is best?
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.
What are some signs that you might be using the incorrect assumptions in a DCF?
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.
If your DCF seems off, what are the easiest ways to fix it?
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.
How do you interpret the results of a DCF?
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.
Does a DCF ever make sense for a company with negative cash flows?
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.
How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from the Unlevered DCF?
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.
Will you get the same results from an Unlevered DCF and a Levered DCF?
No levered DCF calculates debt principal and interest payments so levered would probably be different than unlevered DCF.
Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?
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.
Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?
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
How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company’s business model?
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.
Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a non-cash add-back on the Cash Flow Statement.
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.
What’s the proper tax rate to use when calculating FCF – the effective tax rate, the statutory tax rate, or the cash tax rate?
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.
How should CapEx and Depreciation change within the explicit forecast period?
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.
Should you reflect inflation in the FCF projections?
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.
If the company’s capital structure is expected to change, how do you reflect it in FCF?
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.
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?
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.
How do Net Operating Losses (NOLs) factor into Free Cash Flow?
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.
How does the Pension Expense factor into Free Cash Flow?
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.
Should you ever include items such as asset sales, impairments, or acquisitions in FCF?
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.
What does the Cost of Equity mean intuitively?
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.
What does WACC mean intuitively?
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.
How do you calculate Cost of Equity?
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.
If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?
Use the country that matches the company’s exchange rate on the company’s cash flows.
What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?
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.
How do you calculate the Equity Risk Premium?
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.
