DCF Flashcards
(29 cards)
Walk me through a DCF
DCF is one of the most fundamental valuation techniques and it operates under the theory that a company’s value is equal to the present value of all its future cash flows. To do a DCF, we have to consider the cash flows in 2 stages:
1. In the first stage, assumptions about free cash flows are subject to change. And to predict cash flows in this first stage, we predict revenue, assume operating margin, in addition to forecasting changes in net working capital, CapEx, depreciation, etc, and then just apply the formula EBIT(1-tax) + noncash expense - changes in working capital - CapEx
2. In the second stage, we predict free cash flow using GGM or multiples method
3. Discount to present day using t = how long the explicit forecast period is.
Explain the Gordon Growth Method and Multiples Method in detail. Which one is usually better?
Gordon Grow Method is usually better. This is because choosing a multiple to use can be difficult in the sense that it is easy to overshoot.
How does using levered vs unlevered free cash flow change DCF?
UFCF is like the default DCF. You predict unlevered free cash flows discount them using WACC to get enterprise value. When using LFCF, there are 3 big changes:
1. Using cost of equity rather than WACC to discount
2. Getting equity value instead of enterprise value
3. If using multiple to calculate TV, use an equity-based multiple
What is the the WACC? How do you calculate it? And why does it pair with Unlevered Free Cash Flow?
Cost of debt * (1-tax rate) * (D/D + E) + Cost of equity * (E/D + E). It represents the average cost of lending. I.e. the expected annual return if you were to invest proportionally in all parts of the company’s capital structure. It pairs with UFCF because it pertains to all stakeholders of a business, which is something LFCF does not.
It is forward-looking, meaning: how much would it cost to finance 1 more dollar of operations?
What is mid-year notation in DCF?
Mid year notation is when we discount cash flows to t- 0.5 instead of t. This is more accurate because it works under the assumption that we get our cash flows sometime in the middle of the year rather than the end.
What is a stub year in DCF?
Stub year is an initial period in our DCF that we have to account for because we are discounting halfway through the year. How it works is that we have to subtract free cash flows from the first half (or however long) from this current time period, and discount all cash flows to t-(stub period length in years) instead of t.
What is the cost of equity? How do I calculate it?
Cost of equity is the minimum rate of return that equity investors expect from holding onto a company’s stock. You calculate it by adding the risk free rate (10 year bond rate) with (levered) beta * (equity risk premium). Equity risk premium is how much more a country’s market is expected to earn over the risk free rate.
How do I know if my terminal growth rate and multiple make sense?
Terminal growth rate and multiples imply each other, meaning that if you have one you can calculate the other. Therefore, to see if our multiple/growth rate makes sense, we start with our assumption, calculate the other metric, and see if that answer makes sense. The formula we use is g = r - 1/multiple. For example, if we assume 20x multiple and discount rate of 10%, that gives us terminal growth rate of 5%, which is way too high given economy grows around 2-3%.
Again, how do you calculate UFCF and LFCF? What do they represent?
UCFC = EBIT(1-tax rate) + non-cash expense (D&A) - net change in working capital - CapEx.
LFCF = Net income (to common) + non-cash expense (D&A) - net change in working capital - CapEx - debt repayments
How do you go from revenue to unlevered free cash flow?
(Revenue - COGS - operating expenses)(1 - tax rate) + noncash expenses - net change in working capital - CapEx.
Will you get the same valuation from DCF using UFCF and LFCF? Why?
No we will not. The biggest reason that I know of is due to the fact that they handle debt differently. In UFCF DCF debt interest is handled indirectly in WACC formula, but in LFCF DCF debt is accounted for directly by subtracting interest expense.
What is the logic behind the main components of Unlevered Free Cash Flow? For example, why does it include the Change in Working Capital but not the Net Interest Expense?
UFCF represents cash flow generated from operations that is available to all stakeholders in a company. Therefore, for something to be in UFCF, it must be recurring, relevant to business operations, and reachable (accessible) to all stakeholders. In this case change in working capital is recurring business operation so its included, but net interest expense is only available to debt lenders, so it is not included.
What’s the relationship between subtracting an expense in the FCF projections and the Enterprise-Value-to-Equity-Value “bridge” at the end of the DCF?
Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a noncash add-back on the Cash Flow Statement.
No. Stock-based compensation while not noncash, does affect free cash flow by diluting share count and effectively decreasing the cash for every individual share.
What’s the intuition behind the Gordon Growth formula for Terminal Value?
The intuition behind GGM is that all companies will eventually reach maturity, and when that happens their cash flows become more stable and predictable. This allows us to use a constant growth rate to estimate terminal value.
If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions? Why?
Public comps is most likely the better choice here. Precedent transactions carry the control premium, which may inflate the multiples and make it hard to get an accurate reading of TV.
How do you pick the Terminal Growth Rate when calculating the Terminal Value using the
Gordon Growth Method?
Choose a growth rate that is less than the discount rate and makes sense given macroeconomic conditions like interest rates, inflation, etc.
Does it ever make sense to use a negative Terminal FCF Growth Rate?
Yes. For example, pharma company that lost their patent.
How do you choose an appropriate multiple to calculate the TV?
You’ll first want to find comparable companies using public comp. From there, choose a multiple that makes sense, meaning 1. is equity multiple if using UFCF and enterprise multiple if LFCF and 2. is a reasonably number. To check if multiple is a reasonable number, we can calculate the terminal growth rate that the multiple implies. g = r - 1/multiple.
Explain how you deal with leases and lease accounting in a DCF.
You have just finished building a DCF for a new client. What are some potential “warning signs” that your assumptions may not be correct?
Let’s say that the central bank has just raised short-term interest rates from 2% to 5% to fight inflation. How will this affect the WACC and the DCF valuation of a company
Because short term interest rates are now higher, those short-term investments are now a lot more appealing (risk free rate increases). Therefore, in order to persuade investors to continue investing, they need to promise higher rates of return. This increases WACC and therefore lowers the DCF valuation of a company.
The government has just decided to cut the corporate tax rate in your country from 35% to 20%. How will WACC and the DCF output of your valuation change?
Get back to this
If the tax rate goes down, the cost of debt increases because interest now has a lower tax benefit. Because of increased risk surrounding debt, cost of equity also tends to increase since they now shoulder some of the burden. WACC increases. However, the FCF also increases due to the tax cut, and its effects usually offset the WACC increase such that end value is higher.
You’re building a 10-year DCF for a growth-oriented tech company. Your VP reviews your model and asks you to extend the forecast period to 20 years. How will the output change?
Biggest difference is that PV of TV will account for less of your overall value. (like 50 vs 70%). Its hard to say if overall valuation will be higher or lower just because it depends on how the numbers shake out.
