DCF

Question 1

What’s the basic concept behind a Discounted Cash Flow analysis?

Answer 1

The concept is that you value a company based on the present value of its Free Cash Flows far into the future. You divide the approach into two by estimating the value for a 5- 10 year period and its Terminal Value. You then discount those values back and them together to get the value of the company as money today is worth more than money in the future.

Question 2

Walke me through a DCF

Answer 2

1. Project company’s FCF over a 5-10 year period
2. Calculate the company’s Discount Rate, usually using WACC
3. Discount and sum up FCFs
4. Calculate Terminal Value
5. Discount Terminal Value
6. Add discounted FCFs to discounted Terminal Value

Question 3

Walk me through how you get from Revenue to Free Cash Flow

Answer 3

1. Obtain historical and present revenue and project future revenue.
2. Subtract COGs and operating expenses to obtain EBIT.
3. Apply the company’s effective tax rate and obtain NOPAT
4. Add back non- cash expenses.
5. Adjust for Working Capital
6. Subtract CapEx

For Levered Cash flow you would subtract net interest expense before applying the tax rate and subtract mandatory debt repayments at the end.

Question 4

What’s the point of using Free Cash Flow

Answer 4

You are trying to replicate the Cash Flow Statement by only including items that are recurring and predictable. And in the case of Unlevered Cash flow, you discount debt entirely.

Question 5

Why would you project a company beyond 10 years

Answer 5

You might sometimes do this if it’s a cyclical industry, such as chemicals because it may be important to show the entire cycle from low to high.

Question 6

What do you use for the discount rate

Answer 6

You use WACC for unlevered FCF and Cost of Equity for levered FCF

Question 7

How do you get from Enterprise Value to Implied Share Value

Answer 7

Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and Noncontrolling Interests (and any other debt-like items) to get to Equity Value. Then you divide by the number of outstanding shares.

Question 8

How do we interpret a large discrepancy in the Implied Per Share Value and the current share price

Answer 8

We perform more DCF analyses under different assumptions and if the discrepancy is consistent each time we say that the company is not valued correctly. If the current share price is lower than the Implied Per Share value is higher, then the company is undervalued, and if vice versa, the company is overvalued.

Question 9

Do you always leave out Cash flow from Investing and Financing sections

Answer 9

In most cases yes because they are generally non- recurring or at least do not recur in a predictable way. However, if you have additional information on how items in those sections will change you can factor them in. But, it’s really rare to do that.

Question 10

As an approximation, do you think it’s OK to use EBITDA – Changes in Operating Assets and Liabilities – CapEx to approximate Unlevered Free Cash Flow?

Answer 10

No, because you don’t take taxes into account.

Question 11

What does the change in working capital section of the FCF calculation show

Answer 11

If the company’s assets go up more than its liabilities then it is spending more cash than its getting and vice versa

Question 12

What changes if you use levered cash flow vs unlevered

Answer 12

Levered Cash flow gets you the equity value while unlevered cash flow gets you the enterprise value

Question 13

What Discount Rate do you use for Levered Cash Flow

Answer 13

Cost of Equity

Question 14

Calculation for WACC

Answer 14

WACC = Cost of Equity * (% Equity) + Cost of Debt *

% Debt) * (1 – Tax Rate) + Cost of Preferred *(% Preferred

Question 15

Calculation for Cost of Equity

Answer 15

Cost of Equity = Risk- free Rate + Equity Risk Premium * Levered Beta

Question 16

Cost of Equity tells us the return that an equity investor might expect for investing in a given company – but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 16

Thats already factored in with the Beta Value as it describes returns relative to the market- and those returns include dividends

Question 17

Alternate formula for Cost of Equity

Answer 17

Cost of Equity = (Dividends Per Share/ Share Price) + Growth Rate of Dividends

Question 18

What Beta would you use

Answer 18

Historical or Calculated using Public Company Comparables

Question 19

How can you calculate Beta Using Public Company Comparables

Answer 19

You find the average levered beta of the comparables. Then unlever it using the average Debt/Equity of the comparables. You then relever the unlevered beta by using the Debt/Equity of the company.

Unlevered Beta = Levered Beta/[1 + (1 - Tax Rate) * (Debt / Equity)]

Levered Beta = Unlevered Beta * [1 + (1 - Tax Rate) * (Debt / Equity)]

Question 20

What is the logic behind the Beta Calculation

Answer 20

You take average beta of the comparables and then unlever them to discount the debt related risk of each company’s is different as its capital structure is different. But the debt- related risk is important so you then relever it to get the final beta.

Question 21

How do you treat Preferred Stock in the formulas above for Beta?

Answer 21

It should be counted as Equity there because Preferred Dividends are not tax deductible, unlike interest paid on Debt.

Question 22

Can Beta ever be negative? What would that mean?

Answer 22

Theoretically yes. It means the company moves opposite to the market. This is very very rare.

Question 23

Would you expect a manufacturing company or a technology company to have a higher Beta?

Answer 23

Technology because it is considered riskier

Question 24

Shouldn’t you use a company’s targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?

Answer 24

Yes. It should. If we can predict the company’s future capital structure, thats what we should use to calcualte Beta and the Discount. But its very hard to come across such information, so it would be impractical to make such assumptions.

Question 25

What is the company paying in the cost of equity

Answer 25

1. They pay dividends
2. They give up any future growth in their stock by issuing shares to investors.
   It’s tricky to estimate both so with the cost of equity formula we estimate expected return

Question 26

How do you determine the firm’s optimal capital structure? What does it mean

Answer 26

The optimal capital structure is a combination of equity, debt, and preferred capital that minimizes the WACC.

Question 27

Did WACC increase or decrease during the financial crisis?

Answer 27

Basic: Companies became less valuable during the financial crisis so their net present values would decrease. Thus, it would increase the WACC.

Complex: For the complex answer look at question 15 under Discount Rate and WACC in the DCF guide

Question 28

How do you calculate Terminal Value

Answer 28

Method one: Assume that the company is being sold for a certain factor of its EBITDA, EBIT, or FCF(Multiples Method)

Method two: Gordon Growth Rate; Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) /(Discount Rate – Growth Rate)

Question 29

In banking, which method is most often used

Answer 29

The Multiples Method because it is easier to estimate a multiple using Company Comparables.

Question 30

When would you use the Gordon Growth Method

Answer 30

if you have no good Comparable Companies or if you believe that multiples will change significantly in the industry several years down the road.

Question 31

What’s an appropriate growth rate to use when calculating the Terminal Value?

Answer 31

Anything equal to or less than the GDP Growth Rate, rate of inflation, etc

Question 32

How do you select the appropriate exit multiple when calculating Terminal Value?

Answer 32

You would generally take the median of the company comparables. But usually you show a range of multiples and what the Terminal Value would look like with those multiples on a sensitivity table

Question 33

You’re looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year. Which one has the higher net present value?

Answer 33

Company A because money now is worth more than money tomorrow

Question 34

Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company?

Answer 34

$500 million because smaller companies are usually riskier (therefore outperfrom larger companies in the stock market) to invest in.

Question 35

Would WACC be higher for a $5 billion or $500 million company?

Answer 35

If the capital structures are the same, then it would be higher for the $500 million dollar company because smaller are riskier and therefore outperform larger companies.
If the capital structures are different, then it depends

Question 36

What’s the relationship between Debt and Cost of Equity?

Answer 36

Higher debt means the company is riskier and therefore means higher levered beta. This means a higher cost of equity

Question 37

Two companies are exactly the same, but one has Debt and one does not – which one will have the higher WACC?

Answer 37

The one without debt because debt is “less expensive” than equity for the following reasons

• debt is tax deductible which is why we multiply by (1 - Tax Rate)
• Debt is “senior” to equity- debt investors get paid first
• interest rates on debt are usually lower than interest rates on equity

Question 38

Let’s say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%?

Answer 38

Reducing the discount rate because it affects all parts of the DCF analysis

Question 39

The Free Cash Flows in the projection period of a DCF analysis increase by 10% each year. How much will the company’s Enterprise Value increase by?

Answer 39

Less than 10%