DCF (basic) Flashcards
(24 cards)
- Walk me through a DCF.
A Discounted Cash Flow (DCF) values a company by projecting its future free cash flows and discounting them back to present value using the discount rate (typically WACC).
Step-by-step:
1. Project Free Cash Flows (FCF)
Typically for 5 to 10 years
Start with Revenue, subtract operating costs and taxes, then adjust for:
Non-cash items (e.g. Depreciation)
Changes in Working Capital
Capital Expenditures
2. Calculate Terminal Value
Represents the company’s value beyond the projection period
Two methods:
Gordon Growth (Perpetuity): assumes FCF grows forever
Exit Multiple: based on a multiple of Year 5 or Year 10 EBITDA/EBIT
3. Discount FCF and Terminal Value to Present Value
Use the discount rate (usually WACC for Unlevered FCF)
Discount each year’s FCF and the Terminal Value back to Year 0
4. Sum the present values of the FCFs and Terminal Value
This gives you the company’s Enterprise Value
5. Move from Enterprise Value to Equity Value
Subtract Net Debt, Preferred Stock, Minority Interest
Add Cash if needed
6. Divide Equity Value by Fully Diluted Shares Outstanding
Gives you the company’s Implied Share Price
- Walk me through how you get from Revenue to Free Cash Flow in the projections.
- Start with Revenue
This is the top line — total sales for the year - Subtract Operating Expenses and Cost of Goods Sold (COGS)
Gives you EBIT (Earnings Before Interest and Taxes), also known as Operating Income - Apply the Tax Rate
Calculate NOPAT (Net Operating Profit After Tax):
NOPAT = EBIT × (1 – Tax Rate) - Add back Non-Cash Charges
Most commonly Depreciation and Amortisation
These reduce EBIT but don’t affect cash, so you add them back - Subtract Changes in Working Capital
If working capital increases, it’s a use of cash (e.g. more inventory, more receivables)
If it decreases, it’s a source of cash - Subtract Capital Expenditures (CapEx)
Represents money spent on physical assets like property, equipment, or technology
This is a real cash outflow, so it must be subtracted
Result: Unlevered Free Cash Flow (UFCF)
This is the cash flow available to all investors (debt and equity)
You then discount these UFCFs using WACC
- What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?
You can calculate Free Cash Flow by starting with EBIT (Operating Profit) instead of Net Income. This gives you Unlevered Free Cash Flow, which is the version we use in a standard DCF.
We don’t use net income as it includes:
Interest expense (so its after debt payments)
Capital structure (how much debt vs equity)
So this gives Leveraged Free Cash Flow, which only shows what’s left for equity investors, but in a DCF we want to value the entire company, not just the equity, so we use Unlevered Free Cash Flow, and that means we need to start with EBIT
This is the standard way to calculate Unlevered Free Cash Flow:
EBIT
= Operating Profit (before interest and taxes)
Subtract taxes
= EBIT × (1 – tax rate)
→ This gives you “Net Operating Profit After Tax” (NOPAT)
Add Depreciation and Amortisation
→ These are non-cash expenses that reduced EBIT, so we add them back
Subtract Change in Working Capital
→ If working capital increases, cash goes out (so subtract); if it decreases, cash comes in (so add)
Subtract Capital Expenditures (CapEx)
→ These are real cash outflows used to maintain or grow the business
- Why do you use 5 or 10 years for DCF projections?
Balance between visibility and practicality.
You use 5 to 10 years because that’s typically how far out management teams can provide reasonably accurate forecasts for revenue, margins, and cash flow
Beyond that, predictions become too speculative, and the business is likely to undergo structural changes (new products, markets, M&A, etc.)
Why not shorter?
Less than 5 years may miss out on full value creation (e.g. margin expansion or investments paying off)
Why not longer?
More than 10 years adds excessive uncertainty
Forecasts lose credibility due to economic cycles, market changes, or internal shifts
- What do you usually use for the discount rate?
WACC = Weighted Average Cost of Capital
It’s the average return a company must pay to all its investors — both debt holders (lenders) and equity holders (shareholders) — to compensate them for putting money into the business.
Imagine a company is funded like this:
50% from equity (shareholders)
50% from debt (loans or bonds)
Each group wants a return:
Shareholders want 8% (Cost of Equity)
Lenders want 5% (Cost of Debt)
But the company gets a tax break on interest, so the after-tax Cost of Debt is lower.
WACC is the average of those two costs, based on how much of each the company uses.
So in this example:
WACC = (50% × 8%) + (50% × 5% after tax)
WACC = blended cost of capital = ~6.5%
→ This is the rate you’d use to discount future cash flows in a DCF.
Why do we use WACC in a DCF?
Because the company’s cash flows are going to both debt and equity investors
→ So WACC reflects the required return for the whole capital structure
→ It tells us what return investors expect based on the risk they’re taking
We use Cost of Equity instead for Leveraged Free Cash Flow as we’re only valuing the equity, not the full enterprise
- How do you calculate WACC?
WACC = (E / (E + D)) × Cost of Equity + (D / (E + D)) × Cost of Debt × (1 – Tax Rate)
Where:
E = Market value of equity (i.e. equity value or market cap)
D = Market value of debt
Cost of Equity = Estimated using CAPM
Cost of Debt = Average interest rate the company pays on debt
Tax Rate = Applied because interest is tax-deductible
Steps:
Calculate Cost of Equity using CAPM:
Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
Determine Cost of Debt:
Use the company’s current borrowing rate or interest expense ÷ total debt
Adjust for tax: Cost of Debt × (1 – Tax Rate)
Get capital structure weights:
Use market values, not book values, for both equity and debt
Calculate % equity and % debt of total capital
Plug into WACC formula:
Multiply each cost by its weight
Add them together for the final WACC
- How do you calculate the Cost of Equity?
Cost of Equity is the return that shareholders expect to earn in exchange for the risk they take by investing in a company’s stock. It reflects the minimum rate of return the company must deliver to keep investors satisfied, whether through dividends or share price growth. From the company’s perspective, it’s the “cost” of using shareholder capital, just like interest is the cost of using debt. If the company can’t meet this expected return, investors will choose to invest elsewhere.
The Cost of Equity is calculated using the Capital Asset Pricing Model (CAPM), which estimates the return that investors expect for holding a company’s stock, based on its risk relative to the market.
Because essentially the price is relative to the expected return
CAPM Formula: Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
Explanation of each component:
Risk-Free Rate
Return on a “safe” investment, typically a 10-year government bond
Represents the baseline return with zero risk
Beta
Measures how volatile the stock is relative to the market
A Beta of 1.0 = moves in line with the market
1.0 = more volatile (riskier); <1.0 = less volatile
Equity Risk Premium
The extra return investors require for investing in equities over a risk-free asset
Usually between 4% and 7% based on long-term market averages
- How do you get to Beta in the Cost of Equity calculation?
Beta measures a stock’s volatility relative to the market, and it’s a key input in calculating Cost of Equity using CAPM.
Step-by-step process:
Find the Beta of comparable public companies
Use published sources like Bloomberg, Capital IQ, or Yahoo Finance
These Betas are usually levered (they reflect each company’s capital structure)
Un-lever each comparable company’s Beta
This removes the effect of each company’s debt
Formula:
Unlevered Beta = Levered Beta ÷ [1 + (Debt/Equity) × (1 – Tax Rate)]
Take the average of the Unlevered Betas
This gives you a pure measure of industry risk
Re-lever the Beta for your target company
Reflects the risk based on your company’s debt level
Formula:
Re-levered Beta = Unlevered Beta × [1 + (Debt/Equity) × (1 – Tax Rate)]
Use the re-levered Beta in CAPM to calculate Cost of Equity
If no comparable companies, use the industry average Beta, or the historical average Beta of the company, or make a reasoned estimate based on the company’s risk profile where riskier = higher Beta (and higher Cost of Equity).
- Would you expect a manufacturing company or a technology company to have a higher Beta?
You would expect the technology company to have a higher Beta.
Why?
Tech companies tend to:
Have less predictable cash flows
Be more sensitive to market trends and investor sentiment
Operate in fast-moving, innovation-driven environments
Have higher growth potential, but also higher volatility
Manufacturing companies typically:
Have more stable and asset-heavy operations
Face slower but steadier growth
Are less volatile, especially in established sectors
- Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what is the effect?
If you use Levered Free Cash Flow instead of Unlevered, the DCF will value the equity of the company directly, not the total Enterprise Value.
Key differences:
Unlevered Free Cash Flow (UFCF)
Excludes interest payments → cash flow available to all capital providers (debt and equity)
DCF gives you Enterprise Value
Discount using WACC
Levered Free Cash Flow (LFCF)
Includes interest and debt repayments → cash flow available to equity holders only
DCF gives you Equity Value directly
Discount using Cost of Equity
Effect of using Levered FCF:
You’re skipping the need to calculate Enterprise Value and then subtract debt
But your projections must include:
Interest expense
Debt repayments
Changes in debt levels
- If you use Levered Free Cash Flow, what should you use as the Discount Rate?
If you’re using Levered Free Cash Flow in a DCF, the correct discount rate is the Cost of Equity, not WACC.
Why?
Levered Free Cash Flow represents the cash available only to equity holders (after debt payments)
So you should use a rate that reflects the return equity investors require → Cost of Equity
WACC includes both debt and equity costs, which would overstate the value if you’re only valuing the equity portion
- How do you calculate the Terminal Value?
Terminal Value estimates the company’s value beyond the projection period (usually after Year 5 or Year 10), since we can’t forecast cash flows forever.
There are two main methods:
1. Gordon Growth Method (Perpetuity Growth)
Assumes the company’s Free Cash Flows will grow at a constant rate forever after the final projected year
Best used when the company is expected to operate indefinitely and you have a reasonable, steady growth assumption
Formula:
Terminal Value = Final Year FCF × (1 + g) ÷ (r – g)
Where:
Final Year FCF = Free Cash Flow in the last forecasted year
g = Long-term, constant growth rate (typically between 1% and 3%)
r = Discount rate (usually WACC)
When to use it:
When the company has stable, predictable long-term growth
Common in DCFs for mature companies or infrastructure assets
2. Exit Multiple Method
Assumes the company is sold at the end of the forecast period for a valuation multiple, such as EV/EBITDA or EV/EBIT
Based on how comparable companies are valued today
Formula:
Terminal Value = Final Year EBITDA (or EBIT) × Exit Multiple
Example:
Final Year EBITDA = $120 million
Exit Multiple = 10×
→ Terminal Value = $1.2 billion
When to use it:
When there are strong comparable company multiples
Common in transaction-oriented contexts like M&A or private equity
- Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?
You would use the Gordon Growth Method instead of the Exit Multiple Method when:
a) You don’t have reliable comparable companies
If there are no clear or relevant multiples available from similar companies, the Exit Multiple method becomes subjective or unreliable
b) The company is expected to operate indefinitely
The Gordon Growth method assumes steady, perpetual growth, which is more appropriate for mature, stable businesses (e.g. utilities or infrastructure)
c) You want a more theoretical, intrinsic approach
Gordon Growth is based on cash flow fundamentals and long-term assumptions, not on current market valuations
It’s especially useful when you want to avoid using market-driven or cyclical multiples
- What’s an appropriate growth rate to use when calculating the Terminal Value?
The appropriate growth rate for the Gordon Growth method is typically 1% to 3% in developed markets.
It should not exceed the long-term expected growth rate of the economy or inflation
Why?
Terminal Value assumes the company grows forever, so the growth rate must be conservative and sustainable
If the growth rate is too high, the valuation becomes unrealistically large and overly sensitive
Guidelines:
For a company in a mature industry in a stable country:
→ Use ~2%, in line with inflation or GDP growth
For a company with some long-term upside potential, but still stable:
→ 2.5–3%
For a company in a low-growth or declining market:
→ Use <2%, possibly even 0%
- How do you select the appropriate exit multiple when calculating Terminal Value?
To select the appropriate exit multiple, you typically:
1. Look at current trading multiples for comparable companies
For example, if similar companies are trading at 9–11× EBITDA, you might choose 10× as your exit multiple
2. Use the same multiple range as in your Public Comparables or Precedent Transactions analysis
Keeps your valuation consistent across methods
3. Avoid overly optimistic assumptions
If the company is expected to grow faster than peers, it may justify a multiple at the higher end of the range — but always with caution
4. Cross-check with historical multiples
Make sure the chosen multiple is not outside the typical historical range for the sector
Guidelines:
Stable, mature businesses → lower multiples
High-growth or high-margin businesses → potentially higher multiples
But multiples should reflect market norms, not projections
- What’s the flaw with basing terminal multiples on what public company comparables are trading at?
- Market timing risk
Public comps reflect today’s valuations, which may be:
Inflated during bull markets
Depressed during bear markets
If you apply those multiples to a terminal year (e.g. Year 5 or Year 10), they may no longer be appropriate - Cyclicality
Valuation multiples can vary significantly based on the stage of the economic cycle
Applying today’s multiple in 5–10 years might misstate value if conditions have changed - Mismatch with long-term assumptions
A DCF uses long-term forecasts — but using a short-term, market-driven multiple to calculate Terminal Value introduces inconsistency
- How do you know if your DCF is too dependent on future assumptions?
Your DCF is too dependent on future assumptions if a large portion of the company’s total value comes from the Terminal Value.
If over 70–80% of the DCF’s total value is from the Terminal Value, it suggests the model is heavily relying on what happens after the forecast period, not during it
This is a problem because:
* Terminal Value is based on simplified, long-term assumptions (e.g. constant growth or market multiples)
* If these assumptions are off — even slightly — it can skew the entire valuation
* It may indicate your explicit cash flow projections are too conservative or too short
To fix it:
Revisit and refine your near-term projections
Use sensitivity analysis to show how dependent the output is on Terminal Value inputs
Consider both Gordon Growth and Exit Multiple methods for comparison
- Should Cost of Equity be higher for a $5 billion or $500 million market cap company?
Cost of Equity should be higher for the $500 million company.
This is because smaller companies are generally considered riskier investments:
Less diversified
Less access to capital
More volatile earnings
Less pricing power or market dominance
Investors demand a higher return to compensate for this higher risk
→ This translates to a higher Cost of Equity
In CAPM terms:
Beta is likely to be higher for the smaller company
Size premium may also be added for small-cap stocks, increasing the Cost of Equity further
- What about WACC – will it be higher for a $5 billion or $500 million company?
WACC is usually higher for the $500 million company.
This is because cost of Equity is higher for smaller companies (as explained in Q20) due to:
* Greater risk
* Higher volatility
* Potential lack of liquidity
Cost of Debt is also typically higher:
* Smaller firms have lower credit ratings or less access to cheap financing
* Lenders demand higher interest rates to compensate for risk
* Smaller companies may also use less debt in their capital structure
→ Which reduces the “cheap” component of WACC (since debt is tax-deductible and lower cost than equity)
- What’s the relationship between debt and Cost of Equity?
There is a positive relationship — as a company takes on more debt, its Cost of Equity tends to increase.
Why?
More debt = higher financial risk
Equity holders are now last in line behind more debt holders
In a downturn, they’re less likely to be repaid
As financial leverage increases, the volatility of equity returns increases
→ This leads to a higher Beta
→ Which increases Cost of Equity through the CAPM formula
- Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?
The company with no debt will generally have the higher WACC.
Because:
Debt is cheaper than equity:
* Lenders get paid first, so they require lower returns
* Interest on debt is tax-deductible, making it even cheaper
In a blended average (WACC), including a reasonable amount of debt brings down the overall cost of capital
The company with no debt is funded entirely by equity
→ And equity is more expensive than debt
→ So its WACC is just the Cost of Equity, which is higher
But… if debt is too high:
The company becomes riskier
Cost of equity increases due to higher financial risk
After a point, WACC can start to rise again
- How do you calculate WACC for a private company?
Calculating WACC for a private company is similar to a public one, but you face data limitations, so you need to rely more on estimates and comparable data.
Key steps:
1. Estimate the Cost of Equity (no market cap or Beta available):
Use the CAPM formula, but:
* Get Beta from comparable public companies
Un-lever and re-lever it using the private company’s target capital structure
* Use a reasonable equity risk premium (e.g. 4–6%)
* Risk-free rate = government bond yield
* You might also add a size or illiquidity premium to reflect private company risk
2. Estimate the Cost of Debt:
* Use the company’s current borrowing rate if known
* Or estimate based on similar-sized companies in the same industry
* Apply the after-tax adjustment: Cost of Debt × (1 – Tax Rate)
3. Estimate capital structure weights:
* Use target or industry-average Debt/Equity ratios
* Private companies don’t have market caps, so use estimated or book values as a proxy
- Why would you not use a DCF for a bank or other financial institution?
You generally don’t use a DCF for banks and financial institutions because their business models and financial statements are fundamentally different from typical companies.
Key reasons:
1. Banks don’t reinvest through CapEx
* Their “investment” is through issuing loans and managing capital reserves — not buying physical assets
* So traditional DCF adjustments like CapEx and Working Capital are not meaningful
2. Interest is a core part of operations
* Unlike most companies, banks earn money through interest, and interest expense is an operating cost
* This blurs the line between operating and financing activities, making WACC-based DCFs less relevant
3. Highly regulated capital structure
* Banks are subject to capital requirements (Basel III, etc.), and their debt/equity mix is set by regulation, not market forces
* This makes estimating a consistent WACC and capital structure difficult
4. Better methods exist
* Banks are more often valued using:
* P / E or P / Book Value multiples
* Dividend Discount Models (DDM) — since many banks pay stable, regular dividends
- What types of sensitivity analyses would we look at in a DCF?
Sensitivity analysis in a DCF tests how changes in key assumptions affect the company’s valuation. It helps assess the robustness of the model and highlights which assumptions have the most impact.
Most common variables to sensitise:
1. Discount rate (WACC)
* Small changes in WACC can have a big effect on valuation
* Typical range: ±1% from the base case
2. Terminal growth rate (if using Gordon Growth method)
* Tests impact of changing long-term growth expectations
* Typical range: 1%–3%
3. Exit multiple (if using the Exit Multiple method)
* Sensitise different valuation multiples (e.g. 9x–11x EBITDA)
4. Revenue growth rate
* Test the effect of stronger or weaker sales performance over the forecast period
* EBITDA or EBIT margin
* Tests the effect of changes in operating efficiency or profitability
