DCF (Other)

Question 1

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

Answer 1

You value a company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company’s Current Value, you might be able to
invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell management the price
that it might receive if the company sells, which is often different from its Current Value.

Question 2

2. Public companies already have Market Caps and Share Prices. Why bother valuing
   them?

Answer 2

Because a company’s Market Cap and Share Price reflect its Current Value according to “the
market as a whole” – but the market might be wrong!

Question 3

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

Answer 3

Public Comps are useful because they’re based on real market data, are quick to calculate and
explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for
volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies
have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable
transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to
market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement
over the proper calculations for key figures like the Cost of Equity and WACC.

Question 4

7. Which one 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 4

In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive industry. That means the company’s CapEx and Working Capital requirements will be
lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA) as a result.
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than
industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset
intensity and higher expected growth rates would likely make up for that.
However, this answer is an extreme generalization, so you would need more information to
make a real decision.

Question 5

9. People say that the DCF is an intrinsic valuation methodology, while Public Comps and
   Precedent Transactions are relative valuation.

Answer 5

No, not exactly. The DCF is based on the company’s expected future cash flows, so in that
sense, it is “intrinsic valuation.”
But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use
the Multiples Method to calculate Terminal Value, the multiples are also linked to peer
companies.
The DCF depends less on the market than the other methodologies, but there is still some
dependency.
It’s more accurate to say that the DCF is more of an intrinsic valuation methodology than the
others.

Question 6

4. What does the Discount Rate mean conceptually?

Answer 6

The Discount Rate represents the opportunity cost for the investors – what they could earn by
investing in other, similar companies in this industry.

A higher Discount Rate means the risk and potential returns are both higher; a lower Discount
Rate means lower risk and lower potential returns.

A higher Discount Rate makes a company less valuable because it means the investors have
better options elsewhere; a lower Discount Rate makes a company more valuable.

Question 7

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

Answer 7

Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company
is cash flow-negative right now, the analysis could work if it starts generating positive cash
flows in the future.
If the company has no path to positive cash flows, or you can’t reasonably forecast its cash
flows, then the analysis doesn’t make sense.

Question 8

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

Answer 8

In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount
Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E.
You don’t back into Implied Equity Value at the end because the analysis produces the Implied
Equity Value directly.

An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest
Tax Shield separately and add the Present Value of this Tax Shield at the end.
You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered
Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median
Unlevered Beta from Public Comps).
You then project the Interest Tax Shield each year, discount it at that same Discount Rate,
calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.

Question 9

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

Answer 9

The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more
consistent results than the other methods.
With the other methods, you have to project the company’s Cash and Debt balances, Net
Interest Expense, and changes in Debt principal, all of which require more time and effort.

The Levered DCF sometimes produces odd results because Debt principal repayments can spike
the Levered FCF up or down in individual years.

The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: Increased
chances of bankruptcy. You can try to reflect this risk, but no one agrees on how to estimate it
numerically.
The Unlevered DCF solves this issue because WACC decreases with additional Debt, at first, but
then starts increasing past a certain level, which reflects both the advantages and
disadvantages of Debt.

Question 10

What is the rule of thumb for knowing if an item should be included in FCF

Answer 10

Calculating Unlevered FCF is simple if you remember the key rule: Include only recurring items
that are related to the company’s core business and that are available to all the investor groups.
There are some trickier topics, but you can answer 90% of interview questions by
understanding that rule.

Question 11

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

Answer 11

Unlevered FCF must capture the company’s core, recurring line items that are available to ALL
investor groups.
That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value
of the company’s core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to
all investor groups, you leave it out.
This rule explains why you exclude all of the following items:
• Net Interest Expense – Only available to Debt investors.
• Other Income / (Expense) – Corresponds to non-core-business Assets.
• Most non-cash adjustments besides D&A – They’re non-recurring.
• All Items in Cash Flow from Financing – They’re only available to certain investors.
• Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item

Question 12

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

Answer 12

he Change in Working Capital tells you whether the company generates more cash than
expected as it grows, or whether it requires more cash to fuel that growth.

It’s related to whether a company records expenses and revenue before or after paying or
collecting them in cash.

For example, retailers tend to have negative values for the Change in Working Capital because
they must pay for Inventory upfront before they can sell products.

But subscription-based software companies often have positive values for the Change in
Working Capital because they collect cash from long-term subscriptions upfront and recognize
it as revenue over time.
The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a
major value driver because it’s fairly small for most companies.

Question 13

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

Answer 13

No! You should consider SBC a cash expense in the context of valuation because it creates
additional shares and dilutes the existing investors.

By contrast, Depreciation & Amortization relate to timing differences: The company paid for a
capital asset earlier on but recognizes that payment over many years.

Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context
is different: Accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back,
you should reflect the additional shares by increasing the company’s diluted share count, which
will reduce the Implied Share Price.
Most DCFs get this completely wrong because they use neither approach: They pretend that
SBC is a normal non-cash charge that makes no impact on the share count (wrong!).

Question 14

4. 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 14

The company’s Free Cash Flows should reflect the cash taxes it pays.
So, it doesn’t matter which rate you use as long as the cash taxes are correct.
For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax
Income), and then include Deferred Taxes within the non-cash adjustments.
Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax
adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes and other
items to arrive at the company’s real cash taxes.

It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on
historical trends

Question 15

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

Answer 15

Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast
period, the company’s CapEx and Depreciation should also decline.
High-growth companies tend to spend more on Capital Expenditures to support their growth,
but this spending declines over time as the companies move from “growth” to “maintenance.”
If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be
less of a difference by the end.
Also, if the company’s FCF is growing, CapEx should not equal Depreciation – even in the
Terminal Period.
That’s partially due to inflation (capital assets purchased 5-10 years ago cost less), and partially
because Net PP&E must keep growing to support FCF Growth in the Terminal Period.
If you’re assuming that the company’s FCF stagnates or declines, then you might use different
assumptions.

Question 16

6. Should you reflect inflation in the FCF projections?

Answer 16

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for
prices and salaries tend to be based on nominal figures.
If you reflect inflation, then you also need to forecast inflation far into the future and adjust all
figures in your analysis.
That’s rarely worthwhile because of the uncertainty, extra work, and extra explanations
required.

Question 17

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

Answer 17

You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt
principal will change over time. You’ll also change the Cost of Equity over time to reflect this.

The changing capital structure won’t show up explicitly in Unlevered FCF, but you will still
reflect it in the analysis with the Discount Rate – WACC will change as the company’s Debt and
Equity levels change.

Question 18

8. 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 18

If you include an income or expense line item in Free Cash Flow, then you should exclude the
corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity
Value at the end (and vice versa for items you exclude).
For example, if you capitalize the company’s operating leases and count them as a Debt-like
item at the end, then you should exclude the rental expense from FCF, making it higher.
This rule also explains why you factor in Cash and Debt when moving to the Implied Equity
Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement
(Interest Income and Interest Expense).

Question 19

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

Answer 19

You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also
factoring in NOL accruals if the company earns negative Pre-Tax Income.

If you do this, then you don’t need to count the NOLs in the Implied Enterprise Value to Implied
Equity Value bridge calculation at the end.
However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business
Asset in this calculation at the end.

Beyond the extra work, one problem with the first approach is that the company may not use
all of its NOLs by the end of the explicit forecast period!

Question 20

10. How does the Pension Expense factor into Free Cash Flow?

Answer 20

There are different components of the Pension Expense, including the Service Cost, the Interest
Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and
Other Adjustments.

The Service Cost is an operating expense and should always be included in the company’s Free
Cash Flow.
In an Unlevered DCF, you exclude the Interest Expense, Expected Return on Plan Assets, and
Amortization of Net Losses or Gains, and then subtract the Unfunded portion of the Pension
Obligation when moving from Implied Enterprise Value to Implied Equity Value.
Some companies embed these items within Operating Expenses on the Income Statement, so
you may have to review the filings to calculate EBIT properly.
If company contributions into the pension plan are tax-deductible (varies by country), you have
to multiply the Unfunded Pension by (1 – Tax Rate) as well.

Question 21

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

Answer 21

For the most part, no. You certainly shouldn’t make speculative projections for these items –
they are all non-recurring.
If a company has announced plans to sell an asset, make an acquisition, or record a write-down
in the near future, then you might factor it into FCF for that year.
And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or
received, and you’ll have to change the company’s cash flow after the deal takes place.

Question 22

1. What does the Cost of Equity mean intuitively?

Answer 22

It tells you the average percentage a company’s stock “should” return each year, over the very
long term, factoring in both stock-price appreciation and dividends.

In a valuation, it represents the percentage an Equity investor might earn each year (averaged
over decades).

To a company, the Cost of Equity represents the cost of funding its operations by issuing
additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting
existing investors (thereby giving up stock-price appreciation potential).

Question 23

2. What does WACC mean intuitively?

Answer 23

WACC is similar to Cost of Equity, but it’s the expected annual return if you invest
proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock,
and anything else it has.

To a company, WACC represents the cost of funding its operations by using all its sources of
capital and keeping its capital structure percentages the same over time.

Investors might invest in a company if their expected IRR exceeds WACC, and a company might
decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Question 24

8. What does Beta mean intuitively?

Answer 24

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a
whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt).

If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.

Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so
it’s always less than or equal to Levered Beta.

Question 25

When you unlever and relever beta, you’re not factoring in the interest rate on Debt. Isn’t that wrong?
More expensive Debt should be riskier.

Answer 25

Yes, this is one drawback. However:

1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with
   high Debt / Equity ratios tend to pay higher interest rates as well.
2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result
   in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as
   simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.”
   An interest rate that’s 4x higher might barely change a large company’s financial profile, but it
   might make a much bigger difference for a small company.

Question 26

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

Answer 26

You might say, “The Risk-Free Rate is around .75% for 10-year U.S. Treasuries. A tech company
like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So, if you
assume an Equity Risk Premium of 8%, Cost of Equity might be around 12.75%.”
The numbers will change based on market conditions, but that’s the idea

Question 27

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

Answer 27

Think of Unlevered FCF as “Free Cash Flow to Firm,” or FCFF, instead.
And think of this relationship as: “Unlevered FCF, or FCFF, is available to ALL investors, and
WACC represents ALL investors. Therefore, you pair WACC with Unlevered FCF.”
No Discount Rate can be “capital structure-neutral” since each part of a company’s capital
structure affects the other parts.
“Capital-structure neutrality” is a property of Free Cash Flow, not the Discount Rate.

Question 28

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

Answer 28

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers
higher risk and potential returns than Debt, but lower risk and potential returns than Equity.
That’s because the coupon rates on Preferred Stock tend to be higher than the rates on Debt,
and Preferred Dividends are not tax-deductible.
But these rates are still lower than expected stock market returns. The risk is also lower since
Preferred Stock investors have a higher claim on the company’s Assets than Equity investors.

Question 29

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

Answer 29

The typical formula is:
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)
A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF
Growth Rate is higher.
For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has
$100 in FCF in the first year of the Terminal Period.
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.
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.
Higher growth lets you achieve the same targeted return even when you pay more

Question 30

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

Answer 30

It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years
into the future, because you don’t want to reflect the control premium inherent in Precedent
Transactions, at least not if you’re completing a standalone valuation of the company.
Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your
initial guess; if not, adjust it up or down as necessary.

Question 31

6. 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 31

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 32

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

Answer 32

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.
It doesn’t make the company “worthless”; it just means that the company will be worth less.

Question 33

5. Continuing with the same example, how would the Terminal Value and PV of Terminal
   Value change with this April 30th valuation?

Answer 33

It depends on how you calculate the Terminal Value.

With the Multiples Method, the Terminal
Value calculation stays the same since it’s based on the company’s EBITDA (or another metric)
in the final projected year times an appropriate multiple.
When you discount the Terminal Value, the stub period affects the discount period, but the
mid-year convention does not because the Terminal Value is as of the END of the last projected year.
So, if the valuation date is April 30th
and there are 10 years in the projection period, you would use 9.67 for the discount period to calculate the PV of the Terminal Value.

With the Gordon Growth Method, if you’re using the mid-year convention, you must adjust the
Terminal Value by multiplying it by (1 + Discount Rate) ^ 0.5. You do this because the normal formula – FCF in Year 1 of Terminal Period / (Discount Rate –
Terminal Growth Rate) – gives you the Present Value at Year 10.5 if you’re using the mid-year
convention. When you multiply by (1 + Discount Rate) ^ 0.5, you “move back the Terminal Value” to Year
10.0 instead. Discounting the Terminal Value works the same way as it does with the Multiples Method: Only
the stub period affects it. So, you would also use 9.67 for the discount period.

Question 34

5. 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 34

This is 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, so they’re worth more.
However, Company B will almost certainly have a much higher Terminal Value because it has a
much higher FCF in Year 10.
So, if you count the PV of Terminal Value in the analysis, it’s a good bet that Company B will
have the higher Implied Value.

Question 35

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

Answer 35

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 rate doesn’t matter because there’s no tax benefit to interest paid on Debt.
If the company has some Debt, a higher tax rate will reduce the 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 also be lower because the higher tax rate reduces
FCF and the company’s Terminal Value. Those changes outweigh a lower WACC.
The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and WACC are all
higher, and the Implied Value is also higher

Question 36

What’s the most common not cash adjustment made to UFCF other than D&A

Answer 36

Deferred taxes

You can include it, but it should decrease as book vs. cash-tax timing differences reverse.
So, if Deferred Taxes initially represent 20% of total Income Taxes, they shouldn’t stay at 20%
throughout the entire forecast period; they should drop to a much lower percentage, such as 3-
5%, by the end.