Discounted Cash Flow Questions - Basic

Question 1

Walk me through a DCF.

Answer 1

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.

First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.

Finally, you add the two together to determine the company’s Enterprise Value.

Question 2

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Answer 2

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 – Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.

Question 3

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?

Answer 3

Take Cash Flow From Operations and subtract CapEx – that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question 4

Why do you use 5 or 10 years for DCF projections?

Answer 4

That’s usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Question 5

What do you usually use for the discount rate?

Answer 5

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF.

Question 6

How do you calculate WACC?

Answer 6

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

Question 7

How do you calculate the Cost of Equity?

Answer 7

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

Question 8

How do you get to Beta in the Cost of Equity calculation?

Answer 8

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company’s capital structure. Then you use this Levered Beta in the Cost of Equity calculation.

Question 9

Why do you have to un-lever and re-lever Beta?

Answer 9

Each company’s capital structure is different and we want to look at how “risky” a company is regardless of what % debt or equity it has.
To get that, we need to un-lever Beta each time.
But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Question 10

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

Answer 10

A technology company, because technology is viewed as a “riskier” industry than manufacturing.

Question 11

Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what is the effect?

Answer 11

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).

Question 12

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 12

You would use the Cost of Equity rather than WACC since we’re not concerned with Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise Value.

Question 13

How do you calculate the Terminal Value?

Answer 13

Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).

Question 14

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

Answer 14

If you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Question 15

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

Answer 15

Normally you use the country’s long-term GDP growth rate, the rate of inflation, or something similarly conservative.

For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

Question 16

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

Answer 16

Normally you look at the Comparable Companies and pick the median of the set, or something close to it.

As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number.

So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Question 17

Which method of calculating Terminal Value will give you a higher valuation?

Answer 17

It’s hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Question 18

What’s the flaw with basing terminal multiples on what public company comparables are trading at?

Answer 18

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

Question 19

How do you know if your DCF is too dependent on future assumptions?

Answer 19

If significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

Question 20

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

Answer 20

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be “more risky”). Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.

Question 21

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 21

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above.

If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

Question 22

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

Answer 22

More debt means that the company is more risky, so the company’s Levered Beta will be higher – all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

Question 23

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

Answer 23

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole – and those returns include dividends.

Question 24

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 24

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

Question 25

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

Answer 25

The one without debt will have a higher WACC up to a certain point, because debt is “less expensive” than equity

However this is true only to a certain point. It’s a “U-shape” curve where debt decreases WACC to a point, then starts increasing it.

Question 26

Which has a greater impact on a company’s DCF valuation – a 10% change in
revenue or a 1% change in the discount rate?

Answer 26

It depends but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 27

Which has a greater impact on a company’s DCF valuation a 1% change in revenue vs. a 1% change in the discount rate?

Answer 27

It could go either way, but most of the time the discount rate is likely to have a bigger impact on the valuation.

Question 28

How do you calculate WACC for a private company?

Answer 28

You would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

Question 29

What should you do if you don’t believe management’s projections for a DCF model?

Answer 29

• You can create your own projections.
• You can modify management’s projections downward to make them more
conservative.
• You can show a sensitivity table based on different growth rates and margins and
show the values assuming managements’ projections and assuming a more conservative set of numbers.

Question 30

Why would you not use a DCF for a bank or other financial institution?

Answer 30

Banks use debt differently than other companies and do not re-invest it in the business – they use it to create products instead. Also, interest is a critical part of banks’ business models and working capital takes up a huge part of their Balance Sheets – so a DCF for a financial institution would not make much sense.

Question 31

What types of sensitivity analyses would we look at in a DCF?

Answer 31

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

Question 32

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Answer 32

You don’t account for this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but we only go down to Cash Flow from Operations and then subtract Capital Expenditures to get to Free Cash Flow.