Intrinsic Valuation Flashcards
(44 cards)
Walk me through a DCF.
- Forecast Unlevered Free Cash Flows (“FCFF” or “UFCF”): First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage, should be forecast explicitly for a 5 to 10 year period.
- Calculate Terminal Value (“TV”): Next, the value of all unlevered FCFs beyond
the initial forecast period needs to be calculated – this is called the terminal value.
The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach. - Discount Stage 1 & 2 CFs to Present Value (“PV”): Since we are valuing the company at the current date, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital (“WACC”).
- Move from Enterprise ValueEquity Value: To get to equity value from enterprise value, we would need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the value of non-operating assets such as cash or investments and subtract debt. Then, we would account for any other non-equity claims such as minority interest.
- Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value by diluted shares outstanding as of the valuation date. For public companies, the equity value per share that our DCF just calculated can be compared to the current share price.
- Sensitivity Analysis: Given the DCF’s sensitivity to the assumptions used, the last step is to create sensitivity tables to see how the assumptions used will impact the implied price per share.
Conceptually, what does the discount rate represent?
The discount rate represents the expected return on an investment based on its risk profile (meaning, the discount rate is a function of the riskiness of the cash flows). Put another way, the discount rate is the minimum return threshold of an investment based on comparable investments with similar risks. A higher discount rate makes a company’s cash flows less valuable, as it implies the investment carries a greater amount of risk, and therefore should be expected to yield a higher return (and vice versa).
What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?
Unlevered FCF: FCFF represents cash flows a company generates from its core operations after accounting for all operating expenses and investments. To calculate FCFF, you start with EBIT, which is an unlevered measure of profit because it excludes interest and any other payments to lenders. You’ll then tax effect EBIT, add back non-cash items, make working capital adjustments, and subtract capital expenditures to arrive at FCFF. Tax-affected EBIT is often referred to as Net Operating Profit After Taxes (“NOPAT”) or Earnings Before Interest After Taxes (“EBIAT”).
FCFF=EBIT×(1–TaxRate)+D&A– ChangesinNWC–Capex
Levered FCF: FCFE represents cash flows that remain after payments to lenders since interest expense and debt paydown are deducted. These are the residual cash flows that belong to equity owners. Instead of tax-affected EBIT, you start with net income, add back non-cash items, adjust for changes in working capital, subtract capex, and add cash inflows/(outflows) from new borrowings, net of debt paydowns.
FCFE = Cash from Operations – Capex – Debt Principal Payment
What is the difference between the unlevered DCF and the levered DCF?
Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive
directly at enterprise value. When you have a present value, add any non-operating
assets such as cash and subtract any financing-related liabilities such as debt to get
to the equity value. The appropriate discount rate for the unlevered DCF is the
weighted average cost of capital (WACC) because the rate should reflect the
riskiness to both debt and equity capital providers since UFCFs are cash flows that
belong to debt and equity providers.
Levered DCF: The levered DCF approach, on the other hand, arrives at equity
value directly. First, the levered FCFs are forecasted and discounted, which gets you to equity value directly. The appropriate discount rate on LFCFs is the cost of equity since these cash flows belong solely to equity owners and should thus reflect the risk of equity capital. If you wanted to get to enterprise value, you would add back net debt.
What is the appropriate cost of capital when unlevered FCF (FCFF) and levered FCF (FCFE)?
When doing an unlevered DCF, the weighted average cost of capital (WACC) is the correct cost of capital to use because it reflects the cost of capital to all providers of capital.
However, the cost of equity would be the right cost of capital to use for levered DCFs.
What is the formula to calculate the weighted average cost of capital (WACC)?
The weighted average cost of capital (WACC) can be viewed as the opportunity cost of an investment based on comparable investments with similar risk profiles.
WACC is calculated by multiplying the equity weight by the cost of equity and adding it to the debt weight multiplied by the tax-affected cost of debt.
For the equity and debt values, the market values must be used rather than the book values.
If a company carries no debt, what is its WACC?
If a company has no debt on its capital structure, its WACC will be equivalent to its cost of equity. Most mature companies will take on a moderate amount of leverage once their operating performance stabilizes because they can raise cheaper financing from lenders.
How is the cost of equity calculated?
The cost of equity is most commonly estimated using the capital asset pricing model (“CAPM”), which links the expected return on a security to its sensitivity to the overall market (most often S&P 500 is used as the proxy).
Cost of Equity (Re) = Risk Free Rate + Beta × Equity Risk Premium
How do you determine the risk-free rate?
The risk-free rate (“Rf”) should theoretically reflect the yield to maturity of default-free government bonds of equivalent maturity to the duration of each cash flow being discounted.
However, the lack of liquidity in the longest maturity bonds has made the current yield on 10-year US treasury notes the preferred proxy for the risk-free rate for US-based companies.
What effect does a low-interest-rate environment have on DCF-derived valuations?
If the market’s prevailing interest rates are at low levels, valuations based on DCFs will become higher since the discount rate will be lower from the decreased risk-free rate, all else being equal.
There has been much debate around normalized risk-free rates. Aswath Damodaran has argued against the usage of normalized rates and has written that “you should be using today’s risk-free rates and risk premiums, rather than normalized values when valuing companies or making investment assessments.”
Define the equity risk premium used in the CAPM formula.
The equity risk premium (“ERP”) measures the incremental risk (or excess return) of investing in equities over risk-free securities. Historically, the ERP has ranged between 4% to 6% based on historical spreads between the S&P 500 returns over the yields on risk-free bonds.
Equity Risk Premium (ERP) = Expected Market Return − Risk Free Rate
Explain the concept of beta (β).
Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to the broader market. Said another way, beta equals the covariance between expected returns on the asset and the market, divided by the variance of expected returns on the market.
A company with a beta of 1.0 would expect to see returns consistent with the overall stock market returns. If the market has gone up 10%, the company should see a return of 10%. A company with a beta of 2.0 would expect a return of 20% if the market had gone up 10%.
β = 0- No Market Sensitivity
β < 1- Low Market Sensitivity
β > - High Market Sensitivity
β < 0 - Negative Market Sensitivity
What is the difference between systematic risk and unsystematic risk?
Systematic Risk: Otherwise known as undiversifiable risk (or market risk), this is the risk inherent within the entire equity market rather than specific to a particular company or industry. This type of risk is unavoidable and cannot be mitigated through diversification.
Unsystematic Risk: In contrast, unsystematic risk is the company-specific (or industry) risk that can be reduced through portfolio diversification. The effects of diversification will be more profound when the portfolio contains investments in different asset classes, industries, and geographies.
Does a higher beta translate into a higher or lower valuation?
A company with a high beta suggests more risk and will exhibit higher volatility than the market (i.e., higher sensitivity to market fluctuations). Thus, a higher discount rate will be used by investors to value the company’s cash flows, which directly leads to a lower valuation, all else being equal.
What type of sectors would have higher or lower betas?
A useful question to ask yourself when assessing beta is: “Would consumers require (or demand) this product or service during a recession?”
High Beta: A beta of >1 would mean the industry is highly cyclical and be more volatile than the broad market. For example, the automobile, semiconductors, and construction industry have higher betas since most consumers only purchase cars and new homes during positive economic growth.
Low Beta: A beta of < 1 suggests the security is less volatile than the broad market. Consumer product stores that sell necessary, everyday goods such as toiletries and personal hygiene products would have a low beta. Other sectors with low betas are hospitals/healthcare facilities and utilities, which provide essential goods and services required by consumers regardless of the prevailing economic climate.
What are the benefits of the industry beta approach?
The industry β approach looks at the β of a comparable peer group to the company being valued and then applies this peer-group derived beta to the target. The benefits are that company-specific noise is eliminated, which refers to distorting events that could cause the correlation shown in its beta to be less accurate.So the peer-group derived beta is “normalized” since it takes the average of the unlevered betas of comparable businesses and then relevers it at the target capital structure of the company being valued. The implied assumption is that the company’s business risk will converge with its peer group over the long run.This approach also enables one to arrive at an industry-derived beta for private companies that lack readily observable betas. To perform a DCF analysis for a private company, the industry beta approach would be required as privately-held companies don’t have readily observable betas.
What is the impact of leverage on the beta of a company?
If a company’s capital structure has no leverage, its levered beta (or equity beta) would be equal to its unlevered beta (or asset beta), reflecting only business-specific risk. The removal of the risk from the debt component of levered beta results in unlevered beta. Therefore, the levered beta can either be equal to or greater than unlevered beta, but never lower. This is because levered beta is the combined risk encompassing both business-specific and financial risk. The amount of leverage held by a company directly impacts beta as the financial risk increases from the greater risk of default and bankruptcy (i.e., less margin for error and more volatility if an economic downturn occurs).
What is the typical relationship between beta and the amount of leverage used?
Generally, mature companies with lower betas will have a higher percentage of debt in their capital structure because they can easily get cheap financing based on their long-lasting track record of cash flows and profitability, as well as being non-cyclical and carrying less risk than the broad market.
In comparison, a company with a high beta will be reluctant to use debt or if they do, the terms of the debt would be less favorable. From a financier’s perspective: “Would the lender be comfortable loaning money to a company that has a higher beta and volatility throughout different economic cycles?”
Is it possible for an asset to have a negative beta?
Yes, the most commonly cited example is gold, which has an inverse relationship with the market. When the stock market goes up, the price of gold will often decrease.
However, when the stock market undergoes a correction or enters recession territory, investors flee towards gold as a safe-haven, and the increase in demand drives up gold prices.
How do you estimate the cost of debt?
The cost of debt is readily observable in the market as the yield on debt with equivalent risk. If the company being valued doesn’t have publicly traded debt, the cost of debt can be estimated using a so- called “synthetic rating” and default spread based upon its credit rating and interest coverage ratio.
Which is typically higher, the cost of debt or the cost of equity?
The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax-deductible, creating a “tax shield.”
The cost of equity is typically higher because, unlike lenders, equity investors are not guaranteed fixed payments and are last in line at liquidation (i.e., bottom of the capital structure).
Since the cost of equity is higher than the cost of debt, why not finance using only debt?
The required return on the debt will increase with the debt level because a more highly levered business has a higher default risk. As a result, the “optimal” capital structure for most companies includes a mixture of debt and equity. As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax-deductibility of interest expense (i.e., the “tax shield” benefits). WACC continues to decrease until the optimal capital structure is reached.
But once this threshold is surpassed, the cost of potential financial distress offsets the tax advantages of debt, and the WACC will reverse course and begin an upward trajectory as the risk to all debt and equity stakeholders increases.Besides the risk of a company becoming overburdened with leverage, debt also comes
with more constraints (i.e., covenants) that restrict activity and prevent them from exceeding certain leverage ratios or maintaining a coverage ratio above a certain threshold.
What is the difference between WACC and IRR?
Internal Rate of Return: The IRR is the rate of return on a project’s expenditures. Given a beginning value and ending value, the IRR is the implied interest rate at which the initial capital investment would have to grow to reach the ending value. Alternatively, it’s defined as the discount rate on a stream of cash flows leading to a net present value (NPV) of 0.
Weighted Average Cost of Capital: The WACC (or cost of capital) is the average minimum required internal rate of return for both debt and equity providers of capital. Thus, an IRR that exceeds the WACC is an often-used criterion for deciding whether a project should be pursued.
Which would have more of an impact on a DCF, the discount rate or sales growth rate?
The discount rate and the sales growth rate will be sensitized in a proper DCF model, but the discount rate’s impact would far exceed that of operational assumptions such as the sales growth rate.