Intrinsic Valuation

Question 1

Walk me through a DCF.

Answer 1

1. 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.
2. 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.
3. 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”).
4. Move from Enterprise Value􏰀Equity 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.
5. 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.
6. 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.

Question 2

Conceptually, what does the discount rate represent?

Answer 2

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).

Question 3

What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?

Answer 3

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

Question 4

What is the difference between the unlevered DCF and the levered DCF?

Answer 4

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.

Question 5

What is the appropriate cost of capital when unlevered FCF (FCFF) and levered FCF (FCFE)?

Answer 5

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.

Question 6

What is the formula to calculate the weighted average cost of capital (WACC)?

Answer 6

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.

Question 7

If a company carries no debt, what is its WACC?

Answer 7

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.

Question 8

How is the cost of equity calculated?

Answer 8

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

Question 9

How do you determine the risk-free rate?

Answer 9

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.

Question 10

What effect does a low-interest-rate environment have on DCF-derived valuations?

Answer 10

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.”

Question 11

Define the equity risk premium used in the CAPM formula.

Answer 11

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

Question 12

Explain the concept of beta (β).

Answer 12

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

Question 13

What is the difference between systematic risk and unsystematic risk?

Answer 13

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.

Question 14

Does a higher beta translate into a higher or lower valuation?

Answer 14

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.

Question 15

What type of sectors would have higher or lower betas?

Answer 15

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.

Question 16

What are the benefits of the industry beta approach?

Answer 16

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.

Question 17

What is the impact of leverage on the beta of a company?

Answer 17

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).

Question 18

What is the typical relationship between beta and the amount of leverage used?

Answer 18

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?”

Question 19

Is it possible for an asset to have a negative beta?

Answer 19

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.

Question 20

How do you estimate the cost of debt?

Answer 20

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.

Question 21

Which is typically higher, the cost of debt or the cost of equity?

Answer 21

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).

Question 22

Since the cost of equity is higher than the cost of debt, why not finance using only debt?

Answer 22

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.

Question 23

What is the difference between WACC and IRR?

Answer 23

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.

Question 24

Which would have more of an impact on a DCF, the discount rate or sales growth rate?

Answer 24

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.

Question 25

How is the terminal value calculated?

Answer 25

1. Growth in Perpetuity Approach: Often called the Gordon Growth method, the growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the explicit forecast period and then inserting this assumption into the static perpetuity formula.
2. Exit Multiple Approach: The exit multiple approach calculates the terminal value by applying a multiple assumption on a financial metric (usually EBITDA) in the terminal year. The multiple reflects the multiple of a comparable company in a mature state.

Question 26

Why is it necessary to discount the terminal value back to the present?

Answer 26

Under both approaches, the terminal value represents the present value of the company’s cash flows in the final year of the 1st stage of the explicit forecast period right before entering the perpetuity stage. The TV calculated is the present value of a growing perpetuity at the very end of the stage 1 projection of cash flows.
Thus, this future value must be discounted back to its present value (PV) since the DCF is based on what a company is worth today, the current date of the valuation.

Question 27

For the perpetuity approach, how do you determine the long-term growth rate?

Answer 27

The long-term growth rate is the rate that the company will grow into perpetuity. That being said, it should range somewhere between 1% to 3% (sometimes up to 5%). Often, GDP or the risk-free rate are proxies for g. This growth rate must reflect the steady-state period when growth has slowed down to a sustainable rate.
A hypothetical question to ask would be: “Can this company grow at X% for the next hundred years?” If not, then the perpetuity growth rate should be adjusted downward to be more realistic.

Question 28

What is the argument against using the exit multiple approach in a DCF?

Answer 28

In theory, a DCF is an intrinsic, cash-flow based valuation method independent of the market. By using the exit multiple approach, relative valuation is being brought into the valuation. However, the exit multiple approach is widely used in practice due to being easier to discuss and defend in terms of justifying the assumptions used.

Question 29

What is the purpose of using a mid-year convention in a DCF model?

Answer 29

By using the mid-year convention, we are treating the projected cash flows as if they’re generated at the midpoint of the given period. Without this mid-year adjustment, the DCF implicitly assumes that all cash flows are being received at the end of the year. This would be inaccurate since cash flows are generated steadily throughout the year, depending on the industry.
The compromise is to use a mid-year convention that assumes the CFs are received in the middle of the year. Since the projected cash flows are received earlier, the implied valuation of the company would increase because of the earlier received cash flows. For example, if the cash flow you’re discounting is Year 5 and the discount factor is 5, the mid-year convention would use a discount factor of 4.5 since we are assuming half a year has passed before the cash flow is generated.

Question 30

Could you give me an example of when the mid-year convention might be inappropriate?

Answer 30

While the mid-year convention in a DCF is standard practice, it may be inaccurate for highly seasonal companies. Many retail companies experience strong seasonal patterns in demand, and sales are disproportionally received in the 3rd and 4th quarters.
This is particularly the case for retailers that have a niche in winter clothing. For example, the mid-year convention may be an inappropriate adjustment for Canada Goose, a Canadian company that focuses primarily on winter clothing. The unadjusted, period-end assumption may be more appropriate in this scenario.

Question 31

How would raising additional debt impact a DCF analysis?

Answer 31

The enterprise value based on an unlevered DCF should theoretically remain relatively unchanged since the DCF is capital structure neutral. But if the debt raised changed the capital structure weights substantially, the implied valuation could change. As the percentage of debt in the capital structure increases, the cost of debt increases from the higher default risk (which lowers the implied valuation).

Question 32

Imagine that two companies have the same total leverage ratio with identical free cash flows and profit margins. Do both companies have the same amount of default risk?

Answer 32

If one company has significantly more cash on its balance sheet, it’ll most likely be better positioned from a risk perspective. When assessing leverage risk, a company’s excess cash should be considered since this cash could help paydown debt. Hence, many consider cash to be “negative debt” (i.e., the implied assumption of net debt).
Therefore, one of the main leverage ratios looked at in addition to Total Debt/EBITDA is Net Debt/EBITDA. All else being equal, the company with a higher excess cash balance and lower Net Debt/EBITDA would be at lower risk of bankruptcy (and lower cost of debt).

Question 33

When would a DCF be an inappropriate valuation method?

Answer 33

Practically, when you don’t have access to financial statements, a credible DCF analysis valuation is difficult, and a comps analysis might be more realistic. So if you have a data point such as revenue or EBIT, a comps analysis is easier to implement.
In addition, DCFs may be unfeasible when the company is not expected to generate positive cash flows for the foreseeable future. Here, much of the company’s value is weighted towards the distant future, and the DCF becomes less credible.

Question 34

Why is a DCF not used to value early stage startups?

Answer 34

Although the DCF approach is based upon a company’s future cash flows, this method can still be used on early-stage startups that are cash flow negative. The caveat being, there must be a path towards turning cash flow positive in the distant future.
DCFs become less reliable for early-stage startups that may not reach a sustainable, stable growth rate for 15+ years as it becomes very difficult to accurately predict the FCFs beyond this period. A DCF valuation is most credible when looking at mature companies with an established market position, as opposed to pre-revenue companies that have not yet determined their business model, go-to-market strategy, or target end-user.

Question 35

If 80% of a DCF valuation comes from the terminal value, what should be done?

Answer 35

The explicit forecast period may not be long enough (should range from 5 to 10 years). In the final year in the explicit stage, the company should have reached normalized, stable growth.
Alternatively, the terminal value assumptions may be too aggressive and not reflect stable growth.

Question 36

How would you handle stock options when calculating a company’s share count?

Answer 36

The standard convention for stock options is to include in the dilutive share count any vested (exercisable) options whose strike price is below the current share price (“in-the-money”). In addition, any option proceeds the company received from the exercising of those options are assumed to be used by the company to repurchase shares at the current share price (the treasury stock method).
But certain finance professionals use all outstanding in-the-money options (as opposed to just the vested in- the-money options) to perform the analysis. The logic being that any options that are still unvested will vest soon, and since they’re in-the-money, it’s more conservative to include them in the share count.

Question 37

How would you handle restricted stock in the share count?

Answer 37

Some finance professionals completely ignore restricted stock from the diluted share count because they’re unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the logic that eventually they’ll vest, and it’s thus more conservative to count them.

Question 38

How would you handle convertible preferred stock in the share count?

Answer 38

Convertible preferred stock is assumed to be converted into common stock to calculate diluted shares if the liquidation value (i.e., the preferred stock’s conversion price) is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing 10 million preferred shares, each granting the holder the right to collect either $50 per preferred share (its liquidation value) or to convert it to one share of common stock. Since the current share price is greater than the liquidation value, we would assume that the preferred stock is converted for calculating the diluted share count.
When conversion into common stock is assumed to calculate the share count in a valuation, the preferred stock should be eliminated when calculating net debt to be consistent and avoid double counting.

Question 39

How would you handle convertible bonds in the share count?

Answer 39

Convertible bonds are assumed to be converted into common stock if the conversion price of the bond is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing a bond convertible into 10 million shares of common stock. Since the current share price is greater than the conversion price, we assume the bond is converted to calculate diluted shares.
If conversion into common stock is assumed to calculate the share count, the convertible bonds should be eliminated from the balance sheet when calculating net debt to be consistent (and avoid double-counting).

Question 40

How should operating leases be treated in a DCF valuation?

Answer 40

They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar to debt obligations than to a simple expense (i.e., tenants should present the lease obligation as a liability on their balance sheet as they do for long-term debt). In fact, the option to account for leases as an operating lease was eliminated starting in 2019 for that reason.
Therefore, when operating leases are significant for a business (retailers and capital-intensive businesses), the rent expense should be ignored from the free cash flow build-up, and instead, the present value of the lease obligation should be reflected as part of net debt.

Question 41

For forecasting purposes, do you use the effective or marginal tax rate?

Answer 41

The choice between whether to use the effective or marginal tax rate boils down to one specific assumption found in valuation methods such as the DCF: the tax rate assumption used will be the tax rate paid into perpetuity. In most cases, the effective tax rate will be lower than the marginal tax rate, mainly because many companies will defer paying the government.
Hence, line items such as deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are created. If you use the effective tax rate, you implicitly assume this deferral of taxes to be a recurring line item forever. But this would be inaccurate since DTAs and DTLs unwind, and the balance eventually becomes zero.
The recommended approach is to look at the historical periods (i.e., past 3-5 years) and base your near-term tax rate assumptions on the effective tax rate. But by the time the 2nd stage of the DCF is approaching, the tax rate should be “normalized” and be within close range of the marginal tax rate.

Question 42

How does a lower tax rate impact the valuation from a DCF?

Answer 42

1. Greater Free Cash Flows: A lower tax rate would result in more net income as fewer taxes have to be paid to the government, meaning more earnings retention and higher cash flow.
2. Higher Cost of Debt: A lower tax rate results in a higher after-tax cost of debt and a higher re-levered beta, all else being equal. If the tax rate is reduced, that would mean the after-tax cost of debt would rise, and the benefit from the tax-deductibility of interest (“tax shield”) would be reduced.
3. Higher Beta: A lower tax rate would result in a higher levered beta, which would cause the cost of equity and WACC to increase.
   While the last two implications suggest a lower valuation, the net impact on the company’s valuation would be specific to the company’s fundamentals, and one would have to flow through all the changes in a DCF model to see if the increased FCF offsets the increased WACC.

Question 43

How does a dividend discount model (DDM) differ from a discounted cash flow model (DCF)?

Answer 43

The dividend discount model (“DDM”) stipulates that the value of a company is a function of the present value of all its future dividends paid out, whereas the discounted cash flow states a company is worth the sum of the present value of all the future free cash flows it generates.
The DDM will forecast a company’s future dividends based on a dividend per share (“DPS”) and growth rate assumptions – which are then discounted using the cost of equity. For the terminal value calculation, an equity value based multiple will be used, most commonly P/E. Therefore, the DDM directly calculates the equity value and then equity value per share (similar to levered DCFs, but different from unlevered DCFs).

Question 44

What are the major drawbacks of the dividend discount model (DDM)?

Answer 44

Forward-looking valuation methods each have their shortcomings, and the DDM is no exception, given its sensitivity to assumptions such as the dividend payout ratio, dividend growth rate, and required rate of return.
But some additional drawbacks that help explain why DDM is used less often include:
The DDM cannot be used on high-growth companies as the denominator would turn negative since the growth rate would exceed the expected return rate.
The DDM is more suitable for large, mature companies with a consistent track record of paying out dividends, but even then, it can be very challenging to forecast out the growth rate of dividends paid. Most companies don’t pay out any dividends, especially as share buybacks have become common.
The DDM neglects buybacks, an increasingly important source of returns for shareholders.
If the dividend payout amounts reflected true financial performance, then the output would be similar to the traditional DCF. However, poorly run companies can still issue large dividends, distorting valuations.