3.6) DCF Analysis - Alking Through and Explaining It Flashcards
- Why do you build a DCF analysis to value a company?
You build a DCF analysis because a company is worth the Present Value of its expected future cash flows:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate
But you can’t just use that single formula because a company’s Cash Flow Growth Rate and Discount Rate change over time.
So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: one where those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period).
You then project the company’s cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s).
Then, you compare this sum – the company’s Implied Value – to the company’s Current Value or “Asking Price” to see if it’s valued appropriately.
- Walk me through a DCF analysis.
A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value.
You start by projecting the company’s Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx.
Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything.
Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity.
You then discount the Terminal Value to Present Value using the Discount Rate and add it to the sum of the company’s discounted cash flows.
Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.
- How do you move from Revenue to Free Cash Flow in a DCF?
First, confirm that the interviewer is asking for Unlevered Free Cash Flow (AKA Free Cash Flow to Firm). If so:
Subtract COGS and Operating Expenses from Revenue to get Operating Income (EBIT).
Then, multiply Operating Income by (1 – Tax Rate), add back Depreciation & Amortization, and factor in the Change in Working Capital.
If the company spends extra cash as it grows, the Change in Working Capital will be negative; if it generates extra cash flow due to its growth, it will be positive.
Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow.
Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 – Tax Rate), and you also factor in changes in Debt principal.
- What does the Discount Rate mean?
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 higher risk and potential returns; a lower Discount Rate means lower risk and 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.
- How do you calculate Terminal Value in a DCF, and which method is best?
You can use the Multiples Method or the Gordon Growth Method (AKA Long-Term Growth Method, Perpetuity Growth Method, etc.).
With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF in the final year of the forecast period.
For example, if you apply a 10x TEV / EBITDA multiple to the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000.
With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free Cash Flows in the Terminal Period and assume they’ll grow at that rate forever.
Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate)
The Gordon Growth Method is better from a theoretical perspective because growth always slows down over time; all companies’ cash flows eventually grow more slowly than GDP.
If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense because it implies a growth rate that’s too high. However, many bankers still use and prefer the Multiples Method because it’s “easier” or because they don’t understand that a Terminal Multiple implies a Terminal Growth Rate.
- What are some signs that you might be using the incorrect assumptions in a DCF?
The most common signs of trouble are:
- Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of the company’s total Implied Value, but it shouldn’t represent 95% of its value.
- Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country’s long-term GDP growth rate is 3%, something is wrong.
- You’re Double-Counting Items – If an expense is deducted in FCF, you should not subtract the corresponding Liability in the Enterprise Value → Equity Value “bridge.”
And if an expense is not deducted in FCF, you should subtract the corresponding Liability in the bridge at the end (e.g., Interest and Debt in an Unlevered DCF).
- Mismatched Final Year FCF Growth Rate and Terminal Growth Rate – If the company’s Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal Growth Rate, something is wrong. FCF growth should decline over time and approach the Terminal Growth Rate by the end of the explicit forecast period.
- If your DCF seems wrong, what are the easiest ways to fix it?
The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes a higher percentage of the Implied Value and so that there’s more time for the FCF growth to slow down and approach the Terminal Growth Rate.
So, if you’re using a 5-year forecast period, extend it to 10-15 years and reduce the company’s FCF growth in those extra years as it approaches maturity.
To avoid double-counting items… look at what you’re doing, and don’t double count!
Finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower Terminal Multiple. Terminal Value tends to be overstated in financial models because people don’t understand the theory behind it.
- How do you interpret the results of a DCF?
You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic. For example, if you believe that the company’s Implied Share Price is between $15.00 and $20.00, but its Current Share Price is $8.00, that means the company may be undervalued. But if its Current Share Price is $17.00, then it may be valued appropriately.
- Does a DCF ever make sense for a company with negative cash flows?
Maybe. 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 the company starts generating positive cash flows in the future. But 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.
- How do the Levered DCF and Adjusted Present Value (APV) analysis differ from the Unlevered DCF?
In a Levered DCF, you use Levered FCF for the cash flows (i.e., deduct the Net Interest Expense and include changes in Debt principal) 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 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.
- Will you get the same results from an Unlevered DCF and a Levered DCF?
No. The simplest explanation is that an Unlevered DCF does not directly factor the Cost of Debt into the FCF projections, while a Levered FCF does. The Unlevered DCF indirectly accounts for it via the WACC calculation, but it won’t be equivalent to the Levered version. That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes in Debt principal) will also play a role. It’s very difficult to pick equivalent assumptions, and it’s not worth thinking about because no one uses the Levered DCF in real life.
- Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?
The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results that depend far less on the company’s capital structure. 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 irregular Debt principal repayments can shift the Levered FCF dramatically in certain years. The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: the increased chance of bankruptcy (unless you make a special adjustment for it). The Unlevered DCF solves this issue because WACC initially decreases with additional Debt but then starts increasing past a certain level, reflecting both the advantages and disadvantages of Debt.
