Basic Qs

Question 1

What’s the basic concept behind a DCF analysis?

Answer 1

You value a company based on the PV of its FCF
- divide future into near future - projection period
- and terminal value and add it all together.

Question 2

Walk me through a DCF

Answer 2

DCF values a company based on PV of its cash flows and the PV of its TV
1. Project a company’s financials using assumptions for revenue growth, margins and the change in operating assets and liabilities
2. Calculate FCF for each year, which you discount and sum up to get the NPV
3. Discount Rate is usually the WACC
4. Determine the company’s TV using either MM or GGM, then discount back to NPV
5. Add together to determine the company’s Enterprise Value

Question 3

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

Answer 3

1. Confirm they are asking for UFCF
2. Subtract COGS and operating expenses from revenue to get operating income - EBIT
3. Multiply by (1 - tax rate), add back depreciation, amortisation and other non-cash charges and factor in the changes in working capital
4. Subtract CapEx to calculate UFCF
   LFCF is similar, but you must subtract net interest expense before multiplying by (1-tax rate), must also subtract mandatory debt repayments.

Question 4

What’s the point of Free Cash Flow, anyway? What are you trying to do?

Answer 4

Idea is that you are replicating the CFS, but only including recurring, predictable items. And in the case of UFCF, you also exclude the impact of debt entirely.

That’s why everything in CFI except for CapEx is excluded and why the entire CFF is excluded, only exception being mandatory debt repayments for LFCF

Question 5

Why do you use 5 or 10 years for the “near future” DCF projections?

Answer 5

About as far as reasonably predict, less than 5 is too short to be useful 10+ too difficult to project for most companies.

Question 6

Is there a valid reason why we might sometimes project 10 years or more anyway?

Answer 6

If it is a cyclical industry like chemicals, so maybe important to show entire cycle from low to high

Question 7

What do you usually use for the Discount Rate?

Answer 7

Unlevered DCF - use WACC, which reflects cost of equity, debt and preferred stock
Levered DCF - use CoE instead

Question 8

If I’m working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?

Answer 8

Add cash, subtract debt, preferred stock and NCI to get EV.

Then Divide by companies share count.

Question 9

Let’s say we do this and find that the Implied per Share Value is $10.00. The company’s current share price is $5.00. What does this mean

Answer 9

By itself, does not mean much, would have to look at a range of outputs from a DCF rather than single number.
- see what implied per Share Value is under different assumptions/ values of DR, revenue growth, margins etc.

If consistently find its higher than share price - analysis tells you company is undervalued.

Question 10

An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?)

Answer 10

Setup similar, still project revenue and expenses over a 5-10 yr period and still calculate TV
- difference: do not calculate FCF, instead stop at net income and assume that dividends issued are a % of NI, and then discount those dividends back to PV using CoE.
- then add up and add to present value of TV
- DDM gets you company’s EV as you are using metrics which include interest income and expense.