BIWS Valuation and DCF Analysis

Question 1

What’s the point of valuation? WHY do you value a company?

Answer 1

You value a company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company’s Current Value, you might be able to
invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell the management team
the price that it might receive if the company wants to sell, which is usually different from its
Current Value.

Question 2

But public companies already have Market Caps and share prices. Why bother valuing
them?

Answer 2

Because a company’s Market Cap and Share Price reflect its Current Value according to “the
market” – but the market might be wrong!
You value companies to see if the market’s views are correct or incorrect.

Question 3

What are the advantages and disadvantages of the 3 main valuation methodologies?

Answer 3

Public Comps are useful because they’re based on real market data, are quick to calculate and
explain, and are less subject to far-in-the-future assumptions.
However, there may not be true comparable companies, the analysis will be less accurate for
volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies
have paid for other companies, and they may reflect industry trends more than Public Comps.
However, the data is often spotty and misleading, there may not be comparable transactions,
and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to
market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement
over the proper calculation methods for key figures like Cost of Equity and WACC.

Question 4

Which of the 3 main methodologies will produce the highest Implied Values?

Answer 4

This is a trick question because almost any methodology could produce the highest Implied
Values depending on the industry, time period, and assumptions.
Precedent Transactions generally produce higher Implied Values than Public Comps because of
the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF stacks up because it’s far more dependent on your assumptions.
So the best answer is: “A DCF tends to produce the most variable output, depending on your
assumptions, and Precedent Transactions tend to produce higher values than Public Comps
because of the control premium.”

Question 5

When is a DCF more useful than Public Comps or Precedent Transactions?

Answer 5

You should pretty much always build a DCF since it IS valuation – the other methodologies are
supplemental.
But it’s especially useful when the company you’re valuing is mature and has stable, predictable
cash flows, or when you lack good Public Comps and Precedent Transactions.

Question 6

When are Public Comps or Precedent Transactions more useful than the DCF?

Answer 6

If the company you’re valuing is early-stage, and it is impossible to estimate its future cash
flows or the company has no path to cash flow at all, you have to rely on these other
methodologies.
These other methodologies can also be more useful when you run into problems in the DCF,
such as the inability to estimate the Discount Rate, or when cash flows fluctuate wildly.

Question 7

Which should be worth more: A $500 million EBITDA healthcare company or a $500 million
EBITDA industrials company?
Assume the growth rates, margins, and all other financial stats are the same.

Answer 7

In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive
industry. That means the company’s CapEx and Working Capital requirements will be
lower, and Free Cash Flow will be higher as a result.
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than
industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset
intensity and higher expected growth rates would, more likely than not, make up for that.
However, this answer is an extreme generalization, so you need more information to make a
real decision.

Question 8

How do you value an apple tree?

Answer 8

The same way you value a company: Comparables and a DCF. You’d look at what similar apple
trees have sold for, and then calculate the expected future cash flows from the apples the tree
produces.
You would then discount those cash flows, discount the Terminal Value, and add up everything
to determine its Implied Value.
The Discount Rate would be based on your opportunity cost – what you might be able to earn
each year by investing in other, similar apple trees.

Question 9

People say the DCF is an intrinsic valuation methodology, whereas Public Comps and
Precedent Transactions are relative.
But is that correct?

Answer 9

No, not exactly. The DCF is based on the company’s expected future cash flows, more so than
the others, so in that sense, it is “intrinsic valuation.”
But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use
the Multiples Method to calculate Terminal Value, that multiple is also linked to peer
companies.
The DCF is less subject to market influence than the other methodologies, but there is still some
influence.
It’s better to say that the DCF is more of an intrinsic valuation methodology than the others.

Question 10

Why do you build a DCF analysis to value a company?

Answer 10

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)
However, it’s not as simple as using that 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 company into two periods: One where
those assumptions change (the explicit forecast period) and one where they stay the same (the
Terminal Period).
You then forecast the company’s cash flows in both periods and discount them to their Present
Value 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.

Question 11

Walk me through a DCF analysis.

Answer 11

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 using the Discount Rate and add it to the sum of the
company’s discounted cash flows.
Finally, you compare this to the company’s Current Value, usually its Enterprise Value, though
you’ll often calculate the company’s Implied Share Price so you can compare it to the Current
Share Price.

Question 12

How do you move from Revenue to Free Cash Flow in a DCF?

Answer 12

First, confirm that they are asking for Unlevered Free Cash Flow (Free Cash Flow to Firm). If so:
Subtract COGS and Operating Expenses from Revenue to get to Operating Income (EBIT).
Then, multiply Operating Income by (1 – Tax Rate), add back Depreciation & Amortization, and
then 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 as a result of its growth, it will be positive.
Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow.
Levered Free Cash Flow (FCFE) is similar, but you subtract the Net Interest Expense before
multiplying by (1 – Tax Rate), and you subtract Mandatory Debt Repayments at the end.

Question 13

What does the Discount Rate mean?

Answer 13

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 the risk and potential returns are both higher; a lower Discount
Rate implies lower risk and lower potential returns.
A higher Discount Rate makes a company less valuable because it means the investors have
better opportunities elsewhere; a lower Discount Rate makes a company more valuable.

Question 14

How do you calculate Terminal Value in a DCF, and which method is better?

Answer 14

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 EV / 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)
Ultimately, the Gordon Growth Method is better because growth always slows down over
time; all companies’ cash flows eventually start growing 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 the Multiples Method because they don’t realize the
implications or because it’s “easier.”

Question 15

What are some signs that you might be using the incorrect assumptions in a DCF?

Answer 15

The most common signs of trouble are:
1. 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 account for, say, 95% of its value.
2. 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.
3. You’re Double-Counting Items – If an income or expense line item is included in FCF,
you should not be counting it in the Implied Enterprise Value 􀃆 Implied Equity Value
calculation at the end, and vice versa if it’s excluded from FCF.
4. Mismatched Final Year FCF Growth 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.

Question 16

If your DCF seems off, what are the easiest ways to fix it?

Answer 16

The simplest method is to extend the explicit forecast period so that the company’s Free Cash
Flow contributes more value, and so that there’s more time for 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 or 15 years and reduce the
company’s FCF growth in those extra years as it approaches maturity.
To avoid double-counting items… um, look at what you’re doing and don’t double count!
Finally, you’ll often have to 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.

Question 17

How do you interpret the results of a DCF?

Answer 17

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, based on a range of plausible revenue growth and margin
assumptions, the company’s Implied Share Price is worth between $15.00 and $20.00, but its
Current Share Price is $8.00, then that is good evidence that it may be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.

Question 18

Does a DCF ever make sense for a company with negative cash flows?

Answer 18

Yes, it may. 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 it starts generating positive cash flow
in the future.
If the company has no plausible path to positive cash flow or you can’t reasonably forecast cash
flow, then the analysis doesn’t make sense.

Question 19

How do Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from an
Unlevered DCF?

Answer 19

In a Levered DCF, you use Levered FCF for the cash flows 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 have to back into Implied Equity Value at the end because the analysis already
produces the Implied Equity Value.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest
Tax Shield separately and add its Present Value at the end.
You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered
Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Unlevered
Beta).
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.

Question 20

Will you get the same results from an Unlevered DCF and a Levered DCF?

Answer 20

No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on
the company’s Debt, whereas the Levered DCF does.
That alone will create a difference, but the more volatile cash flows in a Levered DCF and the
difficulty of picking “equivalent” assumptions in both analyses will also create differences.

Question 21

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

Answer 21

The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more
consistent results than the other methods.
With the other methods, you have to project the company’s Cash and Debt, Net Interest
Expense, and mandatory Debt repayments, all of which require more time and effort.
The Levered DCF sometimes produces odd results because Debt principal repayments can spike
the Levered FCF up or down suddenly.
The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: Increased
chances of bankruptcy. You can try to include this risk, but no one agrees on how to estimate it
numerically.
The Unlevered DCF solves this issue because WACC decreases with more Debt, at first, but then
starts increasing past a certain level, which reflects that added risk of bankruptcy.

Question 22

WHY do you calculate Unlevered Free Cash Flow by excluding and including various items
on the financial statements?

Answer 22

Unlevered FCF must capture the company’s core, recurring items that are available to ALL
investor groups.
That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value
of the company’s core business that’s available to all investor groups.
So if an item is NOT recurring, NOT related to the company’s core business, or NOT available to
all investor groups, you leave it out.
This rule explains why you exclude all of the following items:
􀁸 Net Interest Expense – Only available to Debt investors.
􀁸 Other Income / (Expense) – Corresponds to non-core-business Assets.
􀁸 Most non-cash adjustments besides D&A – They’re non-recurring.
􀁸 The Cash Flow from Financing section – They’re available only to certain investors.
􀁸 Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.

Question 23

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you
about a company’s business model?

Answer 23

The Change in Working Capital tells you whether the company generates more cash than
expected as it grows, or whether it requires more cash to fuel that growth.
It’s related to whether a company records items before or after paying or collecting them in
cash.
For example, retailers tend to have negative values for the Change in Working Capital because
they must pay for Inventory upfront before they can sell products.
But subscription-based software companies often have positive values for the Change in
Working Capital because they collect cash from long-term subscriptions upfront and recognize
the revenue over time.
The Change in WC could reduce or increase the company’s Free Cash Flow, but it’s rarely a
major value driver because it tends to be fairly small for most companies.

Question 24

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a noncash
add-back on the Cash Flow Statement.

Answer 24

No! SBC is not a real non-cash expense in the context of valuation because it creates additional
shares and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: The company paid for
something earlier on, but recognizes it over several years.
It’s true that Stock-Based Compensation is a non-cash expense on the Cash Flow Statement, but
the context is different: Accounting rather than valuation.
The financial statements reflect the true impact of SBC because the company’s diluted share
count goes up as a result.
In a DCF, you should either count SBC as a real cash expense or include it as a non-cash addback
and reflect the additional shares, which will reduce the company’s Implied Share Price.
Most DCF analyses get this completely wrong because they don’t use either approach: They
pretend that SBC is a normal non-cash charge that makes no impact on the share count.

Question 25

What’s the proper tax rate to use when calculating FCF – the effective tax rate, the
statutory tax rate, or the cash tax rate?

Answer 25

The company’s Free Cash Flows should reflect the cash taxes it pays.
So it doesn’t matter which rate you use as long as the cash taxes are correct.
For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax
Income), and then factor in Deferred Taxes within the non-cash adjustments.
So if a company pays more or less in taxes than what it has recorded on its Income Statement,
you could adjust afterward.
Or you could calculate the company’s “cash tax rate” and skip the Deferred Tax adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes and other
items to arrive at the company’s real cash taxes.
It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on
historical trends.

Question 26

How should CapEx and Depreciation change over the explicit forecast period?

Answer 26

Just like the company’s Free Cash Flow growth rate should decline over the explicit forecast
period, the company’s CapEx and Depreciation should also decline.
High-growth companies tend to spend more on Capital Expenditures to support their growth,
but this spending declines over time as the companies move from “growth” to “maintenance.”
If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be
less of a difference by the end.
If the company’s FCF is growing, CapEx should never EQUAL Depreciation.
That’s partially due to inflation (capital assets purchased 5-10 years ago cost less back then),
and partially because if you’re assuming FCF growth in the Terminal Period, Net PP&E needs to
keep growing to support it.
If you’re assuming that the company’s FCF declines or stagnates, then you might use different
assumptions.

Question 27

Should you reflect inflation in the FCF projections?

Answer 27

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for
prices and salaries tend to be based on nominal figures.
If you reflect inflation, then you also need to forecast inflation far into the future and adjust all
figures in your analysis.
This extra effort is probably not worth it because of the uncertainty and extra work.

Question 28

If the company’s capital structure is expected to change, how do you reflect it in FCF?

Answer 28

You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt
Repayments will change over time.
It won’t show up explicitly in Unlevered FCF, but you will still reflect it in the analysis by
changing the Discount Rate over time – WACC changes as the company’s Debt and Equity levels
change.
And in a Levered FCF, Cost of Equity will change because additional Debt increases the Cost of
Equity and less Debt reduces it.

Question 29

What’s the relationship between including an income or expense line item in FCF and the
Implied Equity Value calculation at the end of the DCF?

Answer 29

If you include an income or expense in Free Cash Flow, then you should exclude the
corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity
Value at the end (and vice versa for items you include).
For example, if you capitalize the company’s operating leases and count them as a Debt-like
item at the end, then you should exclude the rental expense from FCF, making it higher.
This rule also explains why, in an Unlevered DCF analysis, you have to factor in Cash and Debt
when moving to the Implied Equity Value: You’ve excluded the corresponding items on the
Income Statement (Interest Income and Interest Expense).

Question 30

How do Net Operating Losses (NOLs) factor into Free Cash Flow?

Answer 30

You could set up an NOL schedule and use them to reduce the company’s cash taxes, also
factoring in accruals if the company ever records negative Pre-Tax Income.
If you do this, then you don’t need to count them in the Implied Enterprise Value 􀃆 Implied
Equity Value calculation at the end.
However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business
Asset in this calculation at the end.
Beyond the extra work, one problem with the first approach is that you may not use all the
NOLs by the end of the explicit forecast period!

Question 31

How does the Pension Expense factor into Free Cash Flow?

Answer 31

There are several different components of the Pension Expense, including the Service Cost, the
Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains,
and Other Adjustments.
Most of those count as operating expenses and should be reflected in the company’s Free Cash
Flow.
In an Unlevered DCF, you should exclude the Interest Expense and Expected Return on Plan
Assets within the Pension Expense and then subtract the Unfunded portion of the Pension
Obligation when moving from Implied Enterprise Value to Implied Equity Value.
Some companies embed these items within Operating Expenses on the Income Statement, so
you may have to review the filings to calculate EBIT properly.
You may have to multiply the Unfunded Pension by (1 – Tax Rate) as well, though the treatment
differs under U.S. GAAP and IFRS and in different countries.

Question 32

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

Answer 32

For the most part, no. You certainly shouldn’t make speculative projections for these items –
they are all non-recurring, so it’s not correct to forecast them as if they were recurring,
predictable items.
If a company has announced plans to sell an asset, make an acquisition, or record a write-down
in the near future, then you might factor it into FCF for that year.
And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or
received, and you’ll have to change the company’s revenue and expenses in future periods.

Question 33

What does the Cost of Equity mean intuitively?

Answer 33

It tells you the percentage a company’s stock “should” return each year, over the very long
term, also factoring in dividends and stock repurchases.
In a valuation, it represents the percentage an Equity investor might earn each year.
To a company, Cost of Equity represents the cost of funding its operations by issuing shares to
new investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting
existing investors (and thereby giving more stock appreciation potential to others).

Question 34

What does WACC mean intuitively?

Answer 34

WACC is similar to Cost of Equity, but it’s the expected annual return percentage if you invest
proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock,
etc.
To a company, WACC represents the cost of funding its operations by using all its sources of
capital.
Investors might invest in a company if their expected IRR exceeds WACC, and a company might
decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Question 35

How do you calculate Cost of Equity?

Answer 35

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
The Risk-Free Rate represents what you would earn on “risk-free” government bonds
denominated in the same currency as the company’s cash flows. You usually use 10-year or 20-
year bonds to match the explicit forecast period of the DCF.
Levered Beta represents how volatile this stock is relative to the market as a whole, factoring in
both its intrinsic risk and the risk from leverage.
And the Equity Risk Premium represents how much the stock market in the company’s country
will return above the “risk-free” government bond.
The idea is to say: “Stocks are riskier and have higher potential returns than government
bonds. So let’s take the rate of return on those government bonds, add the extra returns you
could get from the stock market, and then adjust for this company’s specific risk/return.”

Question 36

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

Answer 36

You should use the rate on the government bonds that match the currency of the company’s
cash flows.
So if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if
it reports them in EUR or GBP, you might use the rate on 10-year notes issued by the Bank of
England or the European Central Bank.

Question 37

What should you use for the Risk-Free Rate if government bonds in the country are NOT
risk-free (e.g., Greece)?

Answer 37

One option is to take the Risk-Free Rate in a country that is assumed to be “risk-free,” like the
U.S. or U.K., and then add a default spread based on your country’s credit rating.
For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a
spread of 11.2% for Greece based on its current credit rating.
That rate of 13.7% represents how yields are much higher in Greece due to the significant
chance of the government defaulting on its bonds.

Question 38

How do you calculate the Equity Risk Premium?

Answer 38

There is almost no agreement on how to do it because stock-market returns differ based on the
period and whether you use an arithmetic mean, a geometric mean, or other approaches.
Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for
companies of different sizes in different industries each year.
You could also take the historical data for the U.S. stock market and add a premium based on
the default spread of your country/market.
For example, if the historical U.S. premium is 7%, you might add 3% if your country’s credit
rating is Ba2 and that rating corresponds to a 3% spread.
Finally, some groups just use a “standard” number for each market, such as 6-7%.

Question 39

How do you calculate the Equity Risk Premium for a multinational company that operates
in many different geographies?

Answer 39

You might take the percentage revenue from each country, multiply it by the ERP in that
market, and then add everything up to get a weighted average.
The ERP in each market might be based on anything described above, but the “Historical U.S.
stock market returns + default spread” approach is common.

Question 40

What does Beta mean intuitively?

Answer 40

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a
whole, factoring in both the intrinsic business risk and the risk from leverage (i.e., Debt).
If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so
it’s always less than or equal to Levered Beta.

Question 41

Could Beta ever be negative?

Answer 41

Yes, it’s possible. The company’s stock price has to move in the opposite direction of the market
as a whole for Beta to be negative.
Gold is commonly cited as an Asset that has a negative Beta because it often performs better
when the stock market declines.
However, negative Betas for companies are quite rare and usually revert to positive figures,
even if they’re negative for short periods.

Question 42

Why do you have to un-lever and re-lever Beta when calculating Cost of Equity?

Answer 42

You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical
Beta, i.e. its own Levered Beta, and skip this step.
But in a valuation, you’re estimating the company’s Implied Value – what it should be worth.
If you use the historical Beta, that corresponds more closely to the company’s Current Value –
what the market says it’s worth today.
By un-levering Beta for each comparable company, you isolate each company’s inherent
business risk.
Each company might have a different capital structure, so it’s important to isolate that risk and
remove the risk from leverage.
You then take the median Unlevered Beta from these companies and re-lever it based on the
targeted capital structure of the company you’re valuing.
You do this because, in reality, there will always be business risk and risk from leverage, and so
you need to reflect both for the company you’re valuing.
You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock
price, relative to the market as a whole, should be, based on the median business risk of its peer
companies and this company’s targeted capital structure.”

Question 43

What are the formulas for un-levering and re-levering Beta, and what do they mean?

Answer 43

Assuming the company has only Equity and Debt:
Unlevered Beta = Levered Beta / (1 + Debt/Equity Ratio * (1 – Tax Rate))
Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 – Tax Rate))
If the company has Preferred Stock, you add another term for the Preferred/Equity Ratio.
You use a “1 +” in front of Debt/Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is
always less than or equal to Levered Beta.
And you multiply the Debt/Equity Ratio by (1 – Tax Rate) because the tax-deductibility of
interest reduces the risk of Debt.
The formulas reduce Levered Beta to represent the removal of risk from leverage, but they
increase Unlevered Beta to represent the addition of risk from leverage.

Question 44

In those formulas, you’re not factoring in the interest rate on Debt. Isn’t that wrong?
More expensive Debt should be riskier.

Answer 44

Yes, this is one drawback of this approach. However:

1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with
   high Debt / Equity ratios tend to have higher interest rates as well.
2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result
   in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as
   simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.”
   4x higher interest might barely change a large company’s financial profile, but it might make a
   much bigger difference for a smaller company.

Question 45

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

Answer 45

Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF.
A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and relever
Beta regardless of the type of cash flow in your analysis.

Question 46

What are some different ways to calculate Beta in the Cost of Equity calculation?

Answer 46

Some people argue that you should use Predicted Beta instead of Historical Beta because Cost
of Equity relates to expected future returns.
If you do use historical data, you could use the company’s own Historical Beta or the re-levered
Beta based on the historical performance of comparable companies.
And if you re-lever Beta, you could do it based on the company’s current capital structure or its
targeted or “optimal” capital structure.
Most of these methods will produce similar results, and you always use a range of values
when calculating Cost of Equity and WACC.

Question 47

How would you estimate the Cost of Equity for a U.S.-based technology company?

Answer 47

This question tests your ability to make a guesstimate based on common sense and your
knowledge of current market rates.
You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company
like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So if you
assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.”
The numbers will change based on market conditions, but that’s the idea.

Question 48

How do you calculate WACC, and what makes it tricky?

Answer 48

The formula for WACC is simple:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred
Stock * % Preferred Stock
But it’s tricky to calculate because there’s ambiguity with many of these items:
1. Cost of Debt: Do you use the weighted average coupon rate on the company’s bonds?
Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies?
2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company’s current
capital structure, “optimal” structure, or targeted structure?
3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the
Equity Risk Premium.

Question 49

WACC reflects the company’s capital structure, so why do you pair it with Unlevered FCF?
It’s not capital structure-neutral!

Answer 49

That’s not the best way to think about this concept. Think of Unlevered FCF as “Free Cash Flow
to Firm,” or FCFF, instead (as that is the alternate name for it).
And think of the relationship as: “Unlevered FCF, or FCFF, is available to ALL investors, and
WACC represents ALL investors.”
No Discount Rate can be capital structure-neutral since each part of a company’s capital
structure affects the other parts. So “capital structure neutrality” is a property of Free Cash
Flow and its variants.

Question 50

Should you use the company’s current capital structure or optimal capital structure to
calculate WACC?

Answer 50

A company’s “optimal” capital structure is the one that minimizes WACC. But there’s no way to
calculate it because you can’t tell in advance how the Costs of Equity and Debt will change as
the capital structure changes.
So in practice, you’ll often use the median capital structure percentages from the comparable
public companies as a proxy for the “optimal” capital structure.
The logic is the same as the logic for un-levering and re-levering Beta: You want to capture what
this company’s capital structure should be, not what it is right now.
It’s better to use this expected capital structure because the company’s Implied Value in a DCF
is based on its expected, future cash flows.

Question 51

Should you use Total Debt or Net Debt to determine the capital structure percentages in
the WACC calculation?

Answer 51

Some textbooks claim that you should use Equity Value + Debt + Preferred Stock – Cash for the
denominator of the capital structure percentages in the WACC formula rather than Equity Value
+ Debt + Preferred Stock.
However, we disagree with this approach for several reasons:
1) Cash Does Not “Offset” Debt – For example, many forms of Debt do not allow for early
repayment or penalize the company for early repayment. So a high Cash balance doesn’t
necessarily reduce the risk of Debt.
2) You May Get Nonsensical Results with High Cash Balances – For example, if the
company’s Cash balance exceeds its Debt balance, Debt as a Percentage of Total Capital
will be far too low. This will artificially inflate the Discount Rate since Equity is more
expensive than Debt for most companies.

Question 52

Why is Equity more expensive than Debt?

Answer 52

Because it offers higher risk and higher potential returns.
Expected stock market returns exceed the interest rates on Debt in most cases, which already
makes the Cost of Equity higher. But interest on Debt is also tax-deductible, which further
reduces its cost.
In developed markets like the U.S., the average annual stock market return is around 10-11%.
So a company with a Beta of 1.0 will have a Cost of Equity in that range.
For Cost of Debt to be higher, the Pre-Tax Cost would have to be ~17-18% at a 40% tax rate.
And hardly any Debt has interest rates that high.

Question 53

How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?

Answer 53

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers
higher risk and potential returns than Debt, but lower risk and potential returns than Equity.
That’s because the coupon rates on Preferred Stock tend to be higher than the interest rates on
Debt, and Preferred Dividends are not tax-deductible.
But these rates are still lower than expected stock market returns, and the risk is also lower
since Preferred Stock investors have a higher claim on the company’s Assets than Common
Stock investors.

Question 54

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC
calculation, and what do they mean?

Answer 54

These Costs represent the marginal rates a company would pay if it issued additional Debt or
Preferred Stock.
There is no way to observe these rates, but you can estimate them.
One simple method is to calculate the weighted average coupon rate on the company’s existing
Debt or Preferred Stock or to calculate the median coupon rate on the outstanding issuances of
comparable companies.
You could also use the Yield to Maturity (YTM) instead, which reflects the market prices of the
bonds (a bond with a coupon rate of 5% that’s trading at a discount to par value will have a
YTM higher than 5%).
You could also take the Risk-Free Rate in the country and add a default spread based on the
company’s expected credit rating if it issues more Debt or Preferred Stock (e.g., if you think its
credit rating will go from BB+ to BB after issuing Debt, you’d calculate the average spread for
BB+-rated companies and add it to the Risk-Free Rate).

Question 55

How do convertible bonds factor into the WACC calculation?

Answer 55

If the company’s current share price exceeds the conversion price of the bonds, you count the
bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher
Equity Value for the company and a greater Equity weighting in the WACC formula.
If not – i.e., the bonds are not currently convertible – you count them as Debt and use the
coupon rate (or YTM, or another method above) to calculate their Cost.
Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt
is lower than the Cost of Equity, and the coupon rates on convertible bonds are even lower
than the rates on traditional bonds.
NOTE: This answer assumes that you’re calculating WACC based on the company’s current
capital structure. If you’re using the optimal or targeted structure, the company’s convertible
bonds won’t factor in.

Question 56

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more
Debt?

Answer 56

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of
bankruptcy, which affects all investors.
As a company goes from no Debt to some Debt, WACC decreases at first because Debt is
cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy
starts to outweigh the lower Cost of Debt.
However, the exact impact depends on where you are on that curve. If the company already
has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt,
WACC is more likely to decrease with more Debt.

Question 57

How do all those figures change as the company uses less Debt?

Answer 57

The Cost of Equity and Cost of Debt decrease for the reasons stated above: Less Debt means a
lower risk of bankruptcy and, therefore, less risk for all investors.
WACC could go either way depending on where you are on the curve. If the company already
has a very high level of Debt, WACC will likely decrease with less Debt; if its Debt level is much
lower, WACC will likely increase with less Debt.

Question 58

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt,
how does that affect WACC?

Answer 58

It depends on how you’re calculating WACC. If you’re using the company’s current capital
structure, WACC will most likely increase because 20% Debt is a fairly low level. At that level,
less Debt will most likely increase WACC.
But if you’re using the targeted, optimal, or median capital structure from the comparable
companies, this change won’t affect WACC because you’re not using the company’s current
capital structure at all.

Question 59

Should you ever use different Discount Rates for different years in a DCF?

Answer 59

Yes, sometimes it makes sense to use different Discount Rates.
For example, if a company is growing quickly right now, but it’s expected to mature and grow
more slowly in the future, you might use decreasing Discount Rates.
So if the company’s current WACC is between 11% and 13%, and WACC for mature companies
in the industry is between 8% and 9%, you might start out at 12% and then reduce it by 0.5% in
each year of the explicit forecast period until it reaches 8.5% at the end.
It makes less sense to do this if the company is already stable and mature and it’s not expected
to change much over time.

Question 60

What is the difference between the explicit forecast period and the Terminal Period in a
DCF?

Answer 60

The company’s Free Cash Flow growth rate, and possibly its Discount Rate, change over time in
the explicit forecast period since you forecast cash flow in each year.
But in the Terminal Period, you assume the company remains in a “steady state”: Its Free Cash
Flow grows at the same rate each year, and its Discount Rate remains the same.

Question 61

What’s the intuition behind the Gordon Growth formula for Terminal Value?

Answer 61

The typical formula is:
Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal
FCF Growth Rate)
But it’s more intuitive to think of it as:
Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate)
The intuition is that a company is worth less if the Discount Rate is higher and worth more if
the Terminal FCF Growth Rate is higher.
For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has
$100 in FCF in the first year of the Terminal Period.
You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the
Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay
$100 / 20%, or $500.
That’s because the company is worth more when you have worse investment options
elsewhere, and worth less when you have better investment options elsewhere.
Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay
$100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d
be willing to pay $100 / (10% – 5%), or $2,000, for it.
Higher growth lets you achieve the same targeted return even when you pay more.

Question 62

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from
Public Comps or Precedent Transactions?

Answer 62

The answer is: “Neither one – you just use them as starting points in the analysis, and then you
adjust once you see the Terminal FCF Growth Rates that the selected multiples imply.”
It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years
into the future, because you don’t want to reflect the control premium inherent in Precedent
Transactions.
The company doesn’t necessarily “get sold” at the end of the forecast period; the Terminal
Multiple is just an abbreviated way of expressing its valuation.
Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your
initial guess; if not, you adjust it up or down as necessary.

Question 63

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using
the Gordon Growth Method?

Answer 63

This growth rate should be below the country’s long-term GDP growth rate and in-line with
other macroeconomic variables like the rate of inflation.
For example, if you’re in a developed country where the long-term expected GDP growth is 3%,
you might use numbers ranging from 1.5% to 2.5% for the range of Terminal Growth Rates.
You should NOT pick a rate above the country’s long-term GDP growth rate because the
company will become bigger than the economy as a whole after a certain point!

Question 64

Why do you need to discount the Terminal Value back to its Present Value?

Answer 64

Because the Terminal Value represents the Present Value of the company’s cash flows from the
very end of the explicit forecast period into perpetuity. In other words, it represents the
company’s value IN a future period AT a point in the future.
Valuation tells you what a company is worth TODAY, so any “future value” must always be
discounted back to its Present Value.
If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Value
because you’d be acting as if its Year 6, 11, or 16 cash flows arrived next year.

Question 65

When you discount the Terminal Value, why do you use the number of the last year in the
forecast period for the discount period (for example, 10 for a 10-year forecast)?
Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting
in Year 11?

Answer 65

No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but
it’s the Present Value as of the very end of Year 10.
You would use 11 for the discount period only if your explicit forecast period went to Year 11
and the Terminal Period started in Year 12.

Question 66

What do you do after summing the PV of Terminal Value and PV of Free Cash Flows?

Answer 66

If you’re building a Levered DCF analysis, you’re almost done because this summation gives you
the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity
Value by its diluted share count to get its Implied Share Price (if the company is public).
In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows = Implied Enterprise
Value, so you have to “back into” the company’s Implied Equity Value and then calculate its
Implied Share Price.
You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting
Liability and Equity items that represent other investor groups (Debt, Preferred Stock,
Noncontrolling Interests, etc.).
Then, you divide by the company’s diluted share count to get its Implied Share Price.

Question 67

The diluted share count factors in the company’s in-the-money options.
But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?

Answer 67

In theory, yes. Some academics and professors such as Damodaran use Black-Scholes to value
these out-of-the-money options, and then subtract the value of those options to determine its
true Implied Equity Value.
In practice, banks rarely include out-of-the-money options in a DCF. There are several reasons
why, including the fact that these options tend to make a very small impact and the fact that
the valuation of options gets tricky and requires inputs that you may or may not have.

Question 68

How can you check whether or not your Terminal Value estimate is reasonable?

Answer 68

It’s an iterative process: You start by entering a range of assumptions for the Terminal Multiple
or Terminal FCF Growth Rate, and then you cross-check your assumptions by seeing what
Growth Rates or Multiples they imply.
If it seems wrong, then you adjust the range of Terminal Multiples or Terminal FCF Growth
Rates up or down until you get more reasonable results.
Example: You start by picking 10x EV / EBITDA for the Terminal Multiple. At a Discount Rate of
12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high.
So you reduce it to 6x EV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to 1%,
which is too low.
So you guess 8x EV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more
reasonable since it’s below the expected long-term GDP growth rate.
This 8x figure might be your “Baseline Terminal Multiple,” so you start there and then go
slightly above and below it in sensitivity tables.

Question 69

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

Answer 69

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA
multiples might have very different Free Cash Flow and FCF growth figures. As a result, their
Implied Values might differ significantly even if one multiple is similar for both of them.
You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those
present other issues, such as less comparability across peer companies.
This problem is one reason why the Gordon Growth Method is still the “real” way to calculate
Terminal Value.

Question 70

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Answer 70

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its
key drug expires within the explicit forecast period, you might assume that the company’s cash
flows eventually decline to 0.
A negative Terminal FCF Growth Rate represents your expectation that the company will stop
generating cash flow eventually.
A negative Terminal FCF Growth Rate doesn’t make the company “worthless”; it just means
that the Terminal Value will be much lower.

Question 71

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

Answer 71

The same variables are important in any DCF: The Discount Rate, the Terminal FCF Growth Rate
or Terminal Multiple, and the revenue growth and margin assumptions.
It doesn’t make sense to sensitize much else – assumptions for CapEx and Working Capital, for
example, make a very small difference.
There may also be industry-specific assumptions that are worth sensitizing (e.g., the patent
expiration date for a drug in biotech/pharmaceuticals).

Question 72

Why do you use the mid-year convention in a DCF analysis?

Answer 72

You use it because a company’s cash flow does not arrive 100% at the end of each year – it’s
generated throughout each year.
Using 1, 2, 3, 4, etc. for the discount periods implies that the first cash flow arrives after one
entire year has passed.
But if you use 0.5, 1.5, 2.5, 3.5, etc. instead, you assume that only half a year passes before the
first cash flow is generated, which is a better approximation for real life.

Question 73

What impact does the mid-year convention make?

Answer 73

A DCF that uses the mid-year convention will produce higher Implied Values because the
discount periods are lower. As a result, a formula like this:
Present Value = $100 / ((1 + 10%) ^ Year#)

Will produce higher values because the Year # of the first period would be 1 without the midyear
convention, but 0.5 with the mid-year convention.

Question 74

Why might you include a “stub period” in a DCF, and what does it mean?

Answer 74

You include a “stub period” if you’re valuing a company midway through the year, and it has
already reported some of its financial results.
A DCF is based on expected future cash flow, so you should exclude these previously reported
results and adjust the discount periods as well.
For example, maybe it’s September 30th and the company’s fiscal year ends on December 31st.
The company’s future cash flow for this year will be generated between September 30th and
December 31st.
It’s incorrect to include the cash flow from January 1st to September 30th since that part of the
year has already passed.
So for the first year in the analysis, you include only the expected FCF from September 30th to
the end of the year. To discount the FCF in that 3-month period, you use 0.25 for the discount
period since 3 months is 25% of the year.
You then use 1.25 for the discount period of the next year, 2.25 of the year after that, and so
on.

Question 75

You’re valuing a company on April 30th, and you want to include both the stub period and
the mid-year convention in your analysis.
How would you change the company’s Free Cash Flow, and which discount periods would you
use?

Answer 75

For the FCF, you exclude everything generated between January 1st and April 30th and include
only the projected amount to be generated between April 30th and December 31st.
Since most companies report only quarterly results, you’ll most likely be excluding the first
quarter, not exactly the first 4 months.
If you include both the stub period and the mid-year convention, you divide the stub period of
the first year by 2. And then in each year after that, you subtract 0.5 from the “normal”
discount period.
In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the “normal”
stub discount period is 0.67.
Since you’re using the mid-year convention, you divide that by 2 to get 0.34. You then use that
period to discount the company’s FCF from April 30th to December 31st.
The “normal” discount period of the next year would be 0.67 + 1.00, or 1.67. So you take the
1.67 and subtract 0.50 to get 1.17.
For the next year after that, the “normal” discount period is 0.67 + 2.00, or 2.67, so you
subtract 0.50 and get 2.17. You continue that for the rest of the years.

Question 76

Continuing with the same example, how do the Terminal Value and PV of Terminal Value
calculations change with this April 30th valuation?

Answer 76

It depends on how you calculate the Terminal Value. With the Multiples Method, the Terminal
Value calculation stays the same since it’s based on the company’s EBITDA (or other metric) in
the final projection year times an appropriate multiple.
When you discount the Terminal Value, the stub period affects the discount period, but the
mid-year convention does not because the Terminal Value is as of the END of the last
projection year.
So if the valuation date is April 30th, and there are 10 years in the projection period, you use
9.67 for the discount period to calculate the PV of the Terminal Value.
With the Gordon Growth method, if you’re using the mid-year convention, you must adjust the
Terminal Value by multiplying it by (1 + Discount Rate)^0.5.
You have to do this because the normal formula, FCF in Year 1 of Terminal Period / (Discount
Rate – Terminal Growth Rate), gives you the Present Value at Year 10.5 if you’re using the midyear
convention.
When you multiply by (1 + Discount Rate)^0.5, you “move the Terminal Value back” to the end
of Year 10.
Discounting the Terminal Value works the same way as it does with the Multiples Method: Only
the stub period affects it. So you use also 9.67 for the discount period.

Question 77

Why do you need to adjust the Terminal Value when you use the mid-year convention?
Can’t you just discount it to Present Value using a different discount period?

Answer 77

Yes, you could discount the Terminal Value to its Present Value by using a different discount
period instead.
However, the Terminal Values calculated via both methods should be directly comparable.
In other words, BOTH Terminal Values should be as of the end of Year 10 in a 10-year analysis.
If you do not adjust the Terminal Value from the Gordon Growth Method, and you’re using the
mid-year convention, you can’t compare it to the Terminal Value from the Multiples Method
because one TV is as of Year 10, and the other is as of Year 10.5.

Question 78

Why might you need to create a “Normalized Terminal Year” in a DCF?

Answer 78

You might create a Normalized Terminal Year if something about the company’s revenue
growth, margins, or CapEx is expected to change in a major way in the Terminal Period.
As a result of this change, multiplying FCF in the final projection year by (1 + Terminal FCF
Growth Rate) won’t produce accurate results in the Terminal Value formula.
For example, a key patent might expire in Year 9 or 10, or the company might have a huge
Intangibles balance that gets completely amortized in Year 10.
You use the FCF in this Normalized Year for the Terminal Value calculation rather than
multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).

Question 79

What impact does the Normalized Terminal Year make?

Answer 79

Technically, it could go either way, but in most cases, the Normalized Terminal Year will reduce
a company’s Implied Value because you often adjust down the company’s growth rates and
margins in this year.

Question 80

Which assumptions make the biggest impact on a DCF?

Answer 80

The Discount Rate and Terminal Value make the biggest impact on the DCF output.
That’s because the Discount Rate affects the PV of everything and because the PV of the
Terminal Value often represents 50%+ of the company’s Implied Value.
The assumptions for revenue growth and operating margins also make a significant impact, but
less so than the ones above. Other items, such as CapEx, Working Capital, and non-cash
adjustments, make a much smaller impact.

Question 81

Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value
company?

Answer 81

Assuming that both companies have the same capital structure percentages, Cost of Equity and
WACC should both be higher for the $500 million company.
All else being equal, smaller companies tend to offer higher potential returns and higher risk
than larger companies, which explains why Cost of Equity will be higher.
Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt
(and Preferred) also tends to be higher.
And since all the Costs tend to be higher for smaller companies, WACC must be higher,
assuming the same capital structure percentages.

Question 82

Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from
9% to 10% make a bigger impact on a DCF?

Answer 82

The Discount Rate increase will make a bigger impact. Increasing revenue growth from 9% to
10% will barely impact FCF and the Terminal Value, but the Discount Rate will affect the Present
Value of everything.

Question 83

Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase
the Discount Rate from 9% to 10%?

Answer 83

It’s harder to tell here. More than doubling a company’s revenue growth could make a bigger
impact than changing the Discount Rate by 1%, but when the changes are this different, you’d
have to run the numbers to tell for sure.
These operational changes make a bigger impact over longer projection periods than they do
over shorter ones, so you would see more of a difference for a 10-year DCF than a 5-year one.

Question 84

Two companies produce identical total Free Cash Flows over a 10-year period, but
Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining
9 years. Company B generates the same amount of Free Cash Flow in each year.
Which company will have the higher Implied Value?

Answer 84

This is a bit of a trick question because it depends on what you count toward the Implied Value.
If it’s just this series of cash flows, Company A will have the higher Implied Value because of the
time value of money: The cash flows arrive earlier on, so they’re worth more.
However, Company B will almost certainly have a much higher Terminal Value because it has
higher FCF in Year 10.
So if the Terminal Value comprises a big portion of the Implied Value, and you count it in the
analysis, it’s a good bet that Company B will have the higher Implied Value.

Question 85

How do higher vs. lower tax rates affect the Cost of Equity, Cost of Debt, WACC, and the
Implied Value from a DCF?

Answer 85

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If
the company does not have Debt, or its targeted/optimal capital structure does not include
Debt, the tax rates don’t matter because there’s no tax benefit to interest paid on Debt.
Assuming there’s some Debt, a higher tax rate will reduce Cost of Equity, Cost of Debt, and
WACC.
It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher
rate always reduces the after-tax cost.

But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is
less risky even to Equity investors. And if both of these are lower, WACC will also be lower.
However, the Implied Value from a DCF will be lower because the higher tax rate reduces FCF
and, therefore, the company’s Terminal Value. Those changes tend to outweigh a lower WACC.
The opposite happens with lower taxes: Higher Costs of Equity and Debt, higher WACC, and a
higher Implied Value from the DCF.

Question 86

Can you walk me through how you use Public Comps and Precedent Transactions?

Answer 86

First, you select the companies and transactions based on criteria such as industry, size, and
geography.
Then, you determine the appropriate metrics and multiples for each set – for example,
revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples – and
you calculate them for all the companies and transactions.
Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for
each valuation multiple in the set.
Finally, you apply those numbers to the financial metrics of the company you’re analyzing to
estimate its Implied Value.
For example, if the company you’re valuing has $100 million in EBITDA and the median EBITDA
multiple of a set of comparable companies is 7x, its implied Enterprise Value is $700 million
based on that.
You then calculate its Implied Value for all the other multiples to get a range of values.

Question 87

Why is it important to select Public Comps and Precedent Transactions that are similar?

Answer 87

Because the comparable companies and transactions should have similar Discount Rates.
Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate,
and Expected FCF Growth Rate.
If the companies in your set all have similar Discount Rates, it’s easier to conclude that one
company has a higher multiple because its expected growth rate is higher.
If they don’t have similar Discount Rates, it’s harder to draw meaningful conclusions.

Question 88

How do you select Comparable Companies and Precedent Transactions?

Answer 88

You screen based on geography, industry, and size, and also time for Precedent Transactions.
The most important factor is industry – you’ll always use that because it makes no sense to
compare a mobile gaming company to a steel manufacturing company.
Here are a few example screens:
􀁸 Comparable Company Screen: U.S.-based steel manufacturing companies with over
$500 million in revenue.
􀁸 Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA.
􀁸 Precedent Transaction Screen: Latin American M&A transactions over the past 3 years
involving consumer/retail sellers with over $1 billion USD in revenue.
􀁸 Precedent Transaction Screen: Australian M&A transactions over the past 2 years
involving infrastructure sellers with over $200 million AUD in revenue.

Question 89

Are there any screens you should AVOID when selecting Comparable Companies and
Precedent Transactions?

Answer 89

You should avoid screening by both financial metrics and Equity Value or Enterprise Value.
For example, you should NOT use this screen: “Companies with revenue under $1 billion and
Enterprise Values above $2 billion.”
If you do that, you’re artificially constraining the multiples because EV / Revenue must be
above 2x for every company in the set.

Question 90

Both Public Comps and Precedent Transactions seem similar. What are the main
differences?

Answer 90

The idea is similar – you use Current valuation multiples from similar companies or deals to
value a company – but the execution is different.
Here are the differences for Precedent Transactions:
􀁸 Screening Criteria: In addition to industry, size, and geography, you also use time
because you only want transactions from the past few years. You might also use
Transaction Size, and you might use broader screening criteria in general.
􀁸 Metrics and Multiples: You focus more on historical metrics and multiples, especially
LTM revenue and EBITDA as of the announcement date.
􀁸 Calculations: All the multiples are based on the purchase price as of the announcement
date of the deal.
􀁸 Output: The multiples produced tend to be higher than the multiples from Public Comps
because of the control premium. But the multiples also tend to span wider ranges
because deals can be done for many different reasons.

Question 91

Can you walk me through the process of finding market and financial information for the
Public Comps?

Answer 91

You start by finding each company’s most recent annual and interim (quarterly or half-year)
filing. You calculate its diluted share count and Current Equity Value and Current Enterprise
Value based on the information there and its most recent Balance Sheet.
Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent
annual results, adding the results from the most recent partial period, and subtracting the
results from the same partial period the last year.

For the projected figures, you look in equity research or find consensus figures on Bloomberg.
And then you calculate all the multiples by dividing Current Equity Value or Current Enterprise
Value by the appropriate metric.

Question 92

Can you walk me through the process of finding market and financial information for the
Precedent Transactions?

Answer 92

You find the acquired company’s filings from just before the deal was announced, and you
calculate the LTM financial metrics in the same way using those.
To calculate the company’s Equity Value and Enterprise Value, you use the purchase price the
acquirer paid, and you move from Equity Value to Enterprise Value in the same way you usually
do, using the company’s most recent Balance Sheet as of the announcement date.
You calculate all valuation multiples in the same way, using Transaction Equity Value or
Transaction Enterprise Value as appropriate.

Question 93

How do you decide which metrics and multiples to use in these methodologies?

Answer 93

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitabilitybased
metrics and multiples. For example, you might use Revenue, EBITDA, and Net Income,
and the corresponding multiples: EV / Revenue, EV / EBITDA, and P / E.
You do this because you want to value a company in relation to how much it sells and to how
much it keeps of those sales.
Sometimes, you’ll drop the sales-based multiples and focus on profitability or cash flow-based
ones (e.g., EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Question 94

Why do you look at BOTH historical and projected metrics and multiples in these
methodologies?

Answer 94

Historical metrics are useful because they’re based on what actually happened, but they can
also be deceptive if there were non-recurring items or if the company made acquisitions or
divestitures.
Projected metrics are useful because they assume the company will operate in a “steady state,”
without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because
they’re based on predictions of the future.

Question 95

When you calculate forward multiples for the comparable companies, should you use
each company’s Current Equity Value or Current Enterprise Value, or should you project them
to get the Year 1 or Year 2 values?

Answer 95

No, you always use the Current Equity Value or Current Enterprise Value. NEVER “project”
either one.
A company’s share price, and, therefore, both of these metrics, is based on past performance
and future expectations.
So to “project” these metrics, you’d have to jump into the future and see what future
expectations are at that point, which doesn’t make sense.

Question 96

What should you do if some companies in your set of Public Comps have fiscal years that
end on June 30th and others have fiscal years that end on December 31st?

Answer 96

You have to “calendarize” by adjusting the companies’ fiscal years so that they match up.
For example, to make everything match a December 31st year-end date, you take each
company with a June 30th fiscal-year end and do the following:
􀁸 Start with the company’s full June 30th fiscal-year results.
􀁸 Add the June 30th – December 31st results from this year.
􀁸 Subtract the June 30th – December 31st results from the previous year.
Normally, you calendarize to match the fiscal year of the company you’re valuing.
But you might pick another date if, for example, all the comparable companies have December
31st fiscal years but your company’s ends on June 30th.

Question 97

How do you interpret the Public Comps? What does it mean if the median multiples are
above or below the ones of the company you’re valuing?

Answer 97

The interpretation depends on how the growth rates and margins of your company compare to
those of the comparable companies.

Public Comps are most meaningful when the growth rates and margins are similar, but the
multiples are different. This could mean that the company you’re valuing is mispriced and that
there’s an opportunity to invest and make money.
For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15-
20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these
ranges.
However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable
companies all trade at multiples of 10x to 12x.
That could indicate that your company is undervalued since its multiples are lower, but its
growth rates, margins, industry, and size are all comparable.
If the growth rates and margins are very different, it’s harder to draw conclusions since
companies growing at different rates are expected to trade at different multiples.

Question 98

Is it valid to include both announced and closed deals in your set of Precedent
Transactions?

Answer 98

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed
yet, the simple announcement of the deal reflects what one company believes another is worth.
Note that you base all the metrics and multiples on the financial information as of the
announcement dates.

Question 99

Why do Precedent Transactions often result in more “random” data than Public Comps?

Answer 99

The problem is that the circumstances surrounding each deal might be very different.
For example, one company might have sold itself because it was distressed and about to enter
bankruptcy.
But another company might have sold itself because the acquirer desperately needed it and
was willing to pay a high price.
Some deals are competitive and include multiple acquirers bidding against each other, whereas
others are more targeted and do not involve competitive bidding.
All these factors mean that the multiples tend to vary widely, more so than the multiples for
Public Comps.

Question 100

How do you factor in earn-outs and expected synergies in Precedent Transactions?

Answer 100

You generally don’t factor in expected synergies because they’re so speculative. If you do
include them, you might increase the sellers’ projected revenue or EBITDA figures so that the
valuation multiples end up being lower.
Opinions differ on earn-outs, but you could assume that they have a 50% chance of being paid
out, multiply the earn-out amounts by 50%, and add them to the purchase prices.
Other people ignore earn-outs or add the full earn-out amounts to the purchase prices.

Question 101

Are there any rules about filtering out deals for less than 100% of companies or about
stock vs. cash deals in Precedent Transactions?

Answer 101

Ideally, your set of Precedent Transactions will include only 100% acquisition deals.
However, you may need to go beyond that and also include majority-stake deals (ones where
the acquirer buys more than 50% but less than 100% of the seller).
You can include those because the dynamics are similar, but you should not include minoritystake
deals because acquiring 10% or 20% of a company is quite different.
Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically
include all deals regardless of the form of consideration.
You may note whether each deal was cash, stock, or a mix of both.

Question 102

If there’s a Precedent Transaction where the buyer acquired 80% of the seller, how do you
calculate the valuation multiples?

Answer 102

The multiples are always based on 100% of the seller’s value.
So if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value would
be $500 million / 80% = $625 million. And then you would calculate the Purchase Enterprise
Value based on that figure plus the usual adjustments.
You would then calculate the valuation multiples based on those figures and the financial stats
for 100% of the seller.

Question 103

Why do you use median multiples rather than average multiples or other percentiles?

Answer 103

Median multiples are better than average multiples because of outliers.
If there are 5 companies in your set, and the multiples are 8x, 10x, 9x, 8x, and 25x, you don’t
want the 25x multiple to push up the average when it’s clearly an outlier.
However, there’s no “rule” that you have to use the median rather than other percentiles.
So you could make an argument for using the 25th percentile or 75th percentile.
For example, you could argue that your company’s growth rates and margins are in-line with
companies in the 75th percentile of your set and that the multiples of those companies are,
therefore, most applicable to your company.

Question 104

What is a Liquidation Valuation, and when is it useful and not so useful?

Answer 104

In a Liquidation Valuation, you value a company by determining the market values of all its
Assets, adding them up, and subtracting the market values of all its Liabilities.
It gives you the company’s Implied Equity Value because you’re valuing all the company’s
Assets rather than just its core-business Assets.
This methodology is useful for distressed companies because it tells you how much they might
be worth if they have to liquidate and shut down.
It’s less useful for healthy, growing companies because it tends to undervalue them grossly. A
growing company is worth a lot more than what’s on its Balance Sheet because its cash flows
will grow far into the future.

Question 105

How does a Dividend Discount Model (DDM) differ from a DCF?

Answer 105

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually
based on a percentage of Net Income. You then discount the Dividends to their Present Value
using the Cost of Equity and add them up.
To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E (or the
Gordon Growth Method), and then you discount it to its Present Value using the Cost of Equity.
You get the company’s Implied Equity Value at the end rather than its Implied Enterprise Value,
so you can divide by its diluted share count to get its Implied Share Price.
The DDM is essential in some industries, such as commercial banks and insurance, useful for
other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so
useful for most others.

Question 106

Why might you use an M&A Premiums analysis to value a company?

Answer 106

The M&A Premiums analysis applies only to public companies because you look at acquisitions
of similar public companies and calculate the “premium” each buyer paid for each seller.
For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00
per share, that is a 25% premium.
You take the median for a set of transactions and then use that to value your company. So if the
median premium is 20%, and your company’s share price is $10.00, it’s worth $12.00 per share.
This analysis is useful when Precedent Transactions give nonsensical or useless results, and you
want to use something other than traditional multiples to value your company.
For example, if the precedent transactions were all done at EV / EBITDA multiples between 6x
and 8x, and your company is currently at trading at 10x, the results don’t make sense: A public
company can’t sell for less than its current multiples.
So you could look at the M&A premiums instead. If the median premium is 25%, you might
apply that to your company’s share price and say that a buyer might have to pay that much to
do the deal.

Question 107

How do you build a Future Share Price Analysis?

Answer 107

You take the median historical multiple from the Public Comps, often the P / E multiple, and
apply it to the future metric of the company you’re valuing (Net Income or EPS with the P / E
multiple).
So you assume that in 1 or 2 years, the company will be trading at the median multiple the
comparable companies are currently trading at.
For example, if the median P / E is 15x and the company’s Year 1 projected EPS is $1.00, you
would say the company’s expected “future share price” is 15x * $1.00 = $15.00.
Then, you discount this future share price to its Present Value by using a range of values for the
company’s Cost of Equity.
For Enterprise Value-based multiples, you have to back into the Implied Equity Value and
Implied Share Price in the future years and then discount that share price.

Question 108

What are the advantages and disadvantages of a Sum-of-the-Parts Valuation?

Answer 108

The Sum-of-the-Parts methodology, where you value each division of a company separately and
add them up to determine the company’s Implied Value, works well for conglomerates like
General Electric that have very different divisions.
The divisions operate in such different industries that it would be meaningless to value the
company as a whole – no other company would be truly comparable.
But Sum of the Parts also takes far more time and effort to set up because you have to find
comparable companies and transactions for each division, build a separate DCF for each
division, and so on.
Also, you may not have enough information to do it – companies sometimes don’t disclose EBIT
or CapEx by division, and they may not disclose the corporate overhead expenses that you must
factor in at the end of the analysis.

Question 109

How do you set up an LBO valuation, and when is it useful?

Answer 109

You set up the LBO valuation by creating a leveraged buyout model where a private equity firm
acquires a company for a certain price, using Debt and Equity, holds it for several years, and
then sells it for a certain multiple of EBITDA.

Since most private equity firms target an internal rate of return (IRR) in a specific range, you
work backward and determine the purchase price required to achieve this IRR.
You use the Goal Seek function in Excel to determine the maximum purchase price the PE firm
could pay if it wants to realize a 20% 5-year IRR on a company that it sells for 10x EV / EBITDA.
This methodology is useful for setting a floor on a company’s valuation – you’re constraining
the price because of the IRR requirement.
It’s also useful for estimating what a private equity firm, rather than a normal company, might
be willing to pay for a company.