DCF

Question 1

Walk me through a DCF

Answer 1

• DCF is calculating companies value based on its PV of unlevered free cash flows, and the PV of its terminal value. To calculate PV of free cash flows, you calculate Operating Income, deduct taxes, and then add back non cash expenses and deduct increases in working capital and capital expenditures to get unlevered free cash flow. You then discount them each year using the weighted average cost of capital. To get Terminal value, you would you either the multiple or long term growth rate method. You would then discount erminal value with WACC, You would sum discounted free cash flows and discounted terminal value to get enterprise value, and then deduct debt and add cash to get equity value, before dividing by shares outstanding to get equity value per share

Question 2

• How do you calculate unlevered free cash flows?

Answer 2

Calculate gross profit, deduct operating expenses and non-cash expenses to get operating income, deduct taxes and then add back non-cash expenses, deduct increases in working capital and capital expenditure to get unlevered free cash flow.

Question 3

• How does interest affect unlevered free cash flow?

Answer 3

It doesn’t, because interest is not accounted here because it is unlevered.

Question 4

• How do you calculate levered free cash flow?

Answer 4

Cash flow from operations – CapEx. Or deduct interest received / expense after operating income and before deducting taxes, and then calculate the same way as unlevered free cash flow

Question 5

What stakeholders does unlevered free cash flow and levered free cash flow go to?

Answer 5

• Unlevered free cash flow goes to equity, debt and preferred stock holders (as interest is not deducted) and levered free cash flow goes to equity holders only

Question 6

Why do you use unlevered FCF instead of levered FCF most of the time?

Answer 6

• We use unlevered FCF because we want to get to enterprise value of company, and that unlevered ignores differences in capital structure so make the valuations more comparable

Question 7

• When discounting free cash flows, why use mid-year discount?

Answer 7

Cash flows spread out across the year rather than at the end of the year. Mid year discount means free cash flows will be higher.

Question 8

How to calculate terminal value?

Answer 8

Two methods: * Two methods for calculating terminal value: Ebitda multiple method, or Gordon growth model method

Question 9

When to use multiple method to calculate TV and when to use gordon growth?

Answer 9

Multiple used when you don’t know what long term growth rate is or the company will be sold at a point in time, growth rate method maybe used in a cylical industry when you don’t know what the multiples will be

Question 10

Does gordon growth or multiple method give higher value of TV?

Answer 10

• Neither gives a higher or lower values all the time, depends on the assumption

Question 11

How do you pick EBITDA multiple for TV?

Answer 11

• Company comparables

Question 12

• How to pick Gordon Growth?

Answer 12

Long term GDP or inflation.

Question 13

In a DCF model, what part has the largest impact on the Enterprise value?

Answer 13

Revenue growth, margins, discount rate, terminal value. Terminal value usually has biggest value, as it comprises over 50% of DCF.

Question 14

If you dont trust a company’s financial statement projections, what can you do?

Answer 14

• What do you do if you don’t trust the projections? Discount them further by say 10%, or do a sensitivity table around the assumptions

Question 15

In a DCF, why use 5 years?

Answer 15

Can do between 5-10 years, but things more than 5+ year get very hard to project

Question 16

What are the flaws of a DCF?

Answer 16

Very dependent on future assumptions; can see this through sensitivity tables

Question 17

• What things do you put in sensitivity tables?

Answer 17

Revenue, EBITDA margin, Terminal EBITDA multiple / terminal growth rate, WACC

Question 18

• When would you use something different to dcf?

Answer 18

Different type of transactions, different industries ie financial insitutions use DDM,

Question 19

• Why DDM for financial insitutions?

Answer 19

Doesn’t make sense to use unlevered FCF, because interest is a big part of a banks business model.

Question 20

WACC formula?

Answer 20

• Wacc formula = Cost of equity * % debt + cost of debt * % debt * (1- tax rate) + % preferred stock * cost of preferred stock

Question 21

Cost of equity formula?

Answer 21

• Cost of equity = risk free rate + market beta * (ERP)

Question 22

What do you use as risk free rate?

Answer 22

• Risk free rate = usually us treasury, but could do long term gov debt

Question 23

What do you use for ERP?

Answer 23

• ERP usually from market portfolio

Question 24

Can you add anything else to cost of equity formula?

Answer 24

• Could also add other risk premiums, like size, industry or value risk premiums

Question 25

When would you use unlevered and levered beta?

Answer 25

• Unlevered beta is calculated because we want to look at risk of companies on a capital structure neutral basis

Question 26

How to go from unlevered beta to levered beta?

Answer 26

• Levered beta comes from adding the companies risk without debt and the additional risk coming from debt, but tax shield also reduces risk

Question 27

What causes a higher beta?

Answer 27

More exposed to market portfolio, usually comes from being ‘riskier’ ie smaller, riskier industry etc

Question 28

• What happens to cost of equity when debt goes up?

Answer 28

Goes up, because company is riskier

Question 29

• What happens to wacc when debt goes up?

Answer 29

Usually comes down up to a point, because debt financing is cheaper, but will go back up if distress risk becomes large because cost of debt will go up

Question 30

• What happens to cost of equity if more equity value?

Answer 30

Cost of equituy drops, as d/e ratio lower so company less risky

Question 31

• How doess wacc change for bigger or small company?

Answer 31

Smaller company has bigger wacc, all else equal

Question 32

• If looking at levered free cash flow, what would be discount rate?

Answer 32

Cost of equity only, because debt financing been accounted for when working out levered free cash flow.

Question 33

• Wacc for private companies?

Answer 33

Cant find beta etc. Look for wacc for comparable companies

Question 34

Amendments for real estate / energy companies?

Answer 34

xxx

Question 35

Common flaws of DCF

Answer 35

1) All cash flows are remitted to investors? Not Likely

2) There is never a down year

3) 3) The terminal growth rate is usually too high