DCF Flashcards
Walk through a DCF
A DCF values a company based on PV of its CF and terminal value
First, you project company financials using assumptions on revenue growth, expenses and WC. Then you get down to FCF for each yet which you sum up and discount to NPV using WACC
Second, you determine companys terminal value either with multiples method or in perpetuity.
Add both values and have EV.
How do you get from Revenues to FCF
From Revenues
Revenue
(COGS)
(Operating expenses)
to get EBIT, operating income
EBIT (1 minut tau)
Add back depreciation
Add non cash charges
(CAPEX)
(Changes in NWC)
Note this is UNLEVERED as we use EBIT rather than EBT
Alternative way to obtain FCF
CF operations and subtract CapEx
Levered CF
For unlevered you need to add back tax adjusted interest expense and subtract tax adjusted interest income
What do you use for discount rate
WACC or cost of equity
How do you calculate WACC
Cost of Eq x %equ plus Cost of debt x %debt x (1 moins tau)
Can also have cost of preferred x %preferred
For Cost of equity we can use CAPM
For others we use interest rates and yiels of similar companies to get an estiamte
How do you compute cost of equity
Rfr plus beta x (equity risk premium)
Rfr is 10 or 20 year treasury bond yield
Larger the risk premium the larger the smaller the company usually the riskier it is
How to compute beta
Check comparable betas, un lever them and take medium of the set, lever based on our companys capital structure
Unlever beta
Levered beta over
1 plus 1 moins tau x debt to equity
We unlever an relever because they are levered to reflect each companys capital structure, we want to compare apples to apples. We want how risky a company is regardless of debt %
Re lever as in our CoE calc we need to reflect true risk of our copanu taking into account its capital structure
Higher beta
Higher risk, higher volatilitz compared to market
What is the effect of using levered FCF rather than unlevered FCF
Levered will give us the equity value rather than enterprise value since CF is only available to equity investors and debt investors are already paid with interest payments
Use CoE rather than WACC
How do you calculate the terminal value
Either apply an exit multiple to y5 EBITDA or use perpetuity method
Perpetuituy
Y5 CF x (1 plus g) over (r minus g)
Which method to use for terminal value
In banking always use multiples as its much easier to get appropriate data for exit multiples since they are based on comparable companies
Long term growth rate for in perp is a shot in the dark , but may use if no good comparable . Use GDP growth rate a lil higher. If in mature economies, beyond 5% is quite aggressive because the economies grow much less in aggregare
Select correct exit multiple when calculating terminal value
Median of set of comparable companies
Also show range. If median sits at 8, also show for 6 and 10.
Which terminal value method will give you largest valuation
As everything is in DCF, it is highly dependent on assumptions.
Multiples will be more variable than in perp because multiple can span wider range than possible long term growth
Flaw of multiples method for TV
MEdiam multiple may change greatly in 5 to 10 years and no longer be accurate, whcih is why we do sensitivity analysis
Particularly problematic with cyclical industries
When is DCF too dependent on future assumptions
If more than 50pc of EV comes from TV your DCF is too dependent on future assumptions. But this is almost always the case.
If TV is over 80 p% then rethink assumptions.
CoE and market cap link
CoE should be higher, c.p. for a smaller cap company as it is expected to outperform large cap and hence, hold more risk
WACC and market cap link
If cap structure is the same for both companies WACC should be higher for smaller company for same reason as CoE
If its not the same it could be either large or small cap depending on cap structure and IRs
Link debt and CoE
More debt means the company is more risky, so companys beta will be higher
More debt should raise CoE
CoE
Tells us what kind of returns an equity investor can expect in a given companu.
Dividend yields are already factored into beta because beta describes returns in excess of market as a whole
CoE without CAPM
CoE equals…
Dividends per share over share price plus growth rate of dividends
Can be used if beta info is lacking
IF A has debt and B doesnt, which will have higher WACC
Debt is less expensive than equity so A will have lower WACC until a certain point
Why, interest on debt is tax deductible
Debt is senior to equity
However at some point a the interest rate will rise to reflect risk of incurred debt and may exceed COE
What will impact DCF more, 10% change in revenue or 1% change in discount rate
Depends,
but usually difference in revenue has more impact as it will impact all projections and terminal value
What will impact DCF more, 1% change in revenue or 1% change in discount rate
Change in DR likely to have a bigger impact on the valuation
WACC for a private companu
Issue is you dont have a beta. Use comparable public companies WACC
Why not use a DCF for a bank or other financial institutions
They use debt differently and do not re invest in business but use it to create products instead
Use dividend discount model instead
Sensitivity analysis for DCF
Revenue growth vs terminal multiple
EBITDA margin vs terminal multiple
