DCF

Question 1

Walk me through a DCF

Answer 1

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.
1. Determining the PV of Cash Flows
- Use assumptions for revenue growth, expense, and working capitals to calculate each year’s Free Cash Flow.
- Sums up the Free Cash Flow
- Discount cash flow into present value using WACC
2. Determining the PV of Terminal Value
- Terminal Value: value of business after the forecasted period
- Determine the Terminal Value using either Multiples Method or Gordon Growth Method
- Discount Terminal Value back to the Present Value using WACC
3. Add PV of Cash Flows and PV of Terminal Value to determine the Enterprise Value

Question 1

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

Answer 1

Revenue
- COGS
- Operating Expense
= Operating Income (EBIT)
* (1- Tax Rate)
+ Depreciation and other non-cash charges
- CAPEX
- Changes in Capital

Question 2

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 2

1. Levered Cash Flow (after interest payments are made) :
   - Take Cash Flow From Operations and subtract CapEx
2. Unlevered Cash Flow (before interest payments are made):
   - Add back tax-adjusted interest expense
   - Subtract tax-adjusted interest income

Question 3

Why do you use 5 or 10 years for DCF projections?

Answer 3

5-10 years is a reasonable range to predict into the future. Less than 5 years is too short to be useful, while more than 10 years is too difficult to predict for most companies

Question 4

What do you usually use for the discount rate?

Answer 4

Normally use WAAC, but might also use Cost of Equity

Question 5

How do you calculate WACC?

Answer 5

Cost of Equity * % of Equity + Cost of Debt * % of Debt * (1-Tax Rate) + Cost of Preferred * % Preferred

Question 6

How do you calculate the Cost of Equity?

Answer 6

Risk Free Rate + Beta * Equity Risk Premium
- Risk Free Rate = how much a US Treasury should yield
- Beta: calculated based on the riskiness of the companies
- Equity Risk Premium: % by which the stocks are going to outperform the risk-less assets (e.g. Government Bonds)

Question 7

How do you get to Beta in the Cost of Equity calculation?

Answer 7

• find the Beta for each comparable company
• un-lever the Beta
• take the median
• lever it based on your company’s capital structure
• use this value to calculate the cost of equity

Question 8

Why do you have to un-lever and re-lever Beta?

Answer 8

The Beta posted are levered according to each company’s capital structure. But each company’s capital structure is different and we need to look at how risky a company is regardless of the % of debt. In the end, we need to re-lever to take into account the capital structure of the company we’re valuing.

Question 9

Would you expect a manufacturing company or a technology company to have a higher Beta?

Answer 9

Technology company because it’s more risky.

Question 10

Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what is the effect?

Answer 10

Levered Free Cash Flow would give you Equity Value rather than Enterprise Value since debt investors have already been paid with interest payments.

Question 11

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 11

Cost of Equity only

Question 12

How do you calculate the Terminal Value?

Answer 12

1. Multiple Method:
   Apply an exit multiple to the company’s final year’s EBIT or EBITDA or FCF
2. Gordon Growth
   - Terminal Value = Final Year FCF * (1+Growth Rate)/(Discount Rate-Growth Rate)

Question 13

Why would you use Gordon Growth rather than Multiples Method to calculate the Terminal Value

Answer 13

Almost always use multiples method to calculate Terminal Value because easier to get a more appropriate data for exit multiples as they’re based on the comparable companies, whereas picking a growth rate is likely inaccurate.
Use Gordon Growth if you have no good Comparable Companies or if you believe that the multiples will change significantly in the industry. For example, if the industry is very cyclical.

Question 14

What is an appropriate growth rate?

Answer 14

Normally use the country’s long-term GDP growth rate or the rate of inflation. For companies in developed countries, a growth rate over 5% is quite aggressive.

Question 15

How to select appropriate multiple when calculating Terminal Value?

Answer 15

Normally pick the median of the comparable companies.
- Always show a range of exit multiples and show what the Terminal Value looks like over that range rather than picking one specific number

Question 16

Which method of calculating Terminal Value will give you a higher valuation (Gordon Growth or Multiple method)?

Answer 16

Hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable because exit multiples vary more than long-term growth rates.

Question 17

What is the flaw of the multiples method?

Answer 17

The median multiples may change greatly in the next 5-10 years, so may be no longer accurate ==> important to pick a range of multiples rather than a single number.

The method is particularly problematic with cyclical industries.

Question 18

How do you know if your DCF is too dependent on future assumptions?

Answer 18

if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.

But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

Question 19

Should Cost of Equity be higher for a $5 billion or $500 million market cap company?

Answer 19

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be “more risky”). ==> Higher Equity Risk Premium

Question 20

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 20

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above.

If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

Question 21

What’s the relationship between debt and Cost of Equity?

Answer 21

More debt means more risk ==> higher levered beta . All else equal, higher debt would mean a higher cost of equity.

Question 22

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company – but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 22

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole – and those returns include dividends.

Question 23

Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?

Answer 23

Without debt, a company relies entirely on equity, which is more expensive, leading to a higher WACC.

With moderate debt, the company benefits from the cheaper cost of debt and the tax shield, which reduces WACC.

With excessive debt, the risk increases, and creditors demand higher interest rates, which can cause the WACC to rise again, creating the U-shape curve.

Question 24

Which has a greater impact on a company’s DCF valuation – a 10% change in
revenue or a 1% change in the discount rate?

Answer 24

You should start by saying, “it depends” but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 25

What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 25

It could go either way, but most of the time, the 1% change in discount rate has a bigger impact

Question 26

How do you calculate WACC for a private company?

Answer 26

Private companies don’t have beta or market caps. ==> just estimate WACC based on work done by auditors or valuation specialists, or based on WACC for comparable public companies is.

Question 27

What should you do if you don’t believe management’s projections for a DCF model?

Answer 27

• You can create your own projections.
• You can modify management’s projections downward to make them more
  conservative.
• You can show a sensitivity table based on different growth rates and margins and
  show the values assuming managements’ projections and assuming a more conservative set of numbers.

Question 28

Why would you not use a DCF for a bank or other financial institution?

Answer 28

1. Banks use debts differently.
   - For non-financial companies, debts are used as financing tools to fund operations, or investment in capitals, but for banks, debts are core part of their business model and use them to create product
2. Interest is Integral to Revenue for banks
   - For non-financial companies, interest expenses are excluded and the DCF focuses on operating cash flow. However, for banks, interest is a critical part of the business model.

Question 29

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 29

Cost of Equity = Dividends per share/share price + Growth Rate of dividends

Question 30

What types of sensitivity analyses would we look at in a DCF?

Answer 30

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

Question 31

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Answer 31

We don’t account for this in DCF because paying off debt principal shows up in Cash Flow from Financing on Cash Flow Statement - but we only go down to CFO and then subtract CAPEX.

If we were looking at levered cash flow, then our interest expense would decline but we don’t count the principle repayments themselves.