DCF Flashcards
Walk me through a DCF
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
Walk me through how you get from Revenue to Free Cash Flow in the projections.
Revenue
- COGS
- Operating Expense
= Operating Income (EBIT)
* (1- Tax Rate)
+ Depreciation and other non-cash charges
- CAPEX
- Changes in Capital
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?
- Levered Cash Flow (after interest payments are made) :
- Take Cash Flow From Operations and subtract CapEx - Unlevered Cash Flow (before interest payments are made):
- Add back tax-adjusted interest expense
- Subtract tax-adjusted interest income
Why do you use 5 or 10 years for DCF projections?
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
What do you usually use for the discount rate?
Normally use WAAC, but might also use Cost of Equity
How do you calculate WACC?
Cost of Equity * % of Equity + Cost of Debt * % of Debt * (1-Tax Rate) + Cost of Preferred * % Preferred
How do you calculate the Cost of Equity?
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)
How do you get to Beta in the Cost of Equity calculation?
- 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
Why do you have to un-lever and re-lever Beta?
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.
Would you expect a manufacturing company or a technology company to have a higher Beta?
Technology company because it’s more risky.
Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what is the effect?
Levered Free Cash Flow would give you Equity Value rather than Enterprise Value since debt investors have already been paid with interest payments.
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
Cost of Equity only
How do you calculate the Terminal Value?
- Multiple Method:
Apply an exit multiple to the company’s final year’s EBIT or EBITDA or FCF - Gordon Growth
- Terminal Value = Final Year FCF * (1+Growth Rate)/(Discount Rate-Growth Rate)
Why would you use Gordon Growth rather than Multiples Method to calculate the Terminal Value
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.
What is an appropriate growth rate?
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.
How to select appropriate multiple when calculating Terminal Value?
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
Which method of calculating Terminal Value will give you a higher valuation (Gordon Growth or Multiple method)?
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.
What is the flaw of the multiples method?
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.
How do you know if your DCF is too dependent on future assumptions?
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…
Should Cost of Equity be higher for a $5 billion or $500 million market cap company?
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
What about WACC – will it be higher for a $5 billion or $500 million company?
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.
What’s the relationship between debt and Cost of Equity?
More debt means more risk ==> higher levered beta . All else equal, higher debt would mean a higher cost of equity.
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?
Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole – and those returns include dividends.
Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?
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.
