DCF

Question 1

Walk me thru a DCF

Answer 1

a DCF values a company based on the present value of all future cash flows

1. project FCF for the next 5 to 10 yrs, making assumptions to rev growth, margins, NWC, and CapEx
2. discount cash flows using WACC
3. estimate TV using multiples method or Gordon Growth
4. PV + TV = EV
5. convert EV to EQV so we can find implied share price
6. Conduct a sensitivity analysis to get a valuation range

Question 2

Which would have a larger impact on FCF? $10 more of rev or $10 less of SG&A?

Answer 2

$10 less of SG&A, because when rev increases, COGS also increases

Question 3

When would you use the Gordon Growth model?

Answer 3

Usually, we use both ways of TV to check out assumptions
but in these scenarios, we can only use the Gordon growth model:
1. the company is too big to be sold
2. company is mature and growing at a predictable rate

Question 4

Compare the impact on valuation:
- $10 decrease in CapEx
- $10 decrease in SG&A
- $10 increase in rev

Answer 4

decrease in CapEx > decrease in opex > increase in rev

Decrease in CapEx increases FCF by 10
Decrease in opex will get taxed
Increase in rev will lead to increase in COGS

Question 5

22How do you find an appropriate terminal value with the Exit Mult method?

Answer 5

reference:
- the company’s current multiple
- public comparables
- industry mean multiples
we can conduct sensitivity analysis in the end

Question 6

If a company’s TV makes up 90% of its valuation, what do you think about this?

Answer 6

Usually TV makes up 70% of EV
This is concerning, because we’re basing the valuation on something that’s far away in the future

Double check assumptions with Exit Multiples and Gordon Growth method

Question 7

Walk me from Revenue to U FCF

Answer 7

• COGS
• Opex (SG&A, D&A)
  = EBIT
• (1-t) = NOPAT
  + D&A
  -Capex
• increase in NWC
  = U FCF

Question 8

Walk me from U FCF to L FCF

Answer 8

U FCF - (interest, tax deducted) - mandatory debt principal repayments = L FCF

Question 9

What’s the difference between U FCF and L FCF?

Answer 9

Unlevered free cash flow belongs to all investors. We discount this by WACC to find EV

L FCF only belongs to equity investors. We discount this by cost of E to find EQV

Question 10

What are the differences between UFCF and CFO?

Answer 10

CFO is levered, belongs to equity investors only
- nonrecurring items are added back in CFO, but not UFCF

Question 11

Which is typically higher: EBIT or UFCF? Why?

Answer 11

Depends

Subtractions:
- Capex
- increases in NWC
- taxes

Addbacks:
- D&A

Question 12

A DCF was conducted. It is determined the company is worth $500. However, it turns out that Capex was understated by $50 in year 2, what’s the true value of the company, assuming 10% WACC?

Answer 12

PV = 50/ (1+10%)^2 = 41
true value = 500-41

Question 13

How does increasing the tax rate impact valuation?

Answer 13

• higher income tax expenses reduces FCF
• the tax shield of debt increases, so less interest payments
• levered b decreases, which decreases cost of E, which decreases WACC

Question 14

When wold it be approrpiate to use a levered DCF?

Answer 14

in an LBO situation, where interest and debt principal payments are significant
then we can tell how much FCF is actually attributable to investors over the holding period

Question 15

Why do you typically use unlevered DCF rather than levered?

Answer 15

• for convenience, because you have to project interest expense and mandatory debt repayments
• levered DCF can produce odd results, because debt principal payments can spike cash flow down

Question 16

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

Answer 16

Yes, the company could be growing, which means it’ll make positive cash flow in the future.

If the company has no plausible path to positive cash flow, then no

Question 17

Why would you not want to use a DCF?

Answer 17

• a company has very unpredictable cash flows:
  1. early startups
  2. cyclical businesses
  3. on the verge of bankruptcy
• financial institution companies, which are valued on their balance sheets. You would use a dividend discount model

Question 18

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

Answer 18

• in an unlevered DCF, it won’t show up explicitly, but WACC will change over time
• in a levered DCF, the debt and interest payments will change

Question 19

What are the pros and cons of using a DCF?

Answer 19

pros:
- measures intrinsic value, not influenced by market sentiment
- measures EV

cons:
- requires lots of assumptions
- if CF is negative or hard to forecast, the DCF is not feasible
- TV depends on even more assumptions

Question 20

Walk me through public comps and precedent transactions

Answer 20

1. select companies and transactions that are similar
2. determine the appropriate multiple
3. make a range of multiples
4. find your company’s appropriate place within the range

Question 21

What are the pros and cons of Public Comps?

Answer 21

Pros:
- quick and easy
- reflects market sentiment
- minimal assumptions

Cons:
- can be hard to find
- not exactly comparable

Question 22

What are pros and cons of Precedent Transactions analysis?

Answer 22

Pros:
- includes the control premium
- minimal assumptions

Cons:
- hard to find
- influenced by market premiums at the time

Question 23

Why would a company with similar growth and profitability have a higher multiple than similar companies?

Answer 23

1. the company has a moat, e.g. patent or IP
2. it has greater market share
3. there has been a recent event that triggered higher stock prices

Question 24

a company’s current stock price is 10, it’s P/E multiple is 20x, shares 10M. What is EPS? What happens after a 2-1 stock split?

Answer 24

Market cap: 100M
earnings: 0.5

After the split, price will be 5, earnings 0.25

Question 25

There is a transaction. The buyer acquired 80% of seller equity for 800M. The seller's rev was 300M, EBITDA was 100M. It had 50M in cash and 250M in debt. What were revenue and EBITDA multiples?

Answer 25

EQV is 1000M EV is 1200M EV/Rev = 4x EV/EBITDA.= 12x

Question 26

Comparable companies are trading at 15x EV/EBITDA. Our company's EBITDA is projected to be 80. With 500 cash, 800 debt, and 45 shares outstanding, what is this company's implied share price?

Answer 26

EV = 1200 EQV = 900 = market cap share price: 20

Question 27

What are the advantages and disadvantages of a sum-of-the-parts valuation?

Answer 27

- works well for conglomerates, because the 'parts' truly operate like different companies - takes a lot of time to find comps and model - sometimes, companies don't separately list data for its divisions

Question 28

List as many valuation methods as you can

Answer 28

- DCF - Public comps - precedent transactions - LBO - sum of the parts - Dividend discount model - net asset valuation - liquidation analysis

Question 29

Why would a company sell itself?

Answer 29

- access to greater resources - retirement planning - PE firm end of holding period - need liquidity to meet debt obligations

Question 30

Why would a company buy another company?

Answer 30

- cost synergy - horizontal merger: consolidation - geographic expansion without additional risk - IP/ patent/ key tech - defensive acquisition, to defend market position

Question 31

What are the two types of buyers? Who pays higher?

Answer 31

Financials: - interested in cash flows and cost cutting - usually do levered buyouts - rarely has potential for synergy Strategics: - more willing to pay due to synergy

Question 32

Walk me thru an M&A

Answer 32

1. winning the mandate: creating a pitch, sign the engagement letter, learn about the company 2. create marketing materials, set up a data room, send out teasers 3. IOI: buyers sign the NDA and communicate with management 4. LOI: select a few buyers or go exclusive 5. DD and closing: draft a purchase agreement

Question 33

What are the types of synergies in an M&A transaction?

Answer 33

- Revenue: cross-selling or upselling - Cost: eliminating redundant processes - Financing: the combined company can achieve a lower cost of financing than before

Question 34

What are the ways to fund an M&A transaction?

Answer 34

- excess cash on the balance sheet. Cash is cheapest and fastest, the downside is you might need cash to do something in the future - debt: cheaper than equity and flexible, but this does make future debt issuances more expensive - equity: by issuing shares directly to the seller or selling shares. it dilutes the buyers' existing investors

Question 35

When would a company issue stock to fund an acquisition?

Answer 35

- the buyer's stock is trading at a high price - the seller is too large to be acquired with debt and cash alone - the buyer wants to keep a healthy amount of cash or is highly levered already - the seller believes in the combined company

Question 36

What is WACA? What's the difference in cost of equity between WACC and WACA?

Answer 36

Weighted avg cost of acquisition. In WACC, cost of E represents the opportunity cost of issuing new stock in WACA, cost of E represents how much investors, on average, paid for stock

Question 37

Walk me thru a merger model

Answer 37

The goal is to calculate the impact on EPS 1. calculate the purchase price of the seller 2. list the sources and uses of funds 3. reevaluate all assets at FMV. The purchase price that is beyond the FMV is written into goodwill 4. combine the balance sheet (A+A; L+L) and adjust for acquisition effects 5. divide pro forma income by number of shares to find pro forma EPS and compare it to standalone EPS

Question 38

What's the difference between using CFO vs EBITDA

Answer 38

CFO: levered (not cap structure neutral), adds WC assets and subtracts WC liabilities for companies dealing with AR AP, there can be a lot of fluctuations in cash flow it's better to consider cash flow on an accrual basis rather than inflows/outflows