DCF (400 Q + rede book)

Question 1

walk me through a DCF

Answer 1

1. DCF is when based on the present value of the company’s free cahs flow and present value of its terminal value
2. first you project out a company’s financials and free cash flows based on its revenue growth, expenses and working capital. Then you project its for 5-10 years, and then discount it to its present value using discount, often WACC
3. the you calculate the terminal value, which can use the multiple method or gordon growth method, and then also discount it back to present value using WACC
4. you ad the 2 together to get the company’s EV

Question 2

how do you get from revenue to unlevered free cash flow

Answer 2

1. subtract COGs and SG&A (operating expense) to get to EBIT (operating income) * (1-tax)
2. and then add back D&A and other non-cash adjustments, and then subtract CapEX
3. then subtract change in working capital
4. this gives you unlevered FCF which doesnt include the effect of interest rates

Question 3

how to get from revenue to levered FCF

Answer 3

1. revenue - COGs - SG&A - R&D - tax - interest - D&A
2. add back D&A
3. minus CapEx
4. minus change in NWC

Question 4

alternative ways to get to levered and unlevered FCF

Answer 4

1. levered: cash flow from operations + D&A - change in NWC - capex
2. unlevered: cash flow from operations + D&A - change in NWC - capex + tax adjusted interest expense - tax adjusted interest income

Question 5

why do we use 5-10 yr projections for DCF

Answer 5

1. because 5-10yrs is where we can reasonable predict the cash flow
2. after that it is harder to predict and becomes more innaccurate

Question 6

what is the purpose of Terminal Value

Answer 6

1. it basically that we assume the company is still going to grow after the forecasted period
2. but instead of calculating each year until indefintely we calculate a long term growth for operations and discount it back to PV too

Question 7

What do you usually use for the discount rate?

Answer 7

1. WACC if levered
2. cost of equity only if unlevered

Question 8

what is WACC

Answer 8

1. COst of equity * % equity + cost of debt * % debt * (1-tax rate) + cost of preferred * % preferred

Question 9

how do you calculate Cost of Equity

Answer 9

1. CAPM = risk free rate + levered beta * risk free premium

Question 10

what is risk free premium

Answer 10

1. the excess return from the market by investing in a stock over the risk free rate

Question 11

how do you get beta?

Answer 11

1. stock market, bloomberg
2. Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
3. Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 12

why do nwe have to unlever and then relever beta

Answer 12

1. because bloomberg gives you levered beta by including debt
2. we want to look at how risk a company is regardless of % debt and equity, dont want to look at the effect of capital structure, because debt makes beta more risky
3. we need to re-loever it because our CAPM required levered beta, to account how risky the company is based on its capital structure

Question 13

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

Answer 13

1. levered FCF = use WACC -> Enterprise Value
2. unlevered FCF = use Cost of Equity -> equity value

Question 14

how to calculate terminal value

Answer 14

1. apply an exit multple to company’s final year EBITDA, EBIt or FCF (multiples method
2. Use gordon growth method, where you assume company grows indefinelty using a long term growth rate

Question 15

what does using the multiples method actually mean

Answer 15

1. it means we look at hopw much the company’s TV is based on how other comparable companies EV/EBITDA multiples fare trading at
2. i.e ifn a comparable company is trading at 8x EBITDA, we would assume our company also trades at that in 5 yrs time.

Question 16

what is the Gordon growth method

Answer 16

1. where you assume company growth into perpetuity
2. TV = final year FCF * (1+growth rate)/ (discount rate - growth rate)

Question 17

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

Answer 17

1. when no good comparable companies
2. or if you think that multiples will change significantly in industry in future years
3. cyclical industries maybe better to use long term growth rates

Question 18

why is it better to use gordon growth method for more cyclical industries

Answer 18

Cyclical industries—like commodities, energy, or automotive—often experience large swings in earnings and valuations due to economic cycles.

Using a valuation multiple at a specific point in time might capture the industry at a peak or a trough. As a result, a multiples-based terminal value can become skewed or unrealistic.

Question 19

what are cyclical industries?

Answer 19

1. they are industries which closely follow the markets economy, when economy is bad they are bad, and when economy is good they are good
2. commodities, energy: they rise when industry is up and they are down whenindustries are down
3. luxury goods

Question 20

What’s an appropriate growth rate to use when calculating the Terminal Value?

Answer 20

1. long term GDP growth rates
2. rate of inflation
3. anything over 5% would be aggressive, since developied countries grow less than 5%

Question 21

How do you select the appropriate exit multiple when calculating Terminal Value?

Answer 21

1. use comparable companies
2. pick a range of exit multiples rather than one

Question 22

Which method of calculating Terminal Value will give you a higher valuation?

Answer 22

1. hard to generalize
2. but multiples would give you more vairable range
3. gordon growth would be less variable

Question 23

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

Answer 23

1. debt means more risky so beta would be larger, hence cost of equity would be higher

Question 24

what does WACC actually mean

Answer 24

1. its a reflection of how worthy the company, the minimum return investors expect for providing capital to the company.
2. from investor pov = the minimum requirements it has to make for investors to justify the use of its capital. If the returns fall below the cost of equity it means the investors money might not be efficiently used
3. from company pov = whether the capital is expected to generate value from this investment.

Question 25

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 25

1. dividend is already included and reflected in beta
2. beta describes the returns in excess of the dividends on the market

Question 26

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 26

Cost of equity = (dividend per share)/share price + growth rate of dividends

Question 27

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

Answer 27

1. one with debt will be cheaper at first,
2. because cost of debt is cheaper than cost of equity, and debt is tax deductible -> lower WACC
3. but as you increase debt surpass a certain threshold, the financial distress associated with high leverage will offset the tax benefits, and will start to increase again, causing higher WACC

Question 28

When would you not use a DCF

Answer 28

1. unstable cash flows, hard to predict growth of revenue (startup company)
2. no revenue and no cash flows = cannot estimate or predict cash flows
3. banks and FIGs= they use debt as a product and hence cannot be seen as the same cost, use DDM instead

Question 29

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

Answer 29

1. revenue vs terminal multiple
2. EBITDA vs terminal. multiple
3. discount rate vs terminal multiple
4. long term growth rate vs terminal multiple

Question 30

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 30

you dont, because paying off debt comes from cash flow from financing and not operations
you do include the interest rate expenses

Question 31

why is cost of equity higher than cost of debt

Answer 31

1. cost of debt is tax deductible
2. equity investors are not guaranteed a fixed payment (no interests paid)
3. equity investors are in the last line of seniority if company liquidates

Question 32

Since the cost of equity is higher than the cost of debt, why not finance using only debt?

Answer 32

1. using debt at first will decrease WACC, due to tax benefits
2. however using too much will cause a lot of financial stress in having to pay interests and returns, hence it becomes risker pass a certain threshold, and increases WACC again
3. U shaped curve for WACC
4. also there are constraints to debt usage, preventing them from exceeding leverage ratios

Question 33

What is the difference between WACC and IRR?

Answer 33

1. IRR = rate of return on the projected expenditures. it is the implied growth the company should have in order to meet its exit value. It is the value generated between the entrance multiple and initial investment and how much the investment needs to growt to reach the exit multiple
2. WACC = minimum required return for both debt and equity investors, it is an indicator whethe rthe capital is used efficiently to generate enough returns for investors
3. if IRR is larger than WACC it can be justified to invest in this company

Question 34

Why is it necessary to discount the terminal value back to the present?

Answer 34

1. still calculates the future value of money
2. so we need to discount it to present value to know what the company is worth today, taking into accont the time value of money

Question 35

why not use current EV instead of present EV

Answer 35

1. current EV is based on markets
2. Present EV based on the intrinsic value of how much cash flow company can grow and generate
3. also present EV takes into acount of the time value of money

Question 36

What is the argument against using the exit multiple approach in a DCF?

Answer 36

1. theoretically DCF is meant to be an inrinsic valuation based on company’s operations not on market value
2. using a comparable companies exit multiple makes it influenced by markets (especially since TV makes up 50% of the DCF valuation)

Question 37

How does a lower tax rate impact the valuation from a DCF?

Answer 37

1. lower tax rate means more FCF
2. lower tax rate means higher cost of debt, as the tax deductible benefit of debt is reduced, hence a higher WACC
3. lower tax rate would mean higher levered beta

Question 38

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Answer 38

1. different industries/geographies
2. ROIC is different, higher ROIC - higher P/E

Question 39

Why might one company trade at a higher multiple than another?

Answer 39

1. better financials, better growth prospects
2. lower cost of capital
3. more robust cash flow
4. better ROIC

Question 40

Intuitively, what does the P/E ratio mean?

Answer 40

How much is the market willing to pay for a dollar of this company’s earnings?”
- how much confidence does the market have for this company to grow

Question 41

What does a high P/E ratio relative to a peer group imply?

Answer 41

1. may be overvalued
2. EPS is lower, so lower earnings, and hence expect it to grow

Question 42

When would you value a business using the P/B ratio?

Answer 42

1. when the book value captures its real value
2. commercial banks, where their assets and liabiloities are frequently re-evaluated