DCF Flashcards
Walk me through a DCF.
Determine current free cash flow
Project free cash flow into the future
Determine a terminal free cash flow value
Discount all future free cash flows to the present using WACC
This gives you the present EV of the company
Subtract net debts to get present equity value
How do you calculate free cash flow?
Earnings before interest and taxes -CAPEX \+Depreciation and Amortization - Net increase (or decrease) in working capital \+All other relevant cash flows =free cash flow
How does free cash flow differ from cash from operations?
Cash from operations will not include CAPEX
Cash from operations is levered
Cash from operations will include tax effects of some non cash items not included in the free cash flow calculation(ex R&D)
How do you calculate free cash flow from revenue?
Revenue
-COGS and operating expenses to get operating income (EBIT)
-CAPEX
+Depreciation and Amortization
- Net increase (or +decrease) in working capital
+All other relevant cash flows
=free cash flow
What is net working capital?
Working capital=current assets-current liabilities
A measure of the company’s efficiency and it’s short term financial health
Shows if a company can meet its short term liabilities with its current assets
Why do you start with EBIT when calculating free cash flow?
Start with EBIT because you want operating income before you take into account capital structure and taxes
EBIT is unlevered because it doesn’t take into account the capital structure (interest)
We want it to be unlevered because it is levered when we discount it back by WACC (if it were already levered then we would be deducting the cost of edit twice)
When would it be appropriate to forecast FCF beyond 5-10 years?
Very high growth firm (start up or tech)
What is beta?
Beta is a measure of systematic risk.
The value is based on historical performance, so it’s not always the best indicator for the future
It’s the standardized covariance between market return and the individual security return.
What value does DCF give you?
Enterprise Value (EV)
If working capital increases, what happens to FCF?
Decrease (see equation)
Give me an example of a negative beta
Gold
What are two ways to calculate the terminal value?
Gordon growth model
EBITDA multiples
Is FCF levered?
No because you don’t include interest expense
How would DCF change if you used levered FCF?
You wouldn’t discount by WACC (because it’s levered), instead you would use the cost of equity and the ending would be an equity value instead of EV
Why might a company choose debt over equity financing?
Debt is cheaper because interest is tax deductible
They don’t want to dilute ownership share
You do a DCF and get an EV of $100. But this company is able to charge higher prices (company premium). Is it safe to add another $10 to the resulting DCF to reflect their premium?
No. The premium is reflected in higher prices, which is reflected in the FCF. So we’ve already included the premium and our EV value is correct.
What do you divide EV by to get price per share?
Number of fully diluted shares outstanding
What’s the difference between number of fully diluted shares and basic shares?
Basic: number of shares at a given point in time
Fully diluted: share count with the effects of diluted securities taken into account
What are diluted securities?
Convertible debt, convertible preferred stock, options, and warrants
What CAPEX do you use do FCF?
Maintenance CAPEX because you want to see the FCF in the everyday working of the company. This will be difficult to separate from growth CAPEX because it is not required to be reported separately.
How do you calculate FCF from net income?
Add back depreciation and amortization
Subtract change in net working capital
Subtract CAPEX
Note that this levered
To make it unlevered add in interest expense
Does a change in net working capital include cash changes?
No. This is meant to show sources of cash that don’t match up the net income figure. An example would be buying inventory. That wouldn’t show up on the Income Statement until you sell it but you used cash and need to recognize it.
What’s the formula for WACC?
(%equity)(cost of equity)+(%debt)(cost of debt)(1-t)
What does WACC stand for?
Weighted average cost of capital
What does CAPM stand for?
Capital assets pricing model
How do you calculate the cost of equity?
Use CAPM
How do you calculate the cost of debt
Use the yield on the most recent bond issuance
How do you calculate CAPM?
(Risk free rate)+(company’s beta)(market risk premium)
What is the market risk premium?
Average return on the market-the risk free rate
What is the risk free rate?
The yield on a 10-year US government bond
How do you calculate the value of a terminal year cash flow?
(WACC)+(growth rate)
How could I reduce WACC?
Somehow lower your cost of debt or equity
More likely readjust your capital structure more towards debt (lever up) because the cost of debt is lower
Why is the cost of debt lower?
Debt is senior in the capital structure and has the first claim on assets in the event of bankruptcy. Therefore it demands a lower return.
If you were to graph WACC on the y axis and debt/equity on the x, what would the graph look like?
A “U”
WACC will initially decease as you increase D/E due to the lower cost of debt.
But it will shoot up again due to the riskiness of leverage. This will raise your cost of equity and counteract the advantages of debt.
How do you calculate the value of leveraged beta?
Levered beta= (unlevered beta)[1+(1-tax)(debt/equity)]
Unlevered beta= (levered beta)/[1+(1-tax)(debt/equity)]
When using CAPM to calculate WACC, why do you have to unlever and then relever beta?
Beta takes each company’s debt into account but not its capital structure. In order to use the beta of a comparable company, you must unlever it. You then relever it with your company’s d/e ratio to get a beta that is accurate for your capital structure.
When using CAPM to calculate WACC, what beta do you use?
We typically use an industry beta, which is calculated by taking the mean or median from a list of comparable firms.
This beta will be levered, so it will need to be unlevered and then relevered to reflect the capital structure of the for, you are valuing.
Name some non-recurring changes that need to be added back to a company’s EBIT/EBITDA
You want to add back anything that doesn’t represent a common and recurring expense in the operations of a business.
Restructuring charges, goodwill charges, asset write downs, one time legal expenses, disaster expenses, etc
