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DCF Flashcards

1
Q

What’s the point of valuation?

A

You value a company to find its implied value according to your views of it, which may or may not disagree with what the market thinks its current value is

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2
Q

What are the Advantages and Disadvantages of the 3 main valuation methodologies?

A

Public comps:
A:based on real market data, quick to calculate and explain
D: may not be true comparable companies, this analysis may undervalue companies long term potential
Precedent Transactions:
A: based on real prices that companies have paid for other companies, and they may reflect industry trends more than Public Comps
D: data can be spotty and misleading, there may not be comparable transactions, and specific deal terms and market conditions might distort the multiples
DCF:
A: Less subject to market fluctuations, better reflects company-specific factors and long-term trends
D: dependent on far-future assumptions, and there’s disagreement over how to calc WACC and Cost of Equity

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3
Q

Which of the 3 main valuation methods will produce the highest implied values?

A

No set rule, but generally:
Precendent T’s due to M&A premium > trading comps
then it’s a tossup
DCF tends to produce the most variable output depending on your assumptions

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4
Q

When is a DCF more useful than Public Comps or Precedent Transactions?

A

Well, you pretty much always build a DCF, and use the others as supplemental. But you would not use these when there aren’t any comparable companies or transactions

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5
Q

When are public comps or precedent transactions more useful than a DCF?

A

If company you’re valuing is early-stage and it is impossible to estimate its future cashflows or the company has no path to positive cash flow at all, you have to rely on others.

Other answers: volatility of FCF, inability to estimate WACC

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6
Q

Which would be worth more: a $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?

A

Healthcare company will be worth more because healthcare is a less-asset intensive industry. That mean’s that the company’s CapEx and Working Capital requirements will be lower, and FCF will be higher as a result.

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7
Q

Walk me through a DCF analysis

A

A DCF is an intrinsic valuation method used to determine the implied value of a company.
It is usually done in 2 stages. The first of which is one where you forecast FCF’s in the near term and discount them to PV using a discount rate.
The second stage is where you calculate terminal value and discount that to present value using a discount rate.
If you add up these 2 stages, you get EV and can back into EqV by subtracting Net Debt.

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8
Q

How do you move from revenue to FCF in a DCF?

A 
For unlevered:
Revenue
-COGS
-OpEx
*(1-Tax)
-CapEx
\+/- NWC
\+D&A
For Levered:
Revenue
-COGS
-OpEx
-Interest
-Tax
-CapEx
\+/-NWC
\+D&A
-Mandatory Debt Repayments
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9
Q

3 ways to get to uFCF

A

Revenue -> NOPAT -CapEx +/-Working Capital + D&A

  • leveredFCF + mandatory debt repayments + tax impacted interest
  • Net Income + Tax paid + interest paid *(1-Tax) -CapEx +/-Working Capital + D&A
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10
Q

What does the discount rate mean?

A

Discount rate represents the opportunity cost for investors of what they could earn by investing in other, similar companies in the industry.

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11
Q

How do you calculate TV in a DCF, which method is better?

A

There are two ways to determine TV, through the Gordon Growth Method and the multiples method.

Gordon Growth is where you estimate a terminal growth rate to a company’s FCF.

Multiples method is where you apply a terminal multiple to a company’s EBIT, EBITDA, FCF or other depending on your multiple.

GGM is used more in academia and considered the more technical one since it makes sense that companies slow down to a terminal growth rate. But both are used equally.

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12
Q

Some signs you might be using the incorrect assumptions in a DCF.

A
  1. PV of TV represents over 80% of implied value
  2. Implied terminal growth rate or terminal multiple that doesn’t make sense. EG 8%
  3. Double counting items - if an income or expense is included in calculating FCF you should not be counting it in the implied EV to implied EqV calculation
  4. Mismatched final year FCF growth and terminal growth rate. IF sompany’s FCF is growing at 15% in the final year, but you’ve assumed a 2% Terminal growth rate, something is wrong. FCF growth should decline over time and approach term growth rate
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13
Q

If your DCF seems off what are some ways to fix it?

A

Extend the explicit forecast period so that the company’s FCF contributes more value, and so that there’s more time for FCF growth

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14
Q

How do you interpret the results of a DCF?

A

You can compare the company’s IMPLIED EV, EqV, or Share price to its CURRENT valyes to see if it is over valued or under valued.

You do this over a RANGE of assumptions because investing is probabilistic.

You might make a sensitivity table to test each parameter

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15
Q

Does a DCF ever make sense for a company with negative FCF?

A

It could, if your assumptions or opinions show that the company will be cash flow positive in the near future.

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16
Q

How do Levered DCF Analysis and Adjusted Present Value Analysis differ from an Unlevered DCF?

A

In levered, you use levered fcf and cost of equity for the discount rate. And you calc TV using Equity-value based multiples like P/E. And this gives you EqV

APV is similar to uDCF but you value the company’s interest Tax Shield separately and add its PV at the end. You calc uFCF and TV same way, but you use UNLEVERED COST OF EQUITY for the discount rate.

You then project interest tax shield each year.

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17
Q

Will you get the same results from uDCF and lDCF?

A

No, because uDCF does not factor in the interest rate on the company’s DEbt, whereas Levered DCF does.

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18
Q

Why use uDCF over lDCF or APV?

A

uDCF is usually easier to set up, forecast, and explain, and it produces more consistent results than the other methods.

With the other methods you have to project company’s cash and debt, net interest expense, and mandatory debt repayments which take a lot more time.

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19
Q

WHY do you calculate Unlevered FCF by excluding and including various line items?

A

Unlevered FCF represents the cash flows generated from businesses core operations that are available to all investors.

Thus you exclude items that don’t fit that criteria, like cash. Other items that represent investor groups, like debt or preferred get added back.

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20
Q

How does the Change in Working Capital affect FCF, and what does it tell you about the company’s business model?

A

Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth.

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21
Q

Should you add back stock-based compensation to calculate FCF? It’s a noncash add back on the CFS

A

No, because it affects valuation already through the shares it creates

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22
Q

How should CapEx and Depreciation change over the forecast period?

A

They should both decrease, but Dep is always smaller than CapEx

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23
Q

Should you reflect inflation in the FCF projections?

A

In most cases, no. Most people think in nominal terms, and assumptions for prices and salaries tend to be in nominal figures.

Plus, this would require to forecast inflation far into the future

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24
Q

If a company’s capital structure is expected to change. How do you reflect it in FCF?

A

You’ll reflect it directly in a levered DCF because the company’s debt and interest payments will change over time. Cost of equity will also change.

It won’t show up explicitly in an unlevered DCF, but you will reflect it in the analysis by the CHANGING DISCOUNT RATE over time - wacc changes as the company’s debt and equity levels change.

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25
Q

What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

A

If you include an income or expense in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end

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26
Q

How do NOLs factor into FCF?

A

You could set up an NOL schedule and use them to reduce the company’s cash taxes. Then you wouldn’t count them in the Implied Enterprise Value -> Implied Equity calculation at the end.

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27
Q

How does the Pension Expense factor into FCF?

A

Most of the time they are counted as OpEx when calculating FCF

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28
Q

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

A

No, because they can be considered on-time line items and you should not make speculative projections on them

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29
Q

What does the cost of equity mean intuitively?

A

It tells you the percentage a company’s stock should return each year, over the very long term.
In valuation it represents the % an Equity investor might earn each year
To a company it represents the cost of funding its operations by issuing shares to new investors

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30
Q

What does WACC mean intuitively?

A

WACC represents the expected annual return % if you investment proportionately across the capital structure of the company
To a company, WACC represents the cost of funding its operations by using ALL its sources of capital
Investors might invest in a company if their IRR exceeds WACC

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31
Q

How do you calculate Cost of Equity?

A

CofE = RfR + Levered B*Equity Risk Premium

Equity Risk Prem = (RfR - market risk)

RfR = 10-year treasury rate in home country

32
Q

What is Beta?

A

Levered Beta represents how volatile a stock is relative to the stock market in the company’s country, factoring in both its intrinsic business risk and the risk from leverage

Unlevered beta => only business risk

33
Q

How do you calculate Equity Risk Premium?

A

There is almost no agreement on how to do this because stock market returns differ based on the period and whether you use arithmetic mean or geometric.
I think most people assume 6-7%, but you can use historical US premium % and add a % depending on the home country’s credit rating

34
Q

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

A

You might take the % of revenue from each country, multiply it by the ERP in that market, and then add everything up to get a weighted average

35
Q

What does beta mean intuitively

A

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both the intrinsic business risk and the risk from leverage
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

36
Q

Could beta be negative?

A

Yes, it’s possible. The company’s stock price has to move in the opposite direction of the market as a whole. Gold is commonly cited as an asset that has negative beta

37
Q

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

A

In valuation you’re estimating a company’s Implied Value. If you used historical beta instead of doing this, that corresponds more closely to the company current value - or what the market thinks of it

By unlevering beta for each comparable company, you isolate each company’s inherent business risk and isolating each company’s capital structure.

You find median unlevered beta and u relever it to find what the volatility of this company’s stock price relative to the market should be

38
Q

What’s the formula for unlevering and relevering beta?

A 
UnleveredB = LeveredB / (1+ debt/equity*(1-tax rate))
LeveredB = UnleveredB * (1+ Debt/Equity ratio*(1-tax rate))
39
Q

Why don;t you factor interest rate on debt in Beta?

A

That’s a drawback because more debt = riskier. However:

  1. Debt/Equity ratio is a proxy for interest rates on debt
  2. risk isn’t directly proportional to interest rates
40
Q

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

A

Yes, unlevering and relevering beta has nothing to do with the type of cash flow. It has to do with the cost of equity formula

41
Q

How would you estimate the Cost of Equity for a U.S.-based technology company?

A

RfR ~ 1.5%
Beta ~ 1.5%
ERP ~ 8%
CofE ~ 13.5

42
Q

WACC formula why is it tricky?

A

WACC = %debt(1-Tax)Cost of debt + %equitycostofEq+%prefcostofPref
Tricky because:
1. cost of debt: weighted average coupon rate on firm’s bonds? Yield to Maturity? or YTM of debt of comparable companies?
2. %debt, equity, etc: do you use company’s current capital structure or optimal capital structure?
3. Cost of Equity: How do you calculate beta? or ERP?

43
Q

WACC reflects the company’s capital structure, so why do you pair it with Unlevered FCF? It’s not capital structure-neutral!

A

That’s not the best way to think about this.

uFCF is free cash flow from core operations available to all investors. WACC represents weighted average cost of capital that implies it accounts for all investors.

44
Q

Should you use the company’s current capital structure or optimal capital structure to calculate WACC?

A

Optimal cap structure is one that minimizes WACC. But there is no way to calculate it because you can’t tell in advance how each cost of X will change as the cap structure changes

Often, you’ll use median cap structure among comps as a proxy for optimal cap struct

45
Q

Why is equity more expensive than debt?

A

It offers higher risk and higher potential returns.

Also, it isn’t tax deductible like the interest paid on debt

46
Q

Cost of preferred stock compare to others

A

More expensive than debt, but less expensive than equity. It offers higher risk and potential returns than debt, but not as high as equity

47
Q

How do you determine the cost of debt and cost of preferred stock in the WACC calculation, and what do they mean?

A

CofDebt: look at Yield to Maturity or use the RfR and add a default spread based on the company’s expected credit rating

48
Q

How do convertible bonds factor into the WACC calculation?

A

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count

49
Q

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

A

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors

As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt

50
Q

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect WACC?

A

If you’re using the company’s current capital structure, WACC will most likely increase because 20% Debt is a fairly low level. At that level, less Debt will most likely increase WACC

51
Q

Should you ever use different Discount Rates for different years in a DCF

A

Yes, sometimes it makes sense to use different Discount Rates.
For example, if a company is growing quickly right now, but it’s expected to mature and grow more slowly in the future, you might use decreasing Discount Rates.

52
Q

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

A

The company’s FCF growth rate change over time in the explicit period since you forecast FCF each year. But in the Terminal Period, you assume the company remains in a steady rate

53
Q

What’s the intuition behind the GGM formula for TV?

A

The intuition is that a company is worth less if the discount rate is higher and worth more if the terminal FCF growth rate is higher

54
Q

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from Public Comps or Precedent Transactions?

A

“Neither one – you just use them as starting points in the analysis, and then you adjust once you see the Terminal FCF Growth Rates that the selected multiples imply.

You’d prob start with trading comps since they lack M&A premium

55
Q

Why do you need to discount the Terminal Value back to its Present Value?

A

it represents the company’s value IN a future period AT a point in the future.

56
Q

When you discount the Terminal Value, why do you use the number of the last year in the forecast period for the discount period (for example, 10 for a 10-year forecast)?
Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?

A

No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it’s the Present Value as of the very end of Year 10.

57
Q

What do you do after summing the PV of Terminal Value and PV of Free Cash Flows?

A

In unlevered, you get EV and back into Eqv and divide by diluted shares

58
Q

The diluted share count factors in the company’s in-the-money options.
But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?

A

In theory, yes. Some academics and professors such as Damodaran use Black-Scholes to value these out-of-the-money options, and then subtract the value of those options to determine its true Implied Equity Value.
In practice, banks rarely include out-of-the-money options in a DCF. There are several reasons why, including the fact that these options tend to make a very small impact and the fact that the valuation of options gets tricky and requires inputs that you may or may not have.

59
Q

How can you check wheher TV estimate is reasonable?

A

It’s an iterative process: You start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by seeing what Growth Rates or Multiples they imply.

60
Q

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

A

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if one multiple is similar for both of them.

You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those present other issues, such as less comparability across peer companies.

61
Q

Would it ever make sense to use a negative Terminal FCF Growth Rate?

A

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, you might assume that the company’s cash flows eventually decline to 0

62
Q

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

A

The same variables are important in any DCF: The Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the revenue growth and margin assumptions

63
Q

Why do you use the mid-year convention in a DCF analysis?

A

You use it because a company’s cash flow does not arrive 100% at the end of each year – it’s generated throughout each year.

64
Q

What impact does the mid-year convention make?

A

A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower.

65
Q

Why might you include a “stub period” in a DCF, and what does it mean?

A

You include a “stub period” if you’re valuing a company midway through the year, and it has already reported some of its financial results.
A DCF is based on expected future cash flow, so you should exclude these previously reported results and adjust the discount periods as well.

66
Q

Which assumptions make the biggest impact on a DCF?

A

Discount rate and terminal value

67
Q

Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?

A

Assuming that both companies have the same capital structure percentages, Cost of Equity and WACC should both be higher for the $500 million company.

68
Q

Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?

A

Discount rate

69
Q

Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in each year
Which company will have the higher Implied Value?

A

This is a bit of a trick question because it depends on what you count toward the Implied Value. If it’s just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: The cash flows arrive earlier on, so they’re worth more.
However, Company B will almost certainly have a much higher Terminal Value because it has higher FCF in Year 10.
So if the Terminal Value comprises a big portion of the Implied Value, and you count it in the analysis, it’s a good bet that Company B will have the higher Implied Value

70
Q

How do higher vs. lower tax rates affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

A

tax rate affects wacc only if a company has debt. Taxes wont be a factor in the wacc formula

Nonetheless, High tax => lower cost ofdebt & lower costofEq because of tax benefit lowers risk =>lower wacc =>higher implied value
BUT
tax also affects the near term fcf forecasts and it affects it much higher than wacc, thus when tax increases, implied value decreases

71
Q

Can you walk me through how you use Public Comps and Precedent Transactions?

A

Public comparables and precedent transactions are relative methods to value a company. You select the companies and transactions based on criteria such as industry, size, and geography.
Then you determine the appropriate metrics and multiples for each set - revenue, revenue growth, ebitda, other multiples.
Then you would calculate 25th, 50th and 75th percentile for each valuation multiple
Finally apply those valuation multiples to the financial metrics of your company to estimate its implied value.

72
Q

Why is it important to select Public Comps and Precedent Transactions that are similar?

A

Because the comparable companies and transactions should have similar Discount Rates.
Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate.
If the companies in your set all have similar Discount Rates, it’s easier to conclude that one company has a higher multiple because its expected growth rate is higher.
If they don’t have similar Discount Rates, it’s harder to draw meaningful conclusions

73
Q

How do you select Comparable Companies and Precedent Transactions?

A

You screen based on geography, industry, and size, and also time for Precedent Transactions.

The most important factor is industry – you’ll always use that because it makes no sense to compare a mobile gaming company to a steel manufacturing company.

74
Q

Are there any screens you should AVOID when selecting Comparable Companies and Precedent Transactions?

A

You should avoid screening by both financial metrics and Equity Value or Enterprise Value because you’re artificially constraining the multiples

75
Q

Both Public Comps and Precedent Transactions seem similar. What are the main differences?

A

Screening Criteria: In addition to industry, size, and geography, you also use time because you only want transactions from the past few years
Metrics and Multiples: You focus more on historical metrics and multiples, especially LTM revenue and EBITDA as of the announcement date.
Calculations: All the multiples are based on the purchase price as of the announcement date of the deal
Output: The multiples produced tend to be higher than the multiples from Public Comps because of the control premium

76
Q

How do you decide which metrics and multiples to use in these methodologies? (comps)

A

look at a sales-based metric and its corresponding multiple and 1-2 profitability based metrics and multiples.

77
Q

How do you set up an LBO valuation, and when is it useful

A

You set up the LBO valuation by creating a leveraged buyout model where a private equity firm acquires a company for a certain price, using Debt and Equity, holds it for several years, and then sells it for a certain multiple of EBITDA.
Since most private equity firms target an internal rate of return (IRR) in a specific range, you work backward and determine the purchase price required to achieve this IRR.
This methodology is useful for setting a floor on a company’s valuation – you’re constraining the price because of the IRR requirement.

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