DCF Flashcards
What’s the basic concept behind a Discounted Cash Flow analysis?
The concept is that you value a company based on the present value of its Free Cash Flows far into the future. You divide the approach into two by estimating the value for a 5- 10 year period and its Terminal Value. You then discount those values back and them together to get the value of the company as money today is worth more than money in the future.
Walke me through a DCF
- Project company’s FCF over a 5-10 year period
- Calculate the company’s Discount Rate, usually using WACC
- Discount and sum up FCFs
- Calculate Terminal Value
- Discount Terminal Value
- Add discounted FCFs to discounted Terminal Value
Walk me through how you get from Revenue to Free Cash Flow
- Obtain historical and present revenue and project future revenue.
- Subtract COGs and operating expenses to obtain EBIT.
- Apply the company’s effective tax rate and obtain NOPAT
- Add back non- cash expenses.
- Adjust for Working Capital
- Subtract CapEx
For Levered Cash flow you would subtract net interest expense before applying the tax rate and subtract mandatory debt repayments at the end.
What’s the point of using Free Cash Flow
You are trying to replicate the Cash Flow Statement by only including items that are recurring and predictable. And in the case of Unlevered Cash flow, you discount debt entirely.
Why would you project a company beyond 10 years
You might sometimes do this if it’s a cyclical industry, such as chemicals because it may be important to show the entire cycle from low to high.
What do you use for the discount rate
You use WACC for unlevered FCF and Cost of Equity for levered FCF
How do you get from Enterprise Value to Implied Share Value
Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and Noncontrolling Interests (and any other debt-like items) to get to Equity Value. Then you divide by the number of outstanding shares.
How do we interpret a large discrepancy in the Implied Per Share Value and the current share price
We perform more DCF analyses under different assumptions and if the discrepancy is consistent each time we say that the company is not valued correctly. If the current share price is lower than the Implied Per Share value is higher, then the company is undervalued, and if vice versa, the company is overvalued.
Do you always leave out Cash flow from Investing and Financing sections
In most cases yes because they are generally non- recurring or at least do not recur in a predictable way. However, if you have additional information on how items in those sections will change you can factor them in. But, it’s really rare to do that.
As an approximation, do you think it’s OK to use EBITDA – Changes in Operating Assets and Liabilities – CapEx to approximate Unlevered Free Cash Flow?
No, because you don’t take taxes into account.
What does the change in working capital section of the FCF calculation show
If the company’s assets go up more than its liabilities then it is spending more cash than its getting and vice versa
What changes if you use levered cash flow vs unlevered
Levered Cash flow gets you the equity value while unlevered cash flow gets you the enterprise value
What Discount Rate do you use for Levered Cash Flow
Cost of Equity
Calculation for WACC
WACC = Cost of Equity * (% Equity) + Cost of Debt *
% Debt) * (1 – Tax Rate) + Cost of Preferred *(% Preferred
Calculation for Cost of Equity
Cost of Equity = Risk- free Rate + Equity Risk Premium * Levered Beta
Cost of Equity tells us the return that an equity investor might expect for investing in a given company – but what about dividends? Shouldn’t we factor dividend yield into the formula?
Thats already factored in with the Beta Value as it describes returns relative to the market- and those returns include dividends
Alternate formula for Cost of Equity
Cost of Equity = (Dividends Per Share/ Share Price) + Growth Rate of Dividends
What Beta would you use
Historical or Calculated using Public Company Comparables
How can you calculate Beta Using Public Company Comparables
You find the average levered beta of the comparables. Then unlever it using the average Debt/Equity of the comparables. You then relever the unlevered beta by using the Debt/Equity of the company.
Unlevered Beta = Levered Beta/[1 + (1 - Tax Rate) * (Debt / Equity)]
Levered Beta = Unlevered Beta * [1 + (1 - Tax Rate) * (Debt / Equity)]
What is the logic behind the Beta Calculation
You take average beta of the comparables and then unlever them to discount the debt related risk of each company’s is different as its capital structure is different. But the debt- related risk is important so you then relever it to get the final beta.
How do you treat Preferred Stock in the formulas above for Beta?
It should be counted as Equity there because Preferred Dividends are not tax deductible, unlike interest paid on Debt.
Can Beta ever be negative? What would that mean?
Theoretically yes. It means the company moves opposite to the market. This is very very rare.
Would you expect a manufacturing company or a technology company to have a higher Beta?
Technology because it is considered riskier
Shouldn’t you use a company’s targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?
Yes. It should. If we can predict the company’s future capital structure, thats what we should use to calcualte Beta and the Discount. But its very hard to come across such information, so it would be impractical to make such assumptions.
