DCF - Advanced Flashcards
Explain why we would use the mid-year convention in a DCF.
You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year – instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on.
With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.
What discount period numbers would I use for the mid-year convention if I have a stub period – e.g. Q4 of Year 1 – in my DCF?
The rule is that you divide the stub discount period by 2, and then you simply subtract
0.5 from the “normal” discount periods for the future years. Example for a Q4 stub:
- Normal Discount Periods with Stub :
- Q4: 0.25
- Y1: 1.25
- Y2: 2.25
- Y3: 3.25
- Y4: 4.25
- Y5: 5.25
- Mid-Year Discount Periods with Stub:
- Q4: 0.125
- Y1: 0.75
- Y2: 1.75
- Y3: 2.75
- Y4: 3.75
- Y5: 4.75
How does the terminal value calculation change when we use the mid-year convention?
When you’re discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you’re using the Multiples Method or Gordon Growth Method:
- Multiples Method: You add 0.5 to the final year discount number to reflect the fact that you’re assuming the company gets sold at the end of the year.
- Gordon Growth Method: You use the final year discount number as is, because you’re assuming the cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end.
If I’m working with a public company in a DCF, how do I calculate its per-share value?
Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock, and minority interest (and any other debt-like items) to get to Equity Value.
Then, you need to use a circular calculation that takes into account the basic shares outstanding, options, warrants, convertibles, and other dilutive securities. It’s circular because the dilution from these depends on the per-share price – but the per-share price depends on number of shares outstanding, which depends on the per-share price.
To resolve this, you need to enable iterative calculations in Excel so that it can cycle through to find an approximate per-share price.
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
The mechanics are the same as a DCF, but we use dividends rather than free cash flows:
- Project out the company’s earnings, down to earnings per share (EPS).
- Assume a dividend payout ratio – what percentage of the EPS actually gets paid out to shareholders in the form of dividends – based on what the firm has done historically and how much regulatory capital it needs.
- Use this to calculate dividends over the next 5-10 years.
- Discount each dividend to its present value based on Cost of Equity – NOT WACC – and then sum these up.
- Calculate terminal value based on P / E and EPS in the final year, and then discount this to its present value based on Cost of Equity.
- Sum the present value of the terminal value and the present values of the dividends to get the company’s net present per-share value.
When you’re calculating WACC, let’s say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?
Trick question. If the convertible debt is in-the-money then you do not count it as debt but instead assume that it contributes to dilution, so the company’s Equity Value is higher. If it’s out-of-the-money then you count it as debt and use the interest rate on the convertible for Cost of Debt.
We’re creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the factory purchase, and what would our new Enterprise Value be?
In this scenario, you would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.
The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) – the “4” just represents year 4 here. Then you would subtract this amount from the Enterprise Value.
What’s the point of a “stub period” in a DCF? Can you give an example?
You use a stub period when you’re valuing a company before or after the end of its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year.
For example, it’s currently September 30th and the company’s fiscal year ends on December 31st.
In this case it wouldn’t be correct to assume that Free Cash Flow only starts on January 1st of the next year – there are still 3 months between now and the end of the year, the company still generates FCF in those 3 months, and you need to account for it somewhere in your model.
So you would calculate FCF in that 3-month period, use 0.25 for the discount period, and then use 1.25 for the discount period for the first full year of the model, 2.25 for the next year, and so on.
What if you have a stub period and you’re using the mid-year convention – how does Terminal Value change then?
It’s the same as what’s described above – a stub period in the beginning does not make a difference.
How does a DCF for a private company differ?
The mechanics are the same, but calculating Cost of Equity and WACC is problematic because you can’t find the market value of Equity or Beta for private companies.
So you might estimate WACC based on the median WACC of its Public Comps, and do the same for Cost of Equity if you’re using that as the Discount Rate.
How do you factor in one-time events such as raising Debt, completing acquisitions, and so on in a DCF?
Normally you ignore these types of events because the whole point of calculating Free Cash Flow is to determine the company’s cash flow on a recurring, predictable basis.
If you know for a fact that something is going to occur in the near future, then you could factor that in – issuing Debt or Equity would change Cost of Equity and WACC (and the company’s Free Cash Flow in a Levered DCF); completing an acquisition or buying an asset would reduce cash flow initially but perhaps boost it later on.
What should you do if you don’t believe management’s projections in a DCF model?
You can take a few different approaches:
- You could create your own projections.
- You could “hair-cut” management’s projections (reduce them by a certain
percentage) to make them more conservative. - You could show a sensitivity table based on different growth rates and
margins, and show the values using both management’s projections and a more conservative set of numbers.
Why would you not use a DCF for a bank or other financial institution?
Banks use Debt differently than other companies and do not use it to finance their operations – they use it to create their “products” – loans – instead.
Also, interest is a critical part of banks’ business models and changes in “Operating Assets and Liabilities” can be much larger than a bank’s Net Income. Finally, CapEx does not correspond to re-investment in business for a bank, and is often negligible.
For financial institutions (commercial banks and insurance firms), it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF. See the industry-specific sections of the guide for more.
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
The mechanics are the same as a DCF, but we use Dividends rather than Free
Cash Flows:
- Project the company’s earnings, down to Earnings per Share (EPS).
- Assume a Dividend Payout Ratio – what percentage of the EPS gets paid
out to shareholders in the form of Dividends – based on what the firm has
done historically and how much regulatory capital it needs. - Use this to calculate Dividends over the next 5-10 years.
- Do a check to make sure that the firm still meets its required Tier 1
Capital Ratio and other capital ratios – if not, reduce Dividends. - Discount the Dividends in each year to their present value based on Cost of Equity – NOT WACC – and then sum these up.
- Calculate Terminal Value based on P / BV and Book Value in the final year, and then discount this to its present value based on the Cost of Equity.
- Sum the present value of the Terminal Value and the present values of the Dividends to calculate the company’s net present value per share.
The key difference compared to a DDM for normal companies is the presence of the capital ratios – you can’t just blindly make Dividends per Share a percentage of EPS.
Do you think a DCF would work well for an oil & gas company?
If it’s an exploration & production (E&P)-focused company, generally a DCF will not work well because:
- CapEx needs are enormous and will push FCF down to very low levels.
- Commodity prices are cyclical and both revenue and FCF are difficult to project.
For other types of energy companies – services-based companies or downstream companies that just refine and market oil and gas – a DCF might be more appropriate.
