DCF - Basic

Question 1

Walk me through a DCF.

Answer 1

“A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.

First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.

Finally, you add the two together to determine the company’s Enterprise Value.”

Question 2

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Answer 2

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 – Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.

Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You might want to confirm that this is what the interviewer is asking for.

Question 3

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 3

Take Cash Flow From Operations and subtract CapEx – that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question 4

Why do you use 5 or 10 years for DCF projections?

Answer 4

That’s usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Question 5

What do you usually use for the discount rate?

Answer 5

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF.

Question 6

How do you calculate WACC?

Answer 6

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred).

In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component.

For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM – see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

Question 7

How do you calculate the Cost of Equity?

Answer 7

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield; Beta is calculated based on the “riskiness” of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform “risk-less” assets.

Normally you pull the Equity Risk Premium from a publication called Ibbotson’s.

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a “size premium” and “industry premium” to account for how much a company is expected to outperform its peers is according to its market cap or industry.

Small company stocks are expected to outperform large company stocks and certain industries are expected to outperform others, and these premiums reflect these expectations.

Question 8

How do you get to Beta in the Cost of Equity calculation?

Answer 8

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company’s capital structure. Then you use this Levered Beta in the Cost of Equity calculation.

For your reference, the formulas for un-levering and re-levering Beta are below:

Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 9

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

Answer 9

Again, keep in mind our “apples-to-apples” theme. When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company.

But each company’s capital structure is different and we want to look at how “risky” a company is regardless of what % debt or equity it has.

To get that, we need to un-lever Beta each time.

But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Question 10

Would you expect a manufacturing company or a technology company to have a higher Beta?

Answer 10

A technology company, because technology is viewed as a “riskier” industry than manufacturing.

Question 11

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

Answer 11

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).

Question 12

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 12

You would use the Cost of Equity rather than WACC since we’re not concerned with Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise Value.

Question 13

How do you calculate the Terminal Value?

Answer 13

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.

The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).

Question 14

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

Answer 14

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s much easier to get appropriate data for exit multiples since they are based on Comparable Companies – picking a long-term growth rate, by contrast, is always a shot in the dark.

However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Question 15

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

Answer 15

Normally you use the country’s long-term GDP growth rate, the rate of inflation, or something similarly conservative.

For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

Question 16

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

Answer 16

Normally you look at the Comparable Companies and pick the median of the set, or something close to it.

As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number.

So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Question 17

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

Answer 17

It’s hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Question 18

What’s the flaw with basing terminal multiples on what public company comparables are trading at?

Answer 18

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

This method is particularly problematic with cyclical industries (e.g. semiconductors).

Question 19

How do you know if your DCF is too dependent on future assumptions?

Answer 19

The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.

But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

Question 20

Should Cost of Equity be higher for a $5 billion or $500 million market cap company?

Answer 20

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be “more risky”). Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.

Question 21

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 21

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above.

If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

Question 22

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

Answer 22

More debt means that the company is more risky, so the company’s Levered Beta will be higher – all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

Question 23

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 23

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole – and those returns include dividends.

Question 24

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 24

There is an alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends This is less common than the “standard” formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Question 25

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

Answer 25

This is tricky – the one without debt will have a higher WACC up to a certain point, because debt is “less expensive” than equity. Why?

• Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the WACC formula).
• Debt is senior to equity in a company’s capital structure – debt holders would be paid first in a liquidation or bankruptcy.
• Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will.

However, the above is true only to a certain point. Once a company’s debt goes up high enough, the interest rate will rise dramatically to reflect the additional risk and so the Cost of Debt would start to increase – if it gets high enough, it might become higher than Cost of Equity and additional debt would increase WACC.

It’s a “U-shape” curve where debt decreases WACC to a point, then starts increasing it.

Question 26

Which has a greater impact on a company’s DCF valuation – a 10% change in revenue or a 1% change in the discount rate?

Answer 26

You should start by saying, “it depends” but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 27

What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 27

In this case the discount rate is likely to have a bigger impact on the valuation, though the correct answer should start with, “It could go either way, but most of the time…”

Question 28

How do you calculate WACC for a private company?

Answer 28

This is problematic because private companies don’t have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

Question 29

What should you do if you don’t believe management’s projections for a DCF model?

Answer 29

You can take a few different approaches:

• You can create your own projections.
• You can modify management’s projections downward to make them more conservative.
• You can show a sensitivity table based on different growth rates and margins and show the values assuming managements’ projections and assuming a more conservative set of numbers.

In reality, you’d probably do all of these if you had unrealistic projections.

Question 30

Why would you not use a DCF for a bank or other financial institution?

Answer 30

Banks use debt differently than other companies and do not re-invest it in the business – they use it to create products instead.

Also, interest is a critical part of banks’ business models and working capital takes up a huge part of their Balance Sheets – so a DCF for a financial institution would not make much sense.

For financial institutions, it’s more common to use a dividend discount model for valuation purposes.

Question 31

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

Answer 31

Example sensitivities:

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).

Question 32

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 32

Trick question. You don’t account for this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but we only go down to Cash Flow from Operations and then subtract Capital Expenditures to get to Free Cash Flow.

If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off – but we still wouldn’t count the principal repayments themselves anywhere.

Question 33

What’s the basic concept behind a Discounted Cash Flow analysis?

Answer 33

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 future into a “near future” period of 5-10 years and then calculate, project, discount, and add up those Free Cash Flows; and then there’s also a “far future” period for everything beyond that, which you can’t estimate as precisely, but which you can approximate using different approaches.

You need to discount everything back to its present value because money today is worth more than money tomorrow.

Question 34

What’s the point of Free Cash Flow, anyway? What are you trying to do?

Answer 34

The idea is that you’re replicating the Cash Flow Statement, but only including recurring, predictable items. And in the case of Unlevered Free Cash Flow, you also exclude the impact of Debt entirely.

That’s why everything in Cash Flow from Investing except for CapEx is excluded, and why the entire Cash Flow from Financing section is excluded (the only exception being Mandatory Debt Repayments for Levered FCF).

Question 35

Is there a valid reason why we might sometimes project 10 years or more anyway?

Answer 35

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.

Question 36

If I’m working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?

Answer 36

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 company’s share count (factoring in all dilutive securities) to determine the implied per-share price.

Question 37

Let’s say we do this and find that the Implied per Share Value is $10.00. The company’s current share price is $5.00. What does this mean?

Answer 37

By itself, this does not mean much – you have to look at a range of outputs from a DCF rather than just a single number. So you would see what the Implied per Share Value is under different assumptions for the Discount Rate, revenue growth, margins, and so on.

If you consistently find that it’s greater than the company’s current share price, then the analysis might tell you that the company is undervalued; it might be overvalued if it’s consistently less than the current share price across all ranges.

Question 38

An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?)

Answer 38

The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still calculate Terminal Value.

The difference is that you do not calculate Free Cash Flow – instead, you stop at Net Income and assume that Dividends Issued are a percentage of Net Income, and then you discount those Dividends back to their present value using the Cost of Equity.

Then, you add those up and add them to the present value of the Terminal Value, which you might base on a P / E multiple instead.

Finally, a Dividend Discount Model gets you the company’s Equity Value rather than its Enterprise Value since you’re using metrics that include interest income and expense.

Question 39

Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section?

Answer 39

Most of the time, yes, because all items other than CapEx are generally non- recurring, or at least do not recur in a predictable way.

If you have advance knowledge that a company is going to sell or buy a certain amount of securities, issue a certain amount of stock, or repurchase a certain number of shares every year, then sure, you can factor those in. But it’s extremely rare to do that.

Question 40

Why do you add back non-cash charges when calculating Free Cash Flow?

Answer 40

For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact that they save the company on taxes, but that the company does not actually pay the expense in cash.

Question 41

What’s an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?

Answer 41

There are many “alternate methods” – here are a few common ones:

• EBIT * (1 – Tax Rate) + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx
• Cash Flow from Operations + Tax-Adjusted Net Interest Expense – CapEx
• Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx

The difference with these is that the tax numbers will be slightly different as a result of when you exclude the interest.

Question 42

What about alternate ways to calculate Levered Free Cash Flow?

Answer 42

• Net Income + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx – Mandatory Debt Repayments
• (EBIT – Net Interest Expense) * (1 – Tax Rate) + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx – Mandatory Debt Repayments
• Cash Flow from Operations – CapEx – Mandatory Debt Repayments

Question 43

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?

Answer 43

This is inaccurate because it excludes taxes completely. It would be better to use EBITDA – Taxes – Changes in Operating Assets and Liabilities – CapEx.

If you need a very quick approximation, yes, this formula can work and it will get you closer than EBITDA by itself. But taxes are significant and should not be overlooked.

Question 44

What’s the point of that “Changes in Operating Assets and Liabilities” section? What does it mean?

Answer 44

All it means is that if Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow, whereas if Liabilities are increasing by more than Assets, the company is increasing its cash flow.

For example, if it places a huge order of Inventory, sells products, and records revenue, but hasn’t receive the cash from customers yet, Inventory and Accounts Receivable both go up and represent uses of cash.

Maybe some of its Liabilities, such as Accounts Payable and Deferred Revenue, also increase… but think about what happens: if the Assets increase by, say, $100, and the Liabilities only increase by $50, it’s a net cash flow reduction of $50.

So that is what this section is for – we need to take into account the cash changes from these operationally-linked Balance Sheet items.

Question 45

What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

Answer 45

Nothing “happens” because you can still run the analysis as-is. The company’s value will certainly decrease if one or both of these turn negative, because the present value of Free Cash Flow will decrease as a result.

The analysis is not necessarily invalid even if cash flow is negative – if it turns positive after a point, it could still work.

If the company never turns cash flow-positive, then you may want to skip the DCF because it will always produce negative values.

Question 46

Would you still use Levered Beta with Unlevered Free Cash Flow? What’s the deal with that?

Answer 46

They are different concepts (yes, the names get very confusing here). You always use Levered Beta with Cost of Equity because Debt makes the company’s stock riskier for everyone involved.

And you always use that same Cost of Equity number for both Levered Free Cash Flow, where Cost of Equity itself is the Discount Rate, and also for Unlevered Free Cash Flow, where Cost of Equity is a component of the Discount Rate (WACC).

Question 47

How do you treat Preferred Stock in the formulas for Beta?

Answer 47

It should be counted as Equity there because Preferred Dividends are not tax-deductible, unlike interest paid on Debt.

Question 48

Can Beta ever be negative? What would that mean?

Answer 48

Theoretically, yes, Beta could be negative for certain assets. If Beta is -1, for example, that would mean that the asset moves in the opposite direction from the market as a whole. If the market goes up by 10%, this asset would go down by 10%.

In practice, you rarely, if ever, see negative Betas with real companies. Even something labeled as “counter-cyclical” still follows the market as a whole; a “counter-cyclical” company might have a Beta of 0.5 or 0.7, but not -1.

Question 49

Shouldn’t you use a company’s targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?

Answer 49

In theory, yes. If you know that a company’s capital structure is definitely changing in a certain, predictable way in the future, sure, go ahead and use that.

In practice, you rarely know this information in advance, so it’s not terribly practical to make this kind of assumption.

Question 50

The “cost” of Debt and Preferred Stock make intuitive sense because the company is paying for interest or for the Preferred Dividends. But what about the Cost of Equity? What is the company really paying?

Answer 50

The company “pays” for Equity in two ways:

1. It may issue Dividends to its common shareholders, which is a cash expense.
2. It gives up stock appreciation rights to other investors, so in effect it’s losing some of that upside – a non-cash but very real “cost.”

It is tricky to estimate the impact of both of those, which is why we usually use the Risk-Free Rate + Equity Risk Premium * Beta formula to estimate the company’s expected return instead.

Question 51

If a firm is losing money, do you still multiply the Cost of Debt by (1 – Tax Rate) in the WACC formula? How can a tax shield exist if they’re not even paying taxes?

Answer 51

This is a good point, but in practice you will still multiply by (1 – Tax Rate) anyway. What matters is not whether the Debt is currently reducing the company’s taxes, but whether there’s potential for that to happen in the future.

Question 52

How do you determine a firm’s Optimal Capital Structure? What does it mean?

Answer 52

The “optimal capital structure” is the combination of Debt, Equity, and Preferred Stock that minimizes WACC.

There is no real way to determine this formulaically because you’ll always find that Debt should be 100% of a company’s capital structure since it’s always cheaper than Equity and Preferred Stock… but that can’t happen because all companies need some amount of Equity as well.

Plus, taking on additional Debt will impact the Cost of Equity and the Cost of Preferred, so effectively it is a multivariable equation with no solution.

You may be able to approximate the optimal structure by looking at a few different scenarios and seeing how WACC changes – but there’s no mathematical solution.

Question 53

Let’s take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease?

Answer 53

Break it down and think of the individual components of WACC: Cost of Equity, Cost of Debt, Cost of Preferred, and the percentages for each one.

Then, think about the individual components of Cost of Equity: the Risk-Free Rate, the Equity Risk Premium, and Beta.

• The Risk-Free Rate would decrease because governments worldwide would drop interest rates to encourage spending.
• But then the Equity Risk Premium would also increase by a good amount as investors demand higher returns before investing in stocks.
• Beta would also increase due to all the volatility.
• So overall, we can guess that the Cost of Equity would increase because the latter two increases would likely more than make up for the decrease in the Risk-Free Rate.

Now, for WACC:

• The Cost of Debt and Cost of Preferred Stock would both increase as it would become more difficult for companies to borrow money.
• The Debt to Equity ratio would likely increase because companies’ share prices would fall, meaning that Equity Value decreased for most companies while Debt stayed the same…
• So proportionally, yes, Debt and Preferred would likely make up a higher percentage of a company’s capital structure.
• But remember: the Cost of Debt and Cost of Preferred both increase, so that shift doesn’t matter too much.
• As a result, WACC almost certainly increases because almost all these variables push it up – the only one that pushes it down is the reduced Risk-Free Rate.

There’s a simpler way to think about it as well: all else being equal, did companies become more valuable or less valuable during the financial crisis?

Less valuable – because the market discounted their future cash flows at higher rates. So WACC must have increased.

Question 54

Can you explain the Gordon Growth formula in more detail? I don’t need a full derivation, but what’s the intuition behind it?

Answer 54

We actually do have a full derivation if you look in the Key Rules section above. Here’s the formula:

Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).

And here’s the intuition behind it:

Let’s say that we know for certain that we’ll receive $100 every year indefinitely, and we have a required return of 10%.

That means that we can “afford” to pay $1,000 now ($100 / 10%) to receive $100 in year 1 and $100 in every year after that forever.

But now let’s say that that stream of $100 were actually growing each year – if that’s the case, then we could afford to invest more than the initial $1,000.

Let’s say that we expect the $100 to grow by 5% every year – how much can we afford to pay now to capture all those future payments, if our required return is 10%?

Well, that growth increases our effective return… so now we can pay more and still get that same 10% return.

We can estimate that by dividing the $100 by (10% – 5%). 10% is our required return and 5% is the growth rate. So in this case, $100 / (10% – 5%) = $2,000.

This corresponds to the formula above: $100 represents Final Year Free Cash Flow * (1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate.

The higher the expected growth, the more we can afford to pay upfront. And if the expected growth is the same as the required return, theoretically we can pay an infinite amount (you get a divide by zero error in the equation) to achieve that return.

Question 55

Why isn’t the present value of the Terminal Value, by itself, just the company’s Enterprise Value? Don’t you get Enterprise Value if you apply a multiple to EBITDA?

Answer 55

Yes, you do get Enterprise Value – but that only represents the company’s “far in the future” value. Remember that in a DCF, a company’s value is divided into “near future” and “far future.”

If you leave out the present value of Free Cash Flows in the projection period, you’re saying, “For the next 5 years, this company has no value. But then at the end of year 5, the company is miraculously worth something again!” And that doesn’t make sense.

Question 56

How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense?

Answer 56

The most common method here is to calculate Terminal Value using one method, and then to see what the implied long-term growth rate or implied multiple via the other method would be.

Example: You calculate Terminal Value with a long-term growth rate assumption of 4%. Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and get an implied EBITDA multiple of 15x – but the Public Comps are only trading at a median of 8x EBITDA. In this case your assumption is almost certainly too aggressive and you should reduce that long- term growth rate.

Question 57

You’re looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year.

Which one has the higher net present value?

Answer 57

Company A, because money today is worth more than money tomorrow. All else being equal, generating higher cash flow earlier on will always boost a company’s value in a DCF.

Question 58

Can you say that a company that does not take on Debt is at a disadvantage to one that does? How does that make sense?

Answer 58

The one without Debt is not “at a disadvantage” – but it won’t be valued as highly because of the way the WACC formula works.

Keep in mind that companies do not make big decisions based financial formulas. If a company has no reason to take on Debt (e.g. it is very profitable and does not need funds to expand its business), then it won’t take on Debt.

Question 59

The Free Cash Flows in the projection period of a DCF analysis increase by 10% each year. How much will the company’s Enterprise Value increase by?

Answer 59

A percentage that’s less than 10%, for two reasons:

1. Remember that we discount all those Free Cash Flows – so even if they increase by 10%, the present value change is less than 10%.
2. There’s still the Terminal Value and the present value of that. That has not increased by 10%, so neither has the company’s total value.

You can’t give an exact number for the increase without knowing the rest of the numbers (Discount Rate, Terminal Value, etc.) in the analysis.

Question 60

If you’re using Levered FCF to value a company, is the company better off paying off Debt quickly or repaying the bare minimum required?

Answer 60

It’s always better to pay the bare minimum. Think about the math for a second: interest rates on Debt rarely go above 10-15%… let’s just assume that they’re 10%, and that the company has $1,000 in Debt.

Initially, it pays $100 in interest expense, and after taxes that’s only $60 ($100 * (1 – 40%)). So Levered Free Cash Flow is reduced by $60 each year assuming no principal repayment.

What happens if the company decides to repay $200 of that Debt each year? Levered Free Cash Flow is down by at least $200 each year, and the company still pays interest, albeit lower interest, until the end of the period.

So the company is always better off, valuation-wise, waiting as long as possible to repay Debt.