DCF - Basic

Question 1

Walk me through a DCF

Answer 1

A DCF values a company based on the PV of its cash flows and the PV of its Terminal Value.

First, project out the financials using assumptions for revenue growth, expenses and NWC. Adjust net income to reach EBITDA, then adjust to get to FCF. Sum up FCF for each year and discount using the company’s WACC to the NPV.

Then, determine Terminal Value using either the Multiples Method or the Gordon Growth Method, then discount back to NPV using WACC.

Add the two together to determine the company’s Enterprise Value.

Question 2

Walk me from Revenue to Free Cash Flow

Answer 2

Subtract COGS and Operating Expenses to get EBIT. Apply the effective tax rate, then remove Depreciation and Amortization to arrive at EBITDA (adjusted for cash taxes, rather than tax expense). Remove Capex, changes in NWC and other non-cash items to arrive at FCF. We are excluding Interest, therefore this is unlevered FCF.

Question 3

What is an alternative way to arrive at FCF, other than starting with Net Income?

Answer 3

Start with Cash Flow from Operations on the CF Statement. Subtract Capex an Mandatory Debt Repayments to arrive at Levered FCF.

To get to Unlevered FCF, add back tax-adjusted Interest Expense and remove tax-adjusted Interest Income.

Question 4

Why do you use 5-10 years for most DCFs?

Answer 4

You typically match the period with the expected investment horizon of the buyer. Less than 5 years is too short to be useful, and over 10 years is too difficult to predict.

Question 5

What do you use as the discount rate for a DCF?

Answer 5

Normally use WACC. If you are calculating Equity Value (rather than Enterprise Value), you would use just the cost of Equity.

Question 6

What is the formula for WACC?

Answer 6

WACC = (Cost of Equity * % Equity) + (Cost of Debt * (1-Tax rate) * % Debt) + (Cost of Preferred Equity * % Preferred Equity)

Question 7

How do you calculate the Cost of Equity?

Answer 7

Use the Capital Asset Pricing Model.

Cost of Equity = Risk free rate + (Equity risk premium * Beta of the stock)

Risk free rate: Use 10-yr t-bill yield

Equity risk premium: Use Ibbotsons for baseline ERP. Can also add size premium (smaller = higher premium) and industry premium

Question 8

How do you calculate Beta in CAPM

Answer 8

Look up Betas for comparable companies on Bloomberg, un-lever each one, take the median of the set, then re-lever this value based on your company’s capital structure.

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

Levered Beta = Unlevered Beta * (1 + ((1-Tax Rate) * (Total Debt/Equity)))

Question 9

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

Answer 9

Comparable Betas are levered to the specific debt level of the respective company, which will be different to that of your own company.

To see how risky each company is regardless of what debt:equity mix, we have to un-lever Beta.

We also want the Beta to reflect the true risk of our company, therefore we have to re-lever it.

Question 10

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

Answer 10

Tech companies, as that industry is riskier than manufacturing.

Question 11

What is the impact of using Levered FCF in your DCF rather than Unlevered FCF?

Answer 11

Levered FCF gives you the Equity Value rather than the Enterprise Value, since it is the cash flow available to equity investors after debt investors have been “paid” with interest.

Question 12

If you use Levered Free Cash Flow, what should you use as the discount rate?

Answer 12

Cost of Equity, as WACC includes the cost of Preferred and cost of Debt.

Question 13

How do you calculate the Terminal Value?

Answer 13

Either:

1. (Multiples Method) Apply an exit multiple to the company’s final year EBITDA / EBIT / FCF
2. (Gordon Growth Method) Estimate the terminal value based on its growth rate into perpetuity. Terminal Value = Last year FCF * (1 + Terminal Growth Rate) / (Discount Rate - Growth Rate)

Question 14

Why would you use Gordon Growth vs. Multiples to calculate Terminal Value?

Answer 14

In banking, you almost always use the Multiples Method as it is easier to get the exit multiple data based on comparable companies. Picking a long-term growth rate is always more of a guess.

Gordon Growth is good if there are no comparable companies, or if you believe multiples will change significantly in the future.

Question 15

What is an appropriate growth rate when calculating Terminal Value?

Answer 15

Usually country’s long-term GDP growth rate, inflation rate, or something conservative.

For companies in mature economies, a long-term growth-rate over 5% is aggressive since most developed economies grow at less than 5% per year.

Question 16

How do you select an appropriate exit multiple for TV?

Answer 16

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

You should show a range of exit multiples, and show what TV looks like over that range, rather than one specific number.

If median EBITDA multiple is 8x, you would show a range of TVs using multiples from 6x to 10x.

Question 17

What is the difference in valuation outputs between Multiple Method and Gordon Growth?

Answer 17

Multiples Method is typically more variable than Gordon Growth, as exit multiples usually 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

Public company shares change price depending on multiple factors, and they can vary greatly over time / in cycles.

This is why you choose a large number of comps and do a sensitivity.

Question 19

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

Answer 19

If over 50% of your company’s Enterprise Value comes from its Terminal Value, the DCF is likely too dependent on future assumptions.

Question 20

Should cost of equity be higher for a $5bn or a $500mm market cap company?

Answer 20

All else being equal, it should be higher for the smaller company, as smaller companies are expected to generate higher returns than larger companies.

Question 21

Will WACC be higher for a smaller vs. larger company?

Answer 21

If the capital structure is the same (i.e. debt vs. equity), then WACC should be higher for the smaller company as they are expected to generate higher returns than larger companies.

If the cap structure is not the same, then WACC will depend on how much debt/preferred each company has and the interest rates/dividend yields on each.

Question 22

What is the relationship between debt and Cost of Equity?

Answer 22

More debt means the company is more risky (higher leverage). The company’s levered Beta will therefore 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

How are dividend yields factored into cost of equity?

Answer 23

Dividend yields are factored into Beta, as Beta tells us what return a stock is providing above the market - those returns include dividends.

Question 24

How can we calculate cost of equity without using CAPM?

Answer 24

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

This is useful if dividends are more important to investors than returns/Beta

Question 25

Would a company with debt have a higher WACC than a company without debt?

Answer 25

The company without debt will have a higher WACC, as debt is less expensive (i.e. less risky) than equity:
- Interest on debt is tax deductible
- Debt is senior in the cap structure to equity
- Interest rates are usually lower than cost of equity numbers, therefore the debt portion usually contributes less to WACC than the cost of equity portion.

Question 26

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

Answer 26

It depends, but usually a 10% change in revenue will have more of an impact, as discount rates dont have much of an impact until further into the future, whereas revenue impacts all financial periods.

Question 27

What has more of an impact to DCF valuation, a 1% revenue change or a 1% discount rate change?

Answer 27

It depends, but most likely the discount rate is likely going to have a larger impact on valuation

Question 28

How do you calculate WACC for a private company?

Answer 28

You can’t use market cap or Betas for private companies, therefore you would normally estimate WACC based on work done by auditors or valuation specialists. You can also look at WACCs for comparable public companies.

Question 29

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

Answer 29

Options:
1. Create your own projections
2. Modify management’s projections to make them more conservative
3. Show a sensitivity table based on different growth rates and margins, and compare the values based on both sets (mgmt vs. more conservative) of projections

Question 30

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

Answer 30

Banks use debt differently to other companies - they do not reinvest it in the business but use it as capital assets to generate their products instead.

Interest is a critical part of banks’ business models, and changes in NWC can be much larger than a bank’s net income, so traditional measures of cash flow dont tell you much.

For financial institutions, much more common to use a dividend discount model or residual income model, rather than a DCF

Question 31

What types of sensitivities would we look at in a DCF?

Answer 31

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-term growth rate vs. Discount Rate

Question 32

A company has a high debt load and is paying off a significant portion of its principal each year. How would you account for this in a DCF?

Answer 32

Don’t account for this if using Unlevered FCF in your DCF, because we don’t consider interest expense in our FCF.

If using Levered FCF, then Interest Expense would decline in future years (increasing FCF), but the debt repayments would reduce Levered FCF.