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 companies, 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 net present value based on your discount rate usually WACC

Once you have the present value of the cash flows, you determine the companies 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 added the two together to determine the companies enterprise value

So project free cash flow estimate terminal value using one of the two methods discount cash flows the present value some of the present value values and then calculate your equity value

When you estimate terminal value, it’s usually after the projection. 510 years usually estimate all future cash flows which is known as your terminal value value.

So the method assumes cash flows grow at a constant rate forever

Exit multiple method assumes the business can be sold for a multiple of a certain financial metrics such as EBITDA

When you get your enterprise value, you can subtract any debt and add any cash, which will give you your implied equity value. You can also divide by shares outstanding to get implied share price.

Question 2

Gordon growth model/Perpetual Growth

Answer 2

This method assumes that a business will continue to generate cash flows at a constant rate forever.

Also considered the perpetuity approach

The equation can also look like…

TV = final year FCF x (1 + perpetuity growth rate) / (discount rate - perpetuity growth rate)

Question 3

Exit multiple method

Answer 3

Assumes business can be sold for a multiple of certain financial metric at end of projection.

Most common EBITDA

The equation is…

TV = EBITDA x multiple

TV = value of the firm at termination end of forecasted period

EBITDA = projected in terminal year

Multiple = assumed exit multiple usually based on comps

Question 4

Walk me through how you get from revenue to free cash flow in the projections?

Answer 4

You start with revenue subtract COGS and operating expenses to get operating income

Then multiplied by one minus the tax rate this will give you your operating profit NOPAT

Add back to depreciation other non-cash charges

Subtract capital expenditures and the change in working capital

This gets you to unlevered free cash flow since he went off EBIT rather than EBT

Confirm this is what the interviewer is asking for

To get to leverage cash flow, which is available to stockholders after interest expense on debt

Start with unlevered free cash flow then subtract the interest expense after tax

Interest expense multiplied by one minus the tax rate

Question 5

What’s an alternate way to calculate free cash flow aside from taking net income, adding back depreciation and subtracting changes and operating assets liabilities and capital expenditures?

Answer 5

Take cash flow from operations and subtract capital expenditures and mandatory debt repayments this gets you levered cash flow

Then to get to unlevered, cash flow had back tax adjusted interest, expense, and subtract tax adjusted interest in income

Question 6

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

Answer 6

That’s usually about as far as you can reasonably predict into the future less than five years would be too short to be useful in over 10 years is too difficult to predict for most companies

In many industries of 5 to 10 year projection is considered a standard long-term planning horizon

Question 7

What do you usually use for the discount rate?

Answer 7

Normally, you use WACC the weighted average cost of capital though you might also use cost of equity depending on how you set up the DCF model.

Question 8

Weighted average cost of capital WACC

Answer 8

Average rate of return a company is expected to provide to all its investors equity and debt why we use it?

It takes into account cost of equity and debt, and proportion of each in the capital structure.

It reflects expectations of investors regarding the return they require

It shows the riskiness of cash flows. The discount rate should reflect the riskiness of the cash flows being discounted since WACC incorporates the risk associated with the companies equity in debt. It is a suitable measure for this.

And it’s often interpreted as the hurdle rate which accompany must overcome in order to generate value for its investors

To calculate it…

WACC = E/V x Ke +D/V x Kd x (1- Tc) + P/V x Kp

E = market value of equity
V = total market value of equity debt, and preferred stock if included
Ke = cost of equity dividends capital appreciation
D = market value of debt
Kd = cost of debt interest payments
Tc = corporate tax rate
P = market value of preferred stock
Kp = cost of preferred stock dividend rate

Exclude P stock if none, and if insignificant part of structure

Calculation per component

E = companies, market, capitalization, or current share price times outstanding shares

D = book value of debt estimated sum of short term and long-term debt or bonds issued

Ke = capital asset pricing model CAPM

Rf+ beta (Rm-Rf) Equity risk premium

Rf = risk free rate
Beta = beta of investment it’s a risk measurement
Rm= expected market return

Kd = interest rate the company pays on debt total interest, expense divided by total debt

Tc = corporate tax rate applicable to company

Kp = dividend rate on preferred stock divided by the price of preferred stock

Question 9

Other ways to calculate cost of equity

Answer 9

Dividend capitalization model

Ke= D/p + g

D = dividend per share
P = current market price per share
G = growth, rate of dividends

It’s called cost of equity because “cost” financial expense that a company incurs to raise funds/capital

Earnings capitalization model

Ke= E/P

E = earnings per share EPS
P = current market price per share

Bonus Yield plus risk premium approach

Ke=Y+RP

Y = yield of companies long-term debt?

RP = equity risk, premium additional return required by equity investors over the companies debt yield

Question 10

Cost of capital meaning

Answer 10

Opportunity of making investment equity debt preferred stock

the return that a company needs to generate on its invested capital to satisfy holders and to compensate them for the risk they’re taking on by investing in the company

Question 11

Capitalization meaning

Answer 11

Generally refers to recognizing or accounting for a company sources in a way that reflects their long-term nature

Capitalization assessment of the value of a company, including its equity and debt or the accounting cost of an asset future income into present value

DCM. Dividend capitalization model refers to capitalizes the companies future dividends to derive the present value of the companies equity

Capital Means the sources used to generate value

Question 12

How do you calculate WACC?

Answer 12

Formula is cost of equity times percent of equity plus cost of debt times percent of debt times one minus the tax rate plus cost of preferred times percent of preferred

Percentages represent how much of the companies capital structure is taken up by each component

For cost of equity CAPM others use comparables/debt issuance interest rates and yields to get estimates

Question 13

How do you calculate cost of equity?

Answer 13

Cost of equity equals risk, free rate plus beta times ERP

ERP refers to the equity risk premium

The risk free rate represents how much a 10 year or 20 year US treasury should yield yield referring to earnings

Bonds are considered risk free because they are backed by the faith and credit of the US never default on debt obligations now risk free is meaning default only not interest or an inflation risk

Beta is calculated based on the riskiness of comparable companies, and the equity risk premium is the percentage by which stocks are expected to perform

Risk less assets

Are things like treasury inflation protected securities TIPS
Checking accounts, savings accounts, money market accounts certifications of deposits, most of which are backed by the FDIC federal deposit insurance company

Normally, you pull the equity risk premium from a publication called Ibbetson’s

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 according to market capitalization or industry.

Small company stocks are expected to out perform large company, stocks, and certain industries are expected to out perform others

These premiums reflect their expectations

Small Cap growth Potential under valuation risk reward much risk.

Question 14

How do you get to Beta in the cost of equity calculation?

Answer 14

Look up beta for each comparable company

Unlever each one

Take median of set and then leverage it based on cap structure of company

Use levered beta in the cost of equity calculation

Unlevered, beta or asset beta
Measures market risk of the company without considering debt

The equation is
UB = levered beta/1+((1-tax rate)x debt/equity)

Levered, beta or equity beta
Is the financial risk of a company in addition to the business risk

Financial risk relating to debt, repayment, interest, rate risk, etc.

LB=UB x (1+((1-tax rate)x debt/equity)

Unlevered Beta is considered the business risk (competitive market conditions) as it is like a kid riding a bike with training wheels there is a risk of falling, but it is relatively low because the training wheels provide stability

Levered Beta say the same kid riding a bike but this time no training wheels there’s more risk of falling right?

Risk of company equity when it has debt

Both business risk the kids ability to ride the bike and financial risk, the added risk from removing the training wheels or in a company’s case taking on debt

Question 15

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

Answer 15

Apples to apples theme

When you look up beta on Bloomberg or whatever source, they will be levered to reflect the debt already assumed by each company

But each companies capital structure is different and we want to look at how risky a company is regardless of what percentage of debt or equity it has

To get that we need to unlever beta each time

But at the end, go back to new levered beta because that is what we want to use in the cost of equity calculation to reflect true risk

Allows us to isolate business risk and financial risk

Use capital Structure of company you want to compare it to

Question 16

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

Answer 16

Technology is viewed as a risk gear industry due to uncertain cash flow and rapidly changing markets

Also research and development costs

Project based testing manufacturing, tedious product process

Lots of reinvesting heightens risk

And product release cycles are hard to determine

Question 17

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

Answer 17

Levered FCF 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)

FCFE - levered, use cost of equity for discount rate, risk associated with equity holders

FCFF - unlevered, use WACC for discount rate, risk associated to all cash flows available to all providers of capital

FCFE in DCF, equity value

FCFF in a DCF, firm value

FCFE used to estimate valuation, often used for banks and insurance companies that take in liabilities such as consumer deposits and insurance premiums.

Question 18

If you use Levered FCF, what should you use as the discount rate?

Answer 18

Levered FCF, cash flows that belong solely to equity holders.

Use Ke, rather than WACC since we’re not concerned with debt or preferred stock in this case we’re calculating Equity Value not EV.

Want to reflect expected return and risk of equity capital alone.

Question 19

How do you calculate the Terminal Value?

Answer 19

You can either apply an exit multiple to the company’s year 5 EBITDA, EBIT, or FCF (multiples method)

Or you can use the Gordon Growth Method to estimate its value based on its growth rate into perpetuity (Lasts forever, indefinite annuity)

GGM:
TV= Year 5 FCF x (1+GR)/(DR-GR)

EMM:
TV= Financial metric x Trading multiple

Question 20

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

Answer 20

In banking you almost always use the multiples method to calculate TV in a DCF

It is 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 GGM if you have no good comps or if you have reason to believe that multiples will change significantly in the industry several years down the road.

Very cyclical industries might be better off using long term growth rates rather than exit multiples.

Question 21

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

Answer 21

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.

Long term GDP and inflation are reflective of overall economic growth and price level changes.

Conservative meaning cautious and modest rather than aggressive and optimistic.

Question 22

How do you select the appropriate exit multiple when calculating TV?

Answer 22

Normally look at comparable companies and pick the median of the set or something close to it.

As with almost anything in Finance you always show a range of exit multiples and what TV look like over that range.

Ex: If EBITDA were 8x show a range of values using multiples from 6x to 10x

Look at a range to try and account for the inherently uncertain future financial performance.

Investment decisions based on a range of outcomes

Benchmarking

Variability, potential outcomes

Question 23

Which method of calculating TV will give you a higher valuation?

Answer 23

Hard to generalize because both are highly dependent on assumptions you make.

Multiples method is more variable than GGM because exit multiples tend to span a wider range than possible long term growth rates

The method that gives a higher valuation depends on the specific assumptions and conditions of the business. If the business is expected to grow at a high rate indefinitely, the Perpetuity Growth Model may yield a higher valuation.

On the other hand, if the business is expected to be sold at a high multiple of a certain metric, the Exit Multiple Method may result in a higher valuation.

Question 24

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

Answer 24

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.

Why you normally look at a wide range of multiples and do a sensitivity test to see how the valuation changes over that range.

This method is particularly problematic with cyclical industries (semiconductors)

Question 25

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

Answer 25

The standard answer is 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.

Terminal value relies on projections into the future, the present value of all future cash flows, value flows at termination, end of forecasted period.

Tough because, in reality almost all DCF’s are “too dependent on future assumptions” it’s actually quite rare to see a case where the TV is less than 50% of the EV.

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

The formula for calculating EV in a DCF model is as follows:

EV=NPV(r,arrayofFCFsforyears1throughn) + TV/(1+r)^n

Question 26

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

Answer 26

It should be higher for the $500 million company because all else being equal smaller companies are expected to outperform larger companies in the stock market and therefore be more risky

Smaller companies are less liquid investments so investors demand more.

Using a size premium in your calculation would also ensure that cost of equity is higher for the $500 million company.

Question 27

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

Answer 27

Trick question as it depends on whether or not the capital structure is the same for both companies.

If same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company.

Higher risk, higher capital costs, may rely on more debt financing

Question 28

What’s the relationship between debt and cost of equity?

Answer 28

More debt means that the company is riskier so the company’s levered beta will be higher all else being equal additional debt would raise the Ke and less debt would lower the Ke

CAPM beta is higher, risk is higher

Question 29

Cost of equity tells us what kind of return on equity investors can expect for investing but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 29

Trick question, dividend yields are already factored into Beta because Beta describes returns in excess of the market as a whole including dividends.

Historical returns both stock and market used to calculate Beta includes dividends

Not just change in stock price but also dividends paid out

return of security (stock)
return of market

Question 30

How can we calculate Cost of Equity without using CAPM?

Answer 30

Alternate formula:

Ke=(Dividends Per share/Share Price) + Growth rate of dividends

Less common than the standard formula

use it for companies where dividends are more important or lacking proper beta information or other variables

Question 31

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

Answer 31

One without debt will generally have a higher WACC because debt is less expensive than equity

Interest on debt is tax deductible hence (1-tax rate) multiplication in WACC

Debt is senior to equity in a company’s capital structure debt holders paid first in liquidation or bankruptcy scenarios

Intuitively interest rates on debt are usually lower than the Ke numbers you see (usually over 10%)

Cost of debt portion of WACC will contribute less to the total figure then the Ke portion.

A lot of debt potential for cost of debt to be greater than Ke

Without debt 99% of the time

Question 32

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

Answer 32

It depends but 10% difference in revenue will have a greater impact.

Affects current year revenue but also revenue/EBITDA far into the future and even the terminal value

Higher revenue growth rate, higher valuation

Question 33

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

Answer 33

It could go either way but most of the time this case discount rate

Higher discount rate reduces PV of future cash flows, lower valuation and then viceversa

Question 34

How do you calculate WACC for a private company?

Answer 34

Problematic because private companies don’t have market caps or betas, there is a lack of available information.

This case just estimate WACC based on work done by auditors or valuation specialists or based on what WACC for comparable companies is, comps Beta etc.

Question 35

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

Answer 35

Create your own projections

Modify management projections downward to make more conservative

Show a sensitivity table on different growth rates and margins showing managements numbers and projections and a more conservative set.

Do all of these for unrealistic projections.

Question 36

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

Answer 36

Banks use debt differently and do not reinvest it in the business.

They use it to create “products” loans

Interest is a critical part of their business models and changes in working capital can be much larger than their net income

Traditional measures of cash flow don’t tell you much.

Use DDM or RIM instead of DCF

No capex, no investing in machines and buildings

Source Capital “borrow money”
Lend Capital “invest that capital”

Question 37

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

Answer 37

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

any combination of these except terminal multiple vs long term growth rate

that makes no sense

Accretion analysis, dilution analysis, COGS, Revenue analysis.

Question 38

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

Answer 38

Trick question, you don’t account for this at all in an unlevered DCF because paying off debt principle shows up in CF from financing on CF statement but we only take into account EBIT * (1-tax rate) and then a few items from CF from operations and then subtract capex to get to unlevered FCF

If looking at levered FCF then our interest expense would decline in future years due to principle being paid off

mandatory debt repayments also reduce levered FCF

(repaying debt really does the cash flow that can go to equity investors so it should be subtracted)