DCF + Multiples + EV Bridge Flashcards
Walk me through a DCF.
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.”
Walk me through how you get from Revenue to Free Cash Flow in the projections.
Subtract COGS and Operating Expenses and D&A (and other 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 should confirm that this is what the interviewer is asking for.
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?
Take Cash Flow From Operations and subtract CapEx and mandatory debt repayments – 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.
How do you get to Beta in the Cost of Equity calculation?
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)))
How do you calculate the Terminal Value?
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).
Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?
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.
How do you know if your DCF is too dependent on future assumptions?
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…
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?
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.
How can we calculate Cost of Equity WITHOUT using CAPM?
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.
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently than other companies and do not re-invest it in the business – they use it to create their “products” – loans – instead.
Also, interest is a critical part of banks’ business models and changes in working capital can be much larger than a bank’s net income – so traditional measures of cash flow don’t tell you much.
For financial institutions, it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF.
What types of sensitivity analyses would we look at in a DCF?
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).
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: Q4 Year 1 Year 2 Year 3 Year 4 Year 5 Normal Discount Periods with Stub: 0.25 1.25 2.25 3.25 4.25 5.25 Mid-Year Discount Periods with Stub: 0.125 0.75 1.75 2.75 3.75 4.75
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 noncontrolling 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.
- Do a check to make sure that the firm still meets its target Tier 1 Capital and other capital ratios – if not, reduce dividends.
- Discount the dividend in each year to its 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 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
What are pros and cons of a DCF?
Pros:
- Few assumptions beyond Business Plan
- Perfect method in theory. If all inputs are “true” output is true
- Simple concept
- Quick
- Helpful for companies with few comparables
- Good for cross-checking a LBO as this is also cash focused
Cons:
- Very sensitive
- Therefore, very manipulative
- Used less than multiple (more of a support function)
- WACC is static and doesn’t allow dynamic capital structure over time
- Less important if TV is large
Which method of calculating TV will give you a higher value?
Multiples will generally have a bigger range than GGM but other than that hard to generalize.
Should COE be higher for a $5b or $500m market cap company?
$500m because all else being equal, smaller companies are expected to outperform large ones (size premium).
What has a greater impact in DCF – 10% chg. In revenue or 1% chg. In discount rate?
It depends but usually the 10% chg. In revenue
A company has high debt and is paying off a significant part each year. How do you account for this in a DCF?
You don’t account for this at all in a DCF because paying off debt principal shows up in CF from Financing on the CFS but we only get down to CF from Operations and subtract Capex to get to FCF.
If we would look a LFCF then our interest expense would decline in future years due to principal being paid off but we still wouldn’t count the principal repayments themselves anywhere.
What are EV and Equity values?
EV represent core business to all investors; equity value represents entire business but only to shareholders. You look at equity value because it’s the number the public sees, but EV represents its true value.
How do you get from Equity Value to EV?
EV = Equity Value + Debt + Preferred Stock + Minority Interest – Cash (Simplified)
EV = Equity - Excess Cash \+ Financial Debt \+ Pref. Stock \+ Minority Interest/NCI - Market Value of Non-Core Assets/Equity Investments/Long-Term Investments - Net Operating Losses (NLO) \+ Capital Leases (sometimes you have to convert operating leases and add them) \+ Any other interest-bearing provisions \+ Pension Obligations
How would you calculate Net Debt?
Net Debt = Financial debt \+ Pension Liabilities \+ Asset Retirement Obligations \+ Any other interest-bearing provisions - Excess Cash (trapped cash etc.)
A company is valued. While looking at BS you find accruals for non-interest bearing legal fees. In 2 years, either €50m have to be paid or not. Chances are 50:50 (therefore €25m accrual). Is accrual considered for valuation?
If Company was valued using DCF and €25 was rightly included in CFs then we can ignore it in EV-Equity Bridge.
Why do you add Minority Interest to EV?
You handle majority interest as part of own performance so you have to consider minority interest (usually <50%) as well to also reflect its value in EV. If minorities own stock of company as well you have to pay them too to buy the entire company.
FS are consolidated so EBITDA, EBIT etc. contain 100% of subsidiary (even if only 70% is owned). NI contains only associated percentage so if you want to do EV/EBITDA you can’t compare 70% vs. 100%. You therefore add minority interest to get entire subsidiaries value included in EV.
