DCF Questions (BASIC)

Question 1

What is a DCF?

Answer 1

A DCF intrinsically values a company based on the present value of its unlevered cash flows and the present value of its terminal value.

Question 2

How do you start a DCF?

Answer 2

You would project out a company’s financials using assumptions for revenue growth, expenses, and working capital.

Question 3

How do you calculate free cash flow in a DCF?

Answer 3

First, subtract cost of goods sold and operating expenses from revenues to get operating income (EBIT). Then, multiply operating income by one minus the tax rate to get earnings before interest after taxes. Finally, add back depreciation and other non-cash expenses, and subtract capital expenditures and the change in net working capital.

Question 4

What is an alternate way to calculate free cash flow?

Answer 4

You could take cash flow from operations and subtract capital expenditures to get levered cash flows. Then, add back the tax-adjusted interest expense and subtract the tax-adjusted interest income to get unlevered cash flows.

Question 5

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

Answer 5

That is usually about as far as you can reasonably predict into the future. Less than five years would be too short to be useful and over ten years would typically be too difficult to predict for most companies.

Question 6

What do you usually use for the discount rate in a DCF?

Answer 6

Normally, you will use WACC (Weighted Average Cost of Capital) although you may use the cost of equity if you are working with levered cash flows.

Question 7

How do you calculate WACC?

Answer 7

The formula for WACC is cost of equity times percent equity plus cost of debt times percent debt times one minus the tax rate plus the cost of preferred stock times the percent of preferred stock in the capital structure.

Question 8

How do you calculate the cost of equity?

Answer 8

The cost of equity is derived from the capital assets pricing model and is equal to the risk-free rate plus the beta times the market risk premium.

Question 9

How do you calculate the risk-free rate?

Answer 9

The risk-free rate represents how much a 10-year or 20-year treasury should yield.

Question 10

How do you calculate beta?

Answer 10

The beta is calculated based on the riskiness and volatility of the stock relative to the market and is the slope of the company’s returns regressed against the market’s returns.

Question 11

What is the market risk premium?

Answer 11

The market risk premium represents the percentage by which the market is expected to out-perform ‘risk-less’ assets.

Question 12

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

Answer 12

To find the company’s beta based on comparable companies, look up the betas for comparable companies, un-lever each, take the median of the un-levered betas, and then re-lever the median based on the company’s capital structure.

Question 13

What is the formula for un-levering beta?

Answer 13

Un-levered beta = levered beta / (1 + D/E * (1-T))

Question 14

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

Answer 14

Levered betas reflect the debt already assumed by each company, however, each company has a different capital structure and we want to look at how ‘risky’ a company is regardless of what % debt or equity it has.

Question 15

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

Answer 15

You would expect a technology company to have a higher beta because technology is viewed as a riskier industry than manufacturing.

Question 16

What is the effect of using levered free cash flow rather than unlevered in a DCF?

Answer 16

Levered free cash flow gives you equity value rather than enterprise value since the cash flow is only available to equity investors.

Question 17

What discount rate should you use if you use levered free cash flow?

Answer 17

You would use the cost of equity rather than WACC since we are calculating equity value not enterprise value.

Question 18

How do you calculate the terminal value?

Answer 18

You can either apply an exit multiple to the company’s year 5 EBITDA, EBIT, or free cash flow if you are using the multiples method.

Question 19

What is the Gordon Growth method for calculating terminal value?

Answer 19

You will estimate the value of a firm based on its growth rate into perpetuity using the formula terminal value = year five free cash flow * (one plus the growth rate) / (discount rate minus the growth rate).

Question 20

Why would you use Gordon Growth rather than the multiples method?

Answer 20

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.

Question 21

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

Answer 21

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

Question 22

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

Answer 22

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

Question 23

Which method of calculating terminal value will give you a higher valuation?

Answer 23

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 24

What is the flaw with basing terminal multiples on public company comparables?

Answer 24

The median multiples may change greatly in the next five to ten years, making them potentially inaccurate.

Question 25

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

Answer 25

If significantly more than 50% of the company’s enterprise value comes from its terminal value, the DCF is probably too dependent on future assumptions.

Question 26

Should the 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 smaller companies are expected to outperform large companies and are therefore more risky.

Question 27

Will WACC be higher for a $5 billion or $500 million company?

Answer 27

This will depend on the capital structures of the two companies. If the capital structure is the same, then WACC should be higher for the smaller company.

Question 28

What is the relationship between debt and cost of equity?

Answer 28

More debt means that the company is more risky, so the company’s levered Beta will be higher, raising the cost of equity.

Question 29

Shouldn’t we factor dividend yield into the cost of equity formula?

Answer 29

Dividend yields are already factored into Beta since Beta describes returns in excess of the market as a whole.

Question 30

Can we calculate the cost of equity without using CAPM?

Answer 30

Yes, an alternate formula is: Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends.

Question 31

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

Answer 31

Having a great amount of debt will decrease WACC to a point, and then will start increasing it due to increased risk.

Question 32

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

Answer 32

Most of the time, the 10% difference in revenue will have more of an impact since it affects future revenue and terminal value.

Question 33

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

Answer 33

It could go either way, however, the discount rate is likely to have a bigger impact on the valuation.

Question 34

How do you calculate WACC for a private company?

Answer 34

You may want to estimate the company’s WACC based on the WACC of comparable public companies.

Question 35

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

Answer 35

You can modify management’s projections downwards or show a sensitivity table based on different growth rates and margins.

Question 36

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

Answer 36

Banks use debt differently and interest is a critical part of their business model, making a DCF less appropriate.

Question 37

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

Answer 37

Revenue growth versus the terminal multiple, EBITDA margin versus the terminal multiple, and long-term growth rate versus the discount rate.

Question 38

How do you account for a company with a high debt load in a DCF?

Answer 38

You would not account for this at all in a DCF because paying off debt principal shows up in cash flow from financing.

Question 39

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 39

You would not 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 lookin at levered free cash flow, then our interest expense would decline in future years due to the principal being paid off, however, we still would not count the principal repayments themselves anywhere.