DCF (Reverse) Flashcards
Rf + b(Rm-Rf)
Rf= risk free rate
b= Levered beta
Rm= expected return on the market
- How do you derive Ke?
The PV of the terminal value is the PV for far in the future earnings, and you need to incorporate near earnings as well. It is much more realistic to project FCFs within a period of 5-10 years, and much more uncertain beyond that time frame. Thus, EV needs to incorporate the PVs of near term and long term earnings.
Yes, a multiple of EBITDA to get EV is one way to get an implied valuation of a company. A DCF provides another perspective to reach EV.
Wait, why isn’t the PV of the terminal value just the company’s EV? Also, couldn’t you just use a multiple of EBITDA to get EV?
- Unlevered and levered
- Historical beta and calculated beta
- The relative riskiness or volatility of a company compared to the market
- Unlevered beta is lower because it does not incorporate the riskiness of debt. Levered beta is higher because it includes the risk factor of debt
- a) find a comparable list of companies
b) unlever their betas using the following formula:
levered beta / ((1 + (1 - tax rate)) x (debt / equity value))
c) find the median value
d) re-lever the unlevered beta using the formula”
unlevered beta * (1 + ((1 - tax rate) x (debt / equity value)))
The above re-levering takes into account the company’s debt, equity, and tax rate.
- What are the 2 types of betas?
- What are the 2 types of levered betas?
- Beta measures what?
- Which type of beta is lower than the other? Why?
- What are the steps to derive a calculated beta (aka unlever and re-lever)
Company A has a higher valuation. Money today is worth more than the same amount of money in the future.
You’re looking at two companies that have the same total projected FCF over a 5 year period. Company A generates 90% of its FCF in year 1, and 10% throughout the rest of the years. Company B generates FCF equally over the 5 years. Both have the same discount rate.
Which company has a higher value based on a DCF?
Terminal multiple and perpetuity method
What are the 2 methods to calculate terminal value?
If you were to receive $100 in perpetuity and wanting a 10% required rate of return, you would pay $1000. But, if that $100 were to grow by a fixed growth % each year, you would be willing to pay more for that. Thus, you take that same $100, but divide it by the WACC - Growth rate to get the value to pay if requiring a 10% return.
Explain the idea of the Gordon Growth model (utilized in perpetuity method).
Subtract value of debt, value of preferred stock, value of minority interest and add cash/equivalents. Then, divide by diluted shares outstanding.
How do you derive equity value/share when you’ve calculated enterprise value via a DCF?
Most professionals use book value of debt. However, it is important to adjust that if the market value of the debt is significantly different.
The cost of debt is a risk free rate (typically 10 or 30 year T-Bond) plus a spread to adjust for the company’s risk profile. If the company’s debt is publicly traded, you can directly observe the rate.
If the company’s debt is not publicly traded, I would examine the company’s footnotes looking for a rate, check for latest debt issuances, use a comparable company’s rate, or ask a debt markets professional
How do you get the value of debt?
How is the cost of debt derived? How do you derive it if the company’s debt is not publicly traded?
It applies a valuation multiple such as EV/EBITDA, to the final year’s forecasted metric. For example, a company could have a 8x EV/EBITDA multiple, which it would apply to the final year’s projected EBITDA.
The terminal value is discounted according to the final period FCF was projected.
It is important to use an EV multiple
What is the terminal multiple method?
- The same number
- A number lower than the numerator
- A number greater than the numerator
- When you divide a number by 1, you get what?
- When you divide a number by a number > 1, you get what?
- When you divide a number by a numer < 1, you what what?
- More debt means the company is riskier (potential for more returns) thus it will have a higher beta leading to a higher cost of equity.
- It does NOT affect a DCF if utilizing unlevered FCF, but it will lower the equity value if utilizing levered FCF because you subtract payments of principal on debt.
- What’s the relationship between debt and cost of equity?
- A company has a high debt balance and is paying off a significant portion of it each year. How does this affect a DCF?
10%
Calculate WACC
Risk Free rate 4%
Market risk premium 7%
Levered beta 1.3
Market value of debt $350
Market value of equity $650
Tax rate 35%
Cost of debt 6.6%
- FCF essentially replicates the cash flow statement, but excludes non-recurring cash flows such as particular investing cash flows and financing cash flows such as debt and equity issuances
It more refelcts operating cash flow while including the impact of CapEx
- Why do you use FCF? What is so important about that?
$33
Calculate the equity value per share:
Assume the PV of FCF is $500 million. The PV of the terminal value is $3,000 million. Net debt is $200 million. Cost of equity is 11% and WACC is 9%. There are 100 million diluted shares outstanding.
- It allows us to get to a more realistic version of operating cash flow. In short, if assets are increasing more than liabilities, that means companies are using cash to increase their assets, thus REDUCING cash flow.
On the other hand, if liabilities are increasing greater than assets, that means cash flow is INCREASING.
- What’s the point of adjusted for changes in OWC (operating working capital)
- Higher valuations because your discounting items for a lesser period
- You’re performing valuations before or after a fiscal year end, so there is a period of time in between the start of the next year that you need to account for. For example, if it’s currently Sep 30 and the FYE is Dec 31, then you need to project FCF for those 3 months.
Your first period is .25, then second period would be 1.25 (.25 + 1 year). etc
- Do mid-year conventions produce higher or lower valuations compared to full-year periods (eg: 1 , 2 , 3 , 4)
- What’s the point of a stub period?
Simply add depreciation and amortization to reach EBITDA.
In the terminal multiple method, how do you get EBITDA if you only have EBIT?
- I would apply the gordon growth method to derive the terminal value and then divide it by EBITDA to get a multiple. I would then compare that multiple to the terminal multiple to see if they are compatible.
- How would you ensure that the perpetuity method and terminal multiple method are compatible?
- (Dividends per share / share price) + Growth rate of dividends
- How do you calculate Ke without using CAPM?
- Yes and no. For a very quick approximation, yes, but remember that you exclude taxes completely. It would be better to do EBITDA - taxes - changes in OWC - CapEx
As an approximation, do you think it’s okay to use EBITDA - changes in OWC - CapEx
- A DCF derives enterprise value (assuming using unlevered FCFs), whereas DDM derives equity value
- a) project future dividends as a % of NI
b) discount using Ke
c) derive terminal value using perpetuity method / terminal method and discount to PV (terminal multiple P/E)
- What is the difference between a DCF and the dividend discount model?
- Show me the formula for a DDM.
Company A
Who has the higher PV of the terminal value?
Assume that company A has a WACC of 10% and comapny B has a WACC of 8%. Both companies have a projected year 5 terminal EBITDA of $100 million, but company A’s exit multiple is 10x and company B’s is 8x.
The rate reflecting the years commensurate with the number of years projecting free cash flows.
(Rm-Rf) is the market risk premium, which is the premium investors expect for investing in non-risk free assets.
Beta shows the relative volatility of a stock compared to the market.
Which risk free rate should you use?
What is (Rm-Rf)?
What is beta?
- Current NPV - (100 / (1 + WACC)^4)
We’re creating a DCF for a company that is planning to buy a factory for $100 cash in year 4. Currently, the NPV of the company is $200. How do we adjust the NPV to reflect the new CapEx spend?