DCF Special Cases

Question 1

How does a DCF for a private company differ?

Answer 1

Same mechanics, but calculating CoE and WACC is hard as you cant find market value of equity or Beta for private companies

So could estimate WACC based on the median WACC of its public comps, and do the same for CoE if you’re using that as the DR.

Question 2

How do you factor in one-time events such as raising Debt, completing acquisitions, and so on in a DCF?

Answer 2

Normal ignore, as whole point of FCF is to determine company’s cash flow on a recurring, predictable basis

If you know for certain will occur in near future, then factor it in.

Question 3

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

Answer 3

• create your own
• could haircut them, make them more conservative
• could show sensitivity tables based on different growth rates

Question 4

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

Answer 4

Banks use debt different to other companies, dont use to finance operations, use it to create their products instead.

Also interest is critical and changes to working capital can be much larger than a bank’s net income.

More common to use a dividend discount model or residual income model instead of DCF

Question 5

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

Answer 5

Same mechanics as DCF, but use dividends rather than FCF:
1. Project company’s earnings, down to EPS
2. Assume dividend payout ratio - what % of EPS paid out to shareholders in form of dividends, based on history
3. Use this to calculate dividends over next 5-10 years
4. Do a check, make sure firm still meets required tier 1 capital ratio, if not reduce dividends.
5. Discount dividends each year to present value based on CoE not WACC
6. Calculate TV based on P/BV of final year and discount this to present value based on Cost of Equity
7. Sum present value of the TV and present values of dividends to calculate the company’s NPV per share

Question 6

Key difference compared to a DDM for normal companies

Answer 6

the presence of the capital ratios – you can’t just blindly make Dividends per Share a percentage of EPS.

Question 7

Do you think a DCF would work well for an oil & gas company?

Answer 7

If it’s an exploration & production (E&P)-focused company, no:
- CapEx needs are enormous and will push FCF down to very lo levels
- commodity prices are cyclical and both revenue and FCF are difficult to project
For service-based companies or downstream energy companies, DCF may be more appropriate

Question 8

How does a DCF change if you’re valuing a company in an emerging market?

Answer 8

Much higher DR, might not link to WACC or CoE as they may not be a good set of Public Comps in the country

Might also add in a premium for political risk and uncertainty