DCF Valuation

Question 1

What’s the point of valuation? WHY do you value a company?

Valuation

Answer 1

You value a company to determine its Implied Value according to your views.
If this Implied Value is very different from the company’s Current Value, you might be able to invest in the company and make money if its value changes. If you are advising a client company, you might value it to tell management the price that it might receive if the company sells, which is often different from its Current Value.

Question 2

But public companies already have Market Caps and Share Prices. Why bother valuing them?

Valuation

Answer 2

Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong!
You value companies to see if the market’s views are correct or incorrect.

Question 3

What are the advantages and disadvantages of the 3 main valuation methodologies?

Valuation

Answer 3

Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for
volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies
have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable
transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends. However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.

Question 4

Which of the 3 main methodologies will produce the highest Implied Values?

Valuation

Answer 4

This is a trick question because almost any methodology could produce the highest Implied
Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps because of the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF compares because it’s far more dependent on your
assumptions.
The safest answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than thePublic Comps because of the control premium.”

Question 5

When is a DCF more useful than Public Comps or Precedent Transactions?

Valuation

Answer 5

You should pretty much always build a DCF since it is valuation – the other methodologies are supplemental.
But it’s especially useful when the company you’re valuing is mature and has stable, predictable cash flows or when you lack good Public Comps and Precedent Transactions.

Question 6

When are Public Comps or Precedent Transactions more useful than the DCF?

Valuation

Answer 6

If the company you’re valuing is early-stage and you cannot estimate its future cash flows, or if the company has no path to positive cash flows, you must rely on the other methodologies.
These other methodologies can also be more useful when you run into problems in the DCF,
such as the inability to estimate the Discount Rate.

Question 7

Which one should be worth more: a $500 million EBITDA healthcare company or a $500
million EBITDA industrials company?
Assume the growth rates and margins are the same.

Valuation

Answer 7

In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA).
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than
industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset
intensity and higher expected growth rates would likely make up for that.
However, this answer is an extreme generalization, so you need more information to give a
detailed answer.

Question 8

How do you value an apple tree?

Valuation

Answer 8

The same way you value a company: comparable apple trees and a DCF. You’d look at what
similar apple trees have sold for and calculate the expected future cash flows from this tree.
You would then discount these cash flows to Present Value, discount the Terminal Value to PV, and add everything to determine the apple tree’s Implied Value.
The Discount Rate would be based on your opportunity cost – what you might be able to earn each year by investing in other, similar apple trees.

Question 9

People say that the DCF is intrinsic valuation, while Public Comps and Precedent
Transactions are relative valuation. Is that correct?

Valuation

Answer 9

No, not exactly. The DCF is based on the company’s expected future cash flows, so in that
sense, it is “intrinsic valuation.”
But the Discount Rate used in the DCF is usually linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer companies.
The DCF depends less on the market than the other methodologies, but there is still some
dependency.
It’s more accurate to say that the DCF depends more on your views of the company’s long-term prospects and less on market data than the other methodologies.

Question 10

Why do you build a DCF analysis to value a company?

DCF

Answer 10

You build a DCF analysis because a company is worth the Present Value of its expected future cash flows:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow
Growth Rate < Discount Rate
But you can’t just use that single formula because a company’s Cash Flow Growth Rate and
Discount Rate change over time.
So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: one where
those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period)
You then project the company’s cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s).
Then, you compare this sum – the company’s Implied Value – to the company’s Current Value
or “Asking Price” to see if it’s valued appropriately.

Question 11

Walk me through a DCF analysis.

DCF

Answer 11

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast
period plus the Present Value of its Terminal Value.
You start by projecting the company’s Free Cash Flows over the next 5-10 years by making
assumptions for revenue growth, margins, Working Capital, and CapEx.
Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything.
Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon
Growth Method; it represents the company’s value after those first 5-10 years into perpetuity.
You then discount the Terminal Value to Present Value using the Discount Rate and add it to
the sum of the company’s discounted cash flows.
Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise
Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to
the Current Share Price.

Question 12

How do you move from Revenue to Free Cash Flow in a DCF?

DCF

Answer 12

First, confirm that the interviewer is asking for Unlevered Free Cash Flow (AKA Free Cash Flow
to Firm). If so:Subtract COGS and Operating Expenses from Revenue to get Operating Income (EBIT).
Then, multiply Operating Income by (1 – Tax Rate), add back Depreciation & Amortization, and factor in the Change in Working Capital.
If the company spends extra cash as it grows, the Change in Working Capital will be negative; if it generates extra cash flow due to its growth, it will be positive.
Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow.
Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest
Expense before multiplying by (1 – Tax Rate), and you also factor in changes in Debt principal.

Question 13

What does the Discount Rate mean?

DCF

Answer 13

The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry.
A higher Discount Rate means higher risk and potential returns; a lower Discount Rate means
lower risk and potential returns.
A higher Discount Rate makes a company less valuable because it means the investors have
better options elsewhere; a lower Discount Rate makes a company more valuable.

Question 14

How do you calculate Terminal Value in a DCF, and which method is best?

DCF

Answer 14

You can use the Multiples Method or the Gordon Growth Method (AKA Long-Term Growth
Method, Perpetuity Growth Method, etc.).
With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF in the final year of the forecast period. For example, if you apply a 10x TEV / EBITDA multiple to the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000.
With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free
Cash Flows in the Terminal Period and assume they’ll grow at that rate forever.
Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate –
Terminal Growth Rate)
The Gordon Growth Method is better from a theoretical perspective because growth always
slows down over time; all companies’ cash flows eventually grow more slowly than GDP.
If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense
because it implies a growth rate that’s too high.
However, many bankers still use and prefer the Multiples Method because it’s “easier” or
because they don’t understand that a Terminal Multiple implies a Terminal Growth Rate.

Question 15

What are some signs that you might be using the incorrect assumptions in a DCF?

dcf

Answer 15

The most common signs of trouble are:
* 1. Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of
the company’s total Implied Value, but it shouldn’t represent 95% of its value.
* 2. Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you
pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the
country’s long-term GDP growth rate is 3%, something is wrong.
* 3. You’re Double-Counting Items – If an expense is deducted in FCF, you should not
subtract the corresponding Liability in the Enterprise Value → Equity Value “bridge.”
And if an expense is not deducted in FCF, you should subtract the corresponding
Liability in the bridge at the end (e.g., Interest and Debt in an Unlevered DCF).
* 4. Mismatched Final Year FCF Growth Rate and Terminal Growth Rate – If the company’s
Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal
Growth Rate, something is wrong. FCF growth should decline over time and approach
the Terminal Growth Rate by the end of the explicit forecast period.

Question 16

If your DCF seems wrong, what are the easiest ways to fix it?

dcf

Answer 16

The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes a higher percentage of the Implied Value and so that there’s more time for the FCF growth to slow down and approach the Terminal Growth Rate.
So, if you’re using a 5-year forecast period, extend it to 10-15 years and reduce the company’s FCF growth in those extra years as it approaches maturity.
To avoid double-counting items… look at what you’re doing, and don’t double count!
Finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower
Terminal Multiple. Terminal Value tends to be overstated in financial models because people
don’t understand the theory behind it.

Question 17

How do you interpret the results of a DCF?

dcf

Answer 17

You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic.
For example, if you believe that the company’s Implied Share Price is between $15.00 and
$20.00, but its Current Share Price is $8.00, that means the company may be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.

Question 18

Does a DCF ever make sense for a company with negative cash flows?

dcf

Answer 18

Maybe. A DCF is based on a company’s expected future cash flows, so even if the company is
cash flow-negative right now, the analysis could work if the company starts generating positive cash flows in the future.
But if the company has no path to positive cash flows, or you can’t reasonably forecast its cash flows, then the analysis doesn’t make sense.

Question 19

How do the Levered DCF and Adjusted Present Value (APV) analysis differ from the
Unlevered DCF?

dcf

Answer 19

In a Levered DCF, you use Levered FCF for the cash flows (i.e., deduct the Net Interest Expense and include changes in Debt principal) and Cost of Equity for the Discount Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E.
You don’t back into Implied Equity Value at the end because the analysis produces the Implied Equity Value directly.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest Tax Shield separately and add the Present Value of this Tax Shield at the end.
You still calculate Unlevered FCF and Terminal Value the same way, but you use Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median Unlevered Beta from Public Comps).
You then project the Interest Tax Shield each year, discount it at that same Discount Rate,
calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.

Question 20

Will you get the same results from an Unlevered DCF and a Levered DCF?

dcf

Answer 20

No. The simplest explanation is that an Unlevered DCF does not directly factor the Cost of Debt into the FCF projections, while a Levered FCF does. The Unlevered DCF indirectly accounts for it via the WACC calculation, but it won’t be equivalent to the Levered version.
That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes in Debt principal) will also play a role. It’s very difficult to pick equivalent assumptions, and it’s not worth thinking about because no one uses the Levered DCF in real life.

Question 21

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

dcf

Answer 21

The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more
consistent results that depend far less on the company’s capital structure.
With the other methods, you have to project the company’s Cash and Debt balances, Net
Interest Expense, and changes in Debt principal, all of which require more time and effort.
The Levered DCF sometimes produces odd results because irregular Debt principal repayments can shift the Levered FCF dramatically in certain years.
The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: the
increased chance of bankruptcy (unless you make a special adjustment for it).
The Unlevered DCF solves this issue because WACC initially decreases with additional Debt but then starts increasing past a certain level, reflecting both the advantages and disadvantages of Debt.

Question 22

Why do you calculate Unlevered Free Cash Flow by including and excluding various items
on the financial statements?

fcf

Answer 22

Unlevered FCF must capture the company’s core, recurring line items available to ALL investor groups.
That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company’s core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to all investor groups, you ignore it.
This rule explains why you ignore these items:
* Net Interest Expense – Only available to Debt investors.
* Other Income / (Expense) – Corresponds to non-core or non-operating Assets.
* Most non-cash adjustments besides D&A – They’re non-recurring.
* All Items in Cash Flow from Financing – They’re only available to certain investors.
* Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.

Question 23

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you
about a company’s business model?

fcf

Answer 23

The Change in Working Capital tells you whether the company generates extra cash as it grows or whether it requires extra cash to support its growth.
It’s related to whether a company records expenses and revenue before or after paying or
collecting them in cash.
For example, retailers tend to have negative values for the Change in Working Capital because they usually have to pay for Inventory before delivering it to customers.
But subscription-based software companies often have positive values for the Change in
Working Capital because they might collect cash from long-term subscriptions upfront and
recognize it as revenue over time.
The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a
major value driver because it’s fairly small for most companies.

Question 24

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a noncash add-back on the Cash Flow Statemen

fcf

Answer 24

No! You should consider SBC a cash expense in the context of valuation because it creates
additional shares and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: the company paid for a
capital asset earlier on but divides that payment over many years and recognizes it over time.
Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context is different: accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back, you should assume additional shares by increasing the company’s diluted share count. Either way, the company’s Implied Share Price decreases.
Many DCFs get this wrong because they use neither approach: they pretend that SBC is a non-cash add-back that makes no impact on the share count (wrong!).

Question 25

What’s the proper tax rate to use when calculating FCF – the effective tax rate, the
statutory tax rate, or the cash tax rate?

fcf

Answer 25

The company’s Free Cash Flows should reflect the cash taxes it pays.
So, it doesn’t matter which rate you use as long as the cash taxes are correct.
For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income) and then include an adjustment for Deferred Taxes.
Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax
adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes.
It’s most common to use the effective tax rate and then adjust for the Deferred Taxes based on historical trends.

Question 26

How should CapEx and Depreciation change within the explicit forecast period?

fcf

Answer 26

Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast
period, the company’s CapEx and Depreciation, as percentages of revenue, should decrease.
High-growth companies tend to spend more on Capital Expenditures to support their growth,
but this spending declines over time as they move from “growing” to “mature.”
If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be a smaller difference by the end.
CapEx should not equal Depreciation – even in the Terminal Period (again, assuming the
company is still growing).
That’s partially due to inflation (capital assets purchased 5-10 years ago cost less) and because Net PP&E must keep growing to support FCF Growth in the Terminal Period.
If the company’s FCF stagnates or declines, then you might use different assumptions.

Question 27

Should you include inflation in the FCF projections?

fcf

Answer 27

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for
prices and salaries tend to be based on nominal figures.
If you include inflation, you also need to forecast inflation far into the future and adjust all
figures in your analysis.
That’s rarely worthwhile because of the uncertainty and extra assumptions required.

Question 28

If the company’s capital structure is expected to change, how do you reflect it in FCF?

fcf

Answer 28

You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt principal will change over time. You’ll also change the Cost of Equity over time to reflect this.
The changing capital structure won’t show up explicitly in the projections of an Unlevered DCF, but you will still reflect it with the Discount Rate – WACC will change as the company’s Debt and Equity levels change.

Question 29

What’s the relationship between subtracting an expense in the FCF projections and the
Implied Equity Value calculation at the end of the DCF?

fcf

Answer 29

If you subtract a certain expense in FCF, then you should ignore the corresponding Liability
when moving from Implied Enterprise Value to Implied Equity Value at the end.
For example, with U.S.-based companies, you normally subtract the Rental Expense on
Operating Leases in the FCF projections because Rent is a standard operating expense.
Therefore, you ignore the Operating Lease Liability in the Enterprise Value bridge at the end.
But if you exclude or add back the Rental Expense in FCF, you do the opposite and subtract the Operating Lease Liability in the bridge.
This rule also explains why you subtract Debt in the bridge for an Unlevered analysis: UFCF
excludes the corresponding Interest Expense on the Debt.

Question 30

How do Net Operating Losses (NOLs) factor into Free Cash Flow?

fcf

Answer 30

You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also factoring in NOL accruals if the company earns negative Pre-Tax Income.
If you do this, you don’t need to count the NOLs in the Implied Enterprise Value → Implied
Equity Value bridge at the end.
However, it’s far easier to skip that separate schedule and add NOLs as non-operating Assets in the bridge.
Beyond the extra work, one problem with the first approach is that the company may not use
all of its NOLs by the end of the explicit forecast period!
Yes, you could account for this by calculating the Terminal Value of the NOLs, discounting it to Present Value, and adding it to the other components, but it’s extra work for almost no benefit.

Question 31

How does the Unlevered Free Cash Flow calculation differ for U.S. vs. non-U.S.
companies?

fcf

Answer 31

It’s mostly a question of how you’re treating Operating and Finance Leases, which was
explained in the previous question.
It’s easiest to deduct the full Lease Expense from all lease types in the UFCF calculation. For
IFRS-based companies, that means finding and deducting the Interest element of the lease
expense for both types and adding back only D&A on owned assets.
But you could use the opposite approach as well (described above).
Non-U.S. companies also tend to disclose less information, especially in emerging and frontier markets, so you may have to settle for simpler UFCF projections as well.

Question 32

What does the Cost of Equity mean intuitively?

wacc

Answer 32

It tells you the average percentage a company’s stock “should” return each year, over the very
long term, factoring in both stock-price appreciation and dividends.
In a valuation, it represents the average annualized percentage that equity investors might earn over the long term.
To a company, the Cost of Equity represents the cost of funding its operations by issuing
additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and by diluting
existing investors.

Question 33

What does WACC mean intuitively?

wacc

Answer 33

WACC is similar to Cost of Equity, but it’s the expected annualized return if you invest
proportionately in all parts of the company’s capital structure – Debt, Equity, and Preferred
Stock.
To a company, WACC represents the cost of funding its operations by using all its sources of
capital and keeping its capital structure percentages the same over time.
Investors might invest in a company if its expected IRR exceeds WACC, and a company might
decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Question 34

How do you calculate the Cost of Equity?

wacc

Answer 34

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
The Risk-Free Rate represents the yield on “risk-free” government bonds denominated in the
same currency as the company’s cash flows. You usually use 10-year or 20-year bonds to match the explicit forecast period of the DCF.
Levered Beta represents the volatility of this stock relative to the market as a whole, factoring
in both intrinsic business risk and risk from leverage.
And the Equity Risk Premium represents how much the stock market in the company’s country will return above the “risk-free” government bond yield in the long term.
Stocks are riskier and have higher potential returns than government bonds, so you take the
yield on those government bonds, add the extra returns you could get from the stock market,
and then adjust for this company’s specific risk and potential returns.

Question 35

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

wacc

Answer 35

You should use the yield (to maturity) on the government bonds denominated in the currency of the company’s cash flows.
So, if the company reports its financials in USD, you might use the yield on 10-year U.S.
Treasuries; if it reports them in EUR or GBP, you might use the yield on 10-year bonds issued by the European Central Bank or the Bank of England.

Question 36

What should you use for the Risk-Free Rate if government bonds in the country are NOT
risk-free (e.g., Greece)?

wacc

Answer 36

One option is to take the Risk-Free Rate in a country that is “risk-free,” like the U.S. or U.K., and then add a default spread based on your country’s credit rating.
For example, you might start with a rate of 1.3% for 10-year U.S. Treasuries and then add a
spread of ~7% for Greece based on its current credit rating (this is just an example; these
numbers change all the time).
This 8.3% Risk-Free Rate represents the additional risk because the government has a
significantly higher chance of defaulting.

Question 37

How do you calculate the Equity Risk Premium?

wacc

Answer 37

Stock-market returns differ based on the period and whether you use an arithmetic mean, a
geometric mean, or other approaches, so there’s no universal method.
Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for
companies of different sizes in different industries each year; some academic sources also track and report this data.
You could also take the historical data for the U.S. stock market and add a premium based on
the default spread of a specific country.
For example, if the historical U.S. premium is 7%, you might add 3% to it if your country’s credit rating is Ba2, and that rating corresponds to a 3% spread.
Some groups also use a “standard number” for each market, such as 5-6% in developed
countries.

Question 38

How do you calculate the Equity Risk Premium for a multinational company that operates
in many different geographies?

wacc

Answer 38

You might take the percentage of revenue earned in each country, multiply it by the ERP in that market, and then add the terms to get the weighted average ERP.
To calculate the ERP in each market, you might use one of the methods described in the
previous question. The “Historical U.S. stock market returns + default spread” approach is
common here.

Question 39

What does Beta mean intuitively?

wacc

Answer 39

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a
whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt).
If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

Question 40

Could Beta ever be negative?

wacc

Answer 40

Yes, it’s possible. The company’s stock price must move in the opposite direction of the entire
market for Beta to be negative.
Gold is commonly cited as an Asset with a negative Beta because it often performs better when the stock market declines, and it may act as a “hedge” against disastrous events.
However, negative Betas for traditional companies are quite rare and usually revert to positive figures, even if they’re negative for short periods.

Question 41

Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?

wacc

Answer 41

You don’t “have to” un-lever and re-lever Beta: you could just use the company’s historical
Levered Beta and skip this step.
But in a valuation, you’re estimating the company’s Implied Value: what it should be worth.
The historical Beta corresponds more closely to the company’s Current Value – what the
market says it’s worth today.
By un-levering Beta for each comparable company, you capture the inherent business risk in
“the industry as a whole.”
Each company might have a different capital structure, so it’s useful to remove the risk from
leverage and isolate the inherent business risk.
You then take the median Unlevered Beta from these companies and re-lever it based on the
capital structure (targeted or actual) of the company you’re valuing.
You do this because there will always be business risk and risk from leverage, so you need to
reflect both in the valuation.
You can think of the result, Re-Levered Beta, as: “What the volatility of this company’s stock
price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s capital structure.”

Question 42

What are the formulas for un-levering and re-levering Beta, and what do they mean?

wacc

Answer 42

• Unlevered Beta = Levered Beta / (1 + Debt / Equity * (1 – Tax Rate) + Preferred Stock / Equity)
• Levered Beta = Unlevered Beta * (1 + Debt / Equity * (1 – Tax Rate) + Preferred Stock / Equity)
  You use a “1 +” in front of Debt / Equity * (1 – Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta.
  You multiply the Debt / Equity term by (1 – Tax Rate) because the tax-deductibility of interest
  reduces the risk of Debt.
  The formulas reduce Levered Beta to represent the removal of risk from leverage, but they
  increase Unlevered Beta to represent the addition of risk from leverage.

Question 43

The formulas for Beta do not factor in the interest rate on Debt. Isn’t that wrong? More
expensive Debt should be riskier.

wacc

Answer 43

Yes, this is one drawback. However:
* The Debt / Equity ratio is a proxy for interest rates on Debt because companies with
higher Debt / Equity ratios have to pay higher interest rates as well.
* The risk isn’t directly proportional to interest rates. Higher interest on Debt will result
in lower coverage ratios (EBITDA / Interest), but you can’t say something like, “Interest
is now 4% rather than 1% – the risk from leverage is 4x higher.”
A 4% vs. 1% interest rate barely makes a difference if the Debt balance is small, but it will be a
much bigger deal with large Debt balances and smaller companies.

Question 44

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

wacc

Answer 44

Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF.
A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and re-lever Beta regardless of the type of Free Cash Flow you’re using.

Question 45

What are some different ways to calculate Beta in the Cost of Equity calculation?

wacc

Answer 45

Some people argue that you should use the Predicted Beta instead of the Historical Beta
because the Cost of Equity relates to expected future returns.
If you use the historical data, you could use the company’s Historical Beta or the re-levered
Beta based on the comparable companies.
And if you re-lever Beta, you could do it based on the company’s current capital structure, its
targeted or “optimal” structure, or the capital structure of the comparable companies.
Most of these methods produce similar results, but they’re useful for establishing the proper
range of values for the Cost of Equity and WACC.

Question 46

How would you estimate the Cost of Equity for a U.S.-based high-growth technology
company?

wacc

Answer 46

This question tests your ability to make a guesstimate based on common sense and your
knowledge of current market rates.
You might say, “The Risk-Free Rate is around 1.3% for 10-year U.S. Treasuries. A high-growth
tech company is more volatile than the market as a whole, with a likely Beta of around 1.5. So,
if you assume an Equity Risk Premium of 6%, the Cost of Equity might be around 10.3%.”
The specific numbers will change over time, but that’s the idea.

Question 47

How do you calculate WACC, and what makes it tricky?

wacc

Answer 47

The formula for WACC is simple:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred
Stock * % Preferred Stock
But it’s tricky to calculate because there are different methods to estimate these items:
1. Cost of Debt: Do you use the weighted average coupon rate on the company’s bonds?
Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies?
2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company’s current
capital structure, “optimal” structure, or targeted structure? Or do you use the median
percentages from the comparable public companies to approximate one of those?
3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the
proper Equity Risk Premium.

Question 48

WACC reflects the company’s entire capital structure, so why do you pair it with
Unlevered FCF? WACC is not capital structure-neutral!

wacc

Answer 48

Think of Unlevered FCF as “Free Cash Flow to Firm,” or FCFF, instead.
Unlevered FCF, or FCFF, is available to ALL investors, and WACC represents ALL investors.
Therefore, you pair WACC with Unlevered FCF.
No Discount Rate can be “capital structure-neutral” since each part of a company’s capital
structure affects the other parts.
“Capital-structure neutrality” is a property of Free Cash Flow, not the Discount Rate.

Question 49

Should you use the company’s current capital structure or optimal capital structure to
calculate WACC?

wacc

Answer 49

A company’s “optimal” capital structure is the one that minimizes its WACC. But there’s no way to calculate it because you can’t tell in advance how the Costs of Equity, Debt, and Preferred Stock will change as the capital structure changes.
So, in practice, you’ll often use the median capital structure percentages from the comparable public companies as a proxy for the “optimal” capital structure.
It’s the same as the logic for un-levering and re-levering Beta: you want to capture what this
company’s capital structure should be, not what it is right now.
It’s better to use this expected capital structure because the company’s Implied Value in a DCF is based on its expected future cash flows.

Question 50

Should you use Total Debt or Net Debt to determine the capital structure percentages in
the WACC calculation?

wacc

Answer 50

Some textbooks claim that you should use Equity Value + Debt + Preferred Stock – Cash, rather than Equity Value + Debt + Preferred Stock, for the denominator of the capital structure percentages.
We disagree with this approach for several reasons:
1) Cash Does Not “Offset” Debt – For example, many forms of Debt do not allow for early
repayment or penalize the company for early repayment. So, a high Cash balance
doesn’t necessarily reduce the risk of Debt on a 1:1 basis.
2) You May Get Nonsensical Results with High Cash Balances – For example, consider a
company with an Equity Value of $1,000, Debt of $200, and Cash of $800. If you use
Debt / (Equity Value + Debt – Cash), Debt represents 50% of the company’s capital
structure! But that’s incorrect for this type of company; the ~17% Debt produced by the
traditional method is much closer to reality.

Question 51

Why is Equity more expensive than Debt?

wacc

Answer 51

Because it offers higher risk and higher potential returns.
Expected stock market returns (plus dividends) exceed the yield to maturity on Debt in most
cases, which, by itself, makes the Cost of Equity higher. But the interest on Debt is also taxdeductible, which further reduces the Cost of Debt and makes Equity more expensive.
In developed markets, the average annualized stock market return is often in the 7-10% range, so a company with a Levered Beta of 1.0 will have a Cost of Equity in that range.
For the Cost of Debt to be higher, the Pre-Tax Cost would have to be ~9-13% at a 25% tax rate.
Outside of highly leveraged and distressed companies, corporate bond yields in that range are uncommon when government bond yields are close to 0% (or even below it).

Question 52

How does the Cost of Preferred Stock compare with the Cost of Debt and the Cost of
Equity?

wacc

Answer 52

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: it offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity.
That’s because the coupon rates on Preferred Stock tend to be higher than the coupon rates on Debt (and the same with the YTMs), and Preferred Dividends are not tax-deductible.
But these yields are still lower than expected stock market returns. The risk is also lower since the Preferred Stock investors have a higher claim to the company’s Assets than the common shareholders.

Question 53

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more
Debt?

wacc

Answer 53

The Cost of Equity and the Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors.
As a company goes from no Debt to some Debt, WACC initially decreases because Debt is
cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy
starts to outweigh the cost benefits of Debt.
However, the exact impact depends on where the company is on that curve. If the company
already has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt, WACC is more likely to decrease with more Debt.

Question 54

Should you ever use different Discount Rates for different years in a DCF?

wacc

Answer 54

Yes, sometimes it makes sense to use different Discount Rates.
For example, if a company is growing quickly right now but is expected to grow more slowly in
the future, you might decrease the Discount Rate each year until the company reaches
maturity.
So, if the company’s current WACC is between 11% and 13%, and WACC for mature companies in the industry is between 8% and 9%, you might start it at 12% and then reduce it by 0.4% in each year of the explicit forecast period until it reaches 8.4% by the end.
It makes less sense to do this if the company is already mature.

Question 55

Suppose you’re calculating WACC for two similarly sized companies in the same industry,
but one company is in a developed market (DM), and the other is in an emerging market
(EM). Will the EM company always have a higher WACC?

wacc

Answer 55

It’s fair to say that certain components of WACC, such as the Risk-Free Rate, Equity Risk
Premium, and Cost of Debt, tend to be higher for the EM company.
And if the Levered Beta numbers are similar or higher for the EM company, and the capital
structure percentages are similar, yes, WACC should be higher as well.
However, there are cases where differences in the capital structure or strange results for
Levered Beta might result in a similar or lower WACC for the EM company.
For example, if the government heavily controls the company’s industry in the emerging
market, Levered Beta might be lower for the EM company due to the reduced volatility.

Question 56

What is the difference between the explicit forecast period and the Terminal Period in a
DCF?

Terminal Value

Answer 56

The company’s Free Cash Flow Growth Rate, and possibly its Discount Rate, change over time in the explicit forecast period since the company is still growing and changing.
But in the Terminal Period, you assume that the company remains in a “steady state” forever:
Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

Question 57

What’s the intuition behind the Gordon Growth formula for Terminal Value?

Terminal Value

Answer 57

The typical formula is:
Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal
FCF Growth Rate)
But it’s more intuitive to think of it as:
Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate)
A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF
Growth Rate is higher.
For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It earns
$100 in FCF in the first year of the Terminal Period.
You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the
Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay $100 / 20%, or $500.
The company is worth more when you have worse investment options elsewhere and worth
less when you have better investment options elsewhere.
Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay
$100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d
be willing to pay $100 / (10% – 5%), or $2,000, for it.
Higher growth lets you achieve the same targeted returns even when you pay more.

Question 58

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from
the Public Comps or Precedent Transactions?

Terminal Value

Answer 58

It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years
into the future, because you don’t want to reflect the control premium in the Precedent
Transactions if you’re completing a standalone valuation of the company.
If the selected multiples imply a reasonable Terminal FCF Growth Rate, you might stick with
your initial guess; if not, adjust it up or down as necessary.

Question 59

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using
the Gordon Growth Method?

Terminal Value

Answer 59

This growth rate should be below the country’s long-term GDP growth rate and in-line with
other macroeconomic variables like inflation.
For example, if you’re in a developed country where the expected long-term GDP growth rate is 3.0%, you might use numbers ranging from 1.0% to 2.0% for the range of Terminal Growth
Rates.
You should NOT pick a rate above the country’s long-term GDP growth rate because the
company will become bigger than the economy as a whole if you go far enough into the future.
You can then check your work by calculating the Terminal Multiples implied by these growth
rates.

Question 60

Why do you need to discount the Terminal Value back to its Present Value?

Terminal Value

Answer 60

Because the Terminal Value represents the Present Value of the company’s cash flows from the end of the explicit forecast period into perpetuity. In other words, it represents the company’s value AT a point in the future.
Valuation tells you what a company is worth TODAY, so any “future value” must be discounted
to its Present Value.
If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Valuebecause you’d be acting as if its Year 6, 11, or 16 cash flows arrived in Year 2 instead.

Question 61

When you discount the Terminal Value, why do you use the number of the last year in the
forecast period for the discount period (for example, 10 for a 10-year forecast)?
Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?

Terminal Value

Answer 61

No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it’s the Present Value as of the end of Year 10.
You would use 11 for the discount period only if your explicit forecast period went to Year 11
and the Terminal Period started in Year 12.

Question 62

What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?

Terminal Value

Answer 62

If you’re building a Levered DCF analysis, you’re almost done because this summation gives you the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity Value by its diluted share count to get its Implied Share Price (if the company is public).
In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows equals the company’s
Implied Enterprise Value, so you have to “back into” the Implied Equity Value and then
calculate its Implied Share Price.
You do this by adding non-operating Assets (Cash, Investments, etc.) and subtracting Liability
and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling
Interests, etc.).
Then, you divide by the company’s diluted share count to get its Implied Share Price.

Question 63

The diluted share count includes dilution from the company’s in-the-money options.
But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?

Terminal Value

Answer 63

In theory, yes. Some academic sources use Black-Scholes to value these out-of-the-money
options and then subtract them to determine the company’s Implied Equity Value.
In practice, banks rarely include out-of-the-money options in a DCF. These options tend to
make a small impact on most companies, and options valuation is tricky and requires inputs
that you may or may not have. So, it is usually not worth the time and effort.

Question 64

How can you check whether or not your Terminal Value estimate is reasonable?

Terminal Value

Answer 64

It’s an iterative process: you start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by calculating the Growth Rates or Multiples they imply.
If it seems wrong, you adjust the range of Terminal Multiples or Terminal FCF Growth Rates
until you get more reasonable results.

Question 65

What’s one problem with using TEV / EBITDA multiples to calculate Terminal Value?

Terminal Value

Answer 65

The biggest issue is that EBITDA ignores CapEx. Two companies with similar TEV / EBITDA
multiples might have very different Free Cash Flow and FCF growth figures. As a result, their
Implied Values might differ significantly even if they have similar TEV / EBITDA multiples.
You may get better results by using TEV / EBIT, TEV / NOPAT, or TEV / Unlevered FCF, but those multiples create other issues, such as less comparability across peer companies.
This problem is one reason why the Gordon Growth Method is still the “real” way to calculate
Terminal Value.

Question 66

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Terminal Value

Answer 66

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its
key drug expires within the explicit forecast period, it might be reasonable to assume that the
company never replaces the lost revenue from this drug, which results in declining cash flow.
A negative Terminal FCF Growth Rate represents your expectation that the company will stop
generating cash flow eventually (even if it happens decades into the future).
It doesn’t make the company “worthless”; the company is just worth less.

Question 67

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

Terminal Value

Answer 67

The same assumptions make a big impact in any DCF: the Discount Rate, the Terminal FCF
Growth Rate or Terminal Multiple, and the key operational drivers that affect the company’s
revenue growth and margins.
These drivers could be entire scenarios or specific numbers, such as the long-term price of
steel, depending on the model setup.
It doesn’t make sense to sensitize much else – the assumptions for CapEx and the Change in
Working Capital, for example, tend to make a small difference.
There may also be industry-specific assumptions that are worth sensitizing, such as the patent expiration dates for drugs in the biotech/pharmaceutical industry.