Discounted Cash Flow

Question 1

What is a discounted cash flow analysis

Answer 1

A DCF is a type of valuation method based on the premise that a companies valuation can be derived by finding the present value of all
Of their projected free cash flow

Question 2

What are the pros of a DCF

Answer 2

1) The DCF produces the closest thing to an intrinsic stock value. Meanwhile, alternatives to the DCF are relative valuation methods that use multiples to compare stocks within a sector. These relative valuation methods become questionable when the entire sector is over valued or under valued.
2) The DCF relies on FCF. FCF is a reliable measure because it eliminates the subjective accounting practices involved in reported earnings. Free cash flow is a true measure of the money left over for investors.
3) The DCF can serve as a sanity check. We could plug the company’s current stock price into the DCF Model and work backwards. We can calculate how quickly the company would have to grow its cash flow to achieve the stock price. The DCF can help investors identify where the company’s value is coming from and whether or not it’s current share price is justified.

Question 3

What are the disadvantages of the DCF analysis

Answer 3

1) The DCF valuation is extremely sensitive to assumptions. Especially perpetual growth rate and discount rate. The DCF works best when there is a high degree of confidence about future cash flows. Things get tricky when a company lacks visibility. This means it is difficult to predict sales and cost trends.
2) Terminal value comprises far too much of the total value (65-75%). Even a minor variation in the assumptions on terminal year can have a significant impact on the final valuation.
3) DCF model is not suited for short-term investing. Instead, it focuses on long term value creation.

Question 4

Walk me through a DCF

Answer 4

1) Project FCF for the projection period.
2) Find WACC.
3) Calculate Terminal Value.
4) Apply WACC (discount rate) to each year of projected FCF and Terminal Value. Sum up the values to get Enterprise Value.

Question 5

How to calculate FCF

Answer 5

We Calculate FCF by starting with the company’s EBIT.

We subtract Taxes to find after Tax EBIT.

We then add back D&A since it is a non cash expense and shouldn’t be included in FCF.

Finally we subtract changes in NWC as well as Capital Expenditures. That leads us to FCF. We continue this process throughout our projection period.

Question 6

How to calculate WACC

Answer 6

To find WACC, we find find the after tax cost of debt and multiply that by the amount of debt in the capital structure.

We then add that value to the cost of of equity multiplied by the amount of equity in the capital structure.

Question 7

How do we find the after tax cost of debt

Answer 7

The after tax cost of debt is calculated as the before tax cost of debt multiplied by 1 minus the Tax rate.

(Interest expense) x (1 - Tax Rate)

Question 8

How do we calculate the cost of equity

Answer 8

To calculate the cost of equity, we use the Capital Asset Pricing Method (CAPm)

This is the risk free rate plus levered beta multiplex by the market risk premium.

Rf + Bl (Rm - Rf)

Question 9

In CAPm, why do we unlever then relever beta

Answer 9

We first unlever beta because the beta we receive is from our comp set and is our “industry” beta. It includes the impact of those company’s capital structure. We unlever to take out the impact of their capital structure.

We then relever beta to take into account the capital structure of our target company.

Question 10

How to unlever and relever beta?

Answer 10

Unlevered beta:
(Levered beta) / (1 + ((1 - Tax rate) x (debt/equity)))

Levered Beta:
Unlevered Beta x (1 + ((1 - Tax Rate) x (Debt/Equity)))

Question 11

How do we find terminal value?

Answer 11

We can find terminal value by using either the Exit Multiple Method or the Perpetuity Growth Method.

The exit multiple method assume that a company will cease to exist or will be sold after the projection period. It takes a multiple of EBITDA or EBIT to find how much the company will be worth after the projection period.

The perpetuity growth method assumes that a company will grow at a constant rate until perpetuity. This is done by multiplying the final year of projected free cash flow by 1 plus the growth rate. We then divide that value by WACC minus the growth rate.

(FCFn x (1-Gr)) / (WACC - Gr)

Question 12

How to calculate Enterprise Value

Answer 12

Enterprise value is calculated by multiplying FCF in year N by 1/(1 + WACC)^N

(FCFn) x ((1)/(1 + WACC)^n)

Question 13

How do we calculate market capitalization from the DCF

Answer 13

Once we arrive to our Enterprise Value, we can get Market Cap by adding cash back to EV, subtract debt, subtract minority interest, and subtract preferred shares

Market Cap = (EV + Cash - Debt - minority interest - preferred shares)

From here we can divide by the total amount of shares outstanding to get to our share price.

Question 14

When would you not use a DCF to value a company?

Answer 14

1) If the company has negative free cash flow

2) when the company has low visibility which makes it difficult to predict future growth

Question 15

What tends to give a higher valuation, the perpetuity growth method or the exit multiple method?

Answer 15

.

Question 16

What is a good growth rate to assume for the perpetuity growth method?

Answer 16

We usually look at the growth of the US economy. If a company is growing faster than the US economy, that means that eventually, it will be bigger than the US and that is not an accurate assumption.

Hence we would assume a growth rate that is less than the growth rate of US GDP.

Question 17

What makes up a majority of WACC? Why?

Answer 17

The cost of Equity makes up a majority of WACC because equity investors require a higher return on their investment than debt holders to compensate for the increased risk they are taking.

Question 18

In today’s economy, should we use the Perpetuity Growth Method or the Exit Multiple Method?

Answer 18

.