Discounted Cash Flow - Basic

Question 1

Walk me through a DCF

Answer 1

A DCF values a company based on the Present Value of its Cash Flows and the Present value of its terminal value.

1. Project out o company’s financials using assumptions for revenue growth, expenses and working capital, then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate - usually the WACC

Once you have the PV of the cash flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.

Question 2

Walk me through how you get from Revenue to Free Cash Flow in the projections

Answer 2

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the charge in Working Capital.

Question 3

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 3

Take Cash Flow from operations and subtract CapEx - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question 4

Why do you use 5 or 10 years for DCF projections?

Answer 4

That’s usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Question 5

What do you usually use for the discount rate?

Answer 5

Normally, you use WACC, though you might also use cost of equity depending on how you’ve set up the DCF.

Question 6

How do you calculate WACC?

Answer 6

The formula is cost of equity * (% Equity) + Cost of Debt * (% debt) * (1-Tax Rate) + (cost of preferred) * (% preferred)

Question 7

How do you calculate the Cost of Equity?

Answer 7

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

Question 8

How do you get to Beta in the Cost of Equity?

Answer 8

You look up the Beta for each comparable company, unlever each one, take the median of the set and then lever it based on your company’s capital structure.

Un-levered Beta = Levered / (1+((1-Tax Rate)*(Total Debt/Equity)))

Question 9

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

Answer 9

Keep the apples-to-apples theme

When you look up the Beta on Bloomberg they will be levered to reflect the debt already assumed by each company.

Question 10

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

Answer 10

A technology company, because technology is viewed as a “riskier” industry than manufacturing.

Question 11

Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

Answer 11

Levered Free Cash Flow gives you equity value rather than Enterprise value, since the cash flow is only available to equity investors.

Question 12

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 12

You would use the Cost of Equity rather then WACC since we’re not concerned with Debt or Preferred Stock in this case - we’re calculating Equity Value, not Enterprise Value.

Question 13

How do you calculate the Terminal Value?

Answer 13

You can either apply an exit multiple to the company’s year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.

This formula is Terminal Value = year 5 Free cash flow * (1+Growth Rate) / (Discount Rate - Growth Rate)

Question 14

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

Answer 14

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contract is always a shot in the dark.

Question 15

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

Answer 15

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

For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

Question 16

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

Answer 16

Normally you look at the Comparable Companies and pick the median of the set, or something close to it.

As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number.

So the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Question 17

Which method of calculating Terminal Value will give you a higher valuation?

Answer 17

It’s hard to generalize because both are highly dependent on the assumptions you make. 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 18

What’s the flaw with basing terminal multiples on what public company comparable are trading at?

Answer 18

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

Question 19

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

Answer 19

The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

Question 20

Should cost of equity be higher for a $5 billion or $500 million market cap company?

Answer 20

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market. Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company .

Question 21

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

Answer 21

It depends if the capital structure of both companies are the same. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above.

Question 22

What’s the relationship between debt and Cost of Equity?

Answer 22

More debt means that the company is riskier, so the company’s Levered Beta will be higher - all else being equal, additional debt would raise the cost of equity, and less debt would lower the cost of equity.

Question 23

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company - but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 23

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include dividends.

Question 24

Cost of Equity without using CAPM?

Answer 24

Cost of Equity = (Dividend per share / Share price) + Growth Rate of Dividends

Question 25

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

Answer 25

It depends

Most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 26

Which has a greater impact on a company’s DCF valuation, a 1% change in revenue versus a 1% change in the discount rate?

Answer 26

In this case the discount rate is likely to have a bigger impact on the valuation, though the correct answer should start with it could go either way.

Question 27

How do you calculate WACC for a private company?

Answer 27

This is problematic because private companies don’t have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable companies is.

Question 28

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

Answer 28

Banks use debt differently than other companies and do not re-invest it in the business - they use it to create products instead. Also, interest is a critical part of banks’ business models and working capital takes up a huge part of their balance sheets - so a DCF for a financial institution would not make much sense.

Its more common to use a dividend discount model for valuation purposes.

Question 29

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 29

You don’t account for this at all in the 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.