Discounted Cash Flow Questions - 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. First, you project out a 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 Weighted Average Cost of Capital. Once you have the present value 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. Finally, you add the two together to determine the company’s Enterprise Value.

Question 2

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

Answer 2

1. 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 change in Working Capital.
2. Note: The answer above gets you Unlevered Free Cash Flow. Clarify whether this is what they’re asking for. For Levered Free Cash Flow, you use EBT and follow the same steps, except you subtract debt repayments at the end.

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

5 to 10 years is industry standard. Anything above 10 years would be too difficult to reasonably predict and anything below 5 years would be too short to be useful.

Question 5

What do you usually use for the discount rate?

Answer 5

Normally you would use WACC (Weighted Average Cost of Capital), though when creating a Levered DCF, you might want to use Cost of Equity since you’re only valuing the cash flows available to equity investors.

Question 6

How do you calculate WACC?

Answer 6

The formula is: Percentage of Equity x Cost of Equity + Percentage of Debt x Cost of Debt x (1 - Tax Rate).
1. The percentages refer to how much of the company’s capital structure is taken up by each component.
2. Cost of Preferred x Percentage of Preferred should be included when a company has preferred stock in its capital structure.

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 calculation?

Answer 8

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company’s capital structure. Then you use this Levered Beta in the Cost of Equity calculation.

Question 9

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

Answer 9

When looking up Betas, they are typically levered to reflect the debt already assumed by each company. We need the unlevered Beta because each company’s capital structure is different, and we want to assess how risky a company is regardless of its debt or equity mix. After calculating the average unlevered Beta, we re-lever it to reflect the true risk of our company, taking into account its specific capital structure.

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 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 than 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 use one of two methods. Either the Multiples Method where you apply an exit multiple to the company’s Year 5 EBIT, EBITDA, or Free Cash Flow or you can use the Gordon Growth Method where you estimate its value based on its growth rate into perpetuity. The formula is: 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

You typically use the Multiples Method to calculate Terminal Value because it’s easier to obtain appropriate data for exit multiples, which are based on Comparable Companies. In contrast, choosing a long-term growth rate is less reliable. However, there are cases where the Gordon Growth Method might be preferable. If there are no good Comparable Companies or if you believe multiples will change significantly in the future, using long-term growth rates may be a better option than relying on exit multiples.

Question 15

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

Answer 15

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

Question 16

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

Answer 16

You would look at the Comparable Companies and find the median of their exit multiples. It’s best practice however, to choose a range rather than one specific number and show what the Terminal Value looks like over that range. For example, if 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

Generally, the Multiples Method tends to result in a higher valuation than the Gordon Growth Method because exit multiples often reflect current market conditions and sentiment, which can be more optimistic. In contrast, the Gordon Growth Method uses a conservative, long-term growth rate that is typically lower.

Question 18

What’s the flaw with basing terminal multiples on what public company comparables 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 analysis 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

If more than 50% of your company’s Enterprise Value comes from the Terminal Value, your DCF is probably too dependent on future assumptions. If it’s over 80%, you need to seriously rethink your 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 carry more market risk and have higher growth potential. The bigger a company gets the slower it tends to grow and the more stable it becomes. You can use a Size Premium in your calculation to take this into account and ensure a higher Cost of Equity for the smaller company.

Question 21

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 21

It depends on whether both companies have the same capital structure. If they do, WACC should be higher for the $500 million company due to Cost of Equity being higher.

Question 22

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

Answer 22

The more debt a company has, the more risky it is as an investment. The company will have a higher Levered Beta and all else being equal, an increased Cost of Equity. 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

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 24

There is an alternate formula: Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends. This is less common than the standard CAPM formula but is used in certain situations, such as when dividends are more important or when proper information on beta and other variables required for CAPM is unavailable.

Question 25

Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?

Answer 25

It really depends on how much debt that company has. Typically, the one without debt will have a higher WACC since debt is cheaper than equity due to its tax shield and lower interest rates compared to the Cost of Equity. However, when a company has large amounts of debt, the interest rate will rise to reflect the additional risk, increasing the cost of debt. If it rises high enough, it might surpass the Cost of Equity, causing additional debt to increase WACC. It forms a “U-shaped” curve, where debt initially decreases WACC to a point, then starts increasing it.

Question 26

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 26

It depends but 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 27

What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 27

It could go either way, but most of the time, the discount rate is likely to have a greater impact on the valuation.

Question 28

How do you calculate WACC for a private company?

Answer 28

Since private companies don’t have market caps or Betas, in most cases you would estimate WACC based on work done by auditors or valuation specialists, or based on what WACC is for comparable public companies.

Question 29

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

Answer 29

You can do a couple different things:
1. You can create your own projections.
2. You can modify management’s projections downward to make them more conservative.
3. You can show a sensitivity table based on different growth rates and margins and show the values assuming managements’ projections and assuming a more conservative set of numbers.

Question 30

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

Answer 30

Banks use debt differently from non-financial companies. Rather than taking on debt to reinvest in their business operations, banks use it to create products such as loans. Banks also rely on interest as a critical part of their business and have large amounts of working capital on their Balance Sheet. This is why a DCF wouldn’t make much sense for banks and other financial institutions. You would instead most likely use a Dividend Discount Model for valuation purposes.

Question 31

What types of sensitivity analyses would we look at in a DCF?

Answer 31

Some example sensitivities would be:
1. Revenue Growth vs. Terminal Multiple.
2. EBITDA Margin vs. Terminal Multiple.
3. Terminal Multiple vs. Discount Rate.
4. Long-Term Growth Rate vs. Discount Rate.
5. And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).

Question 32

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 32

You don’t account for debt principal repayments in a DCF because they are part of Cash Flow from Financing, not Operating Cash Flow. In a DCF, we focus on Free Cash Flow, which is derived from Cash Flow from Operations, and subtract Capital Expenditures. Principal repayments don’t affect this calculation. However, if we were using Levered Free Cash Flow, the declining interest expense due to lower debt would be reflected, but the principal repayments themselves still wouldn’t be included.