Intrinsic Valuation: DCF Flashcards
What are some of the main valuation methods?
Walk me through a DCF
What does the discount rate represent?
The expected return on an investment based on its risk profile.
Minimum return threshold based on comparable investments with similar risks.
Higher discount rate make a company’s cash flows less valuable
Difference between levered and unlevered free cash flows
Unlevered cash flows represent the cash flows from operations available to both debt and equity holders.
Levered cash flows represent the cash flows from operations that are available after debt payments and interest expense have been made - these are the residual cash flows to the equity holders - calculated as per FCF except we start with NET INCOME, which includes the impact of interest expenses and taxes: Net Income - CAPEX - Increase / + Decrease in Working Capital
What’s the difference between unlevered and levered DCF?
Unlevered DCF arrives at Enterprise Value directly using the WACC because it should reflect the risks to both debt and equity providers.
Levered DCF arrives at Equity Value directly using the cost of equity: forecast and discount LFCFs
WACC Formula
Re x (E/V) + Rd x (D/V) x (1 - t) (interest is tax deductible)
How do you determine the risk free rate?
Should theoretically reflect the yield to maturity of default free of equivalent maturity to the duration of the cash flows being measured.
However, lack of liquidity in the longest maturity bonds has made the current yield on 10-yr US treasuries the preferred proxy
Explain the concept of Beta
A beta measures the sensitivity of a security to changes in the market - it represents the portion of a security’s risk that cannot be diversified away and which moves with the market (systematic or market risk).
A beta of 1: = changes with the market. A beta of more than 1: greater than the market. Etc.
Which types of sectors have higher or lower betas?
High beta: Highly cyclical and sensitive to changes in the market: aviation, construction industry?
Low beta: Stores that sell everyday, necessary items, healthcare, essential goods and services
What is the impact of leverage on the beta of a company?
In general, the more leverage used in a company’s capital structure, the higher the beta given the company has to pay down debt, has less cash on the balance sheet, and is more exposed to changes in the market
What is the formula to unlever and relever a beta?
Is it possible for an asset to have a negative beta?
Yes - e.g. gold, has an inverse relationship with the market.
When stock prices increase, the price of gold will decrease, and vice versa.
How do you estimate the cost of debt?
Which is typically higher, the cost of debt or the cost of equity?
Why not just finance with debt?
What is the relationship/difference between the WACC and IRR?
For the perpetuity approach, how do you determine the long term growth rate?
What is the argument against using the exit multiples approach in DCF?
What is the mid-year convention in a DCF model and why is it used?
When would the mid-year convention be inappropriate?
If two companies have the same total leverage ratio free cash flows and profit margins, do they have the same default risk?
Is DCF appropriate to use on an early stage start up?
How does a lower tax rate impact the valuation from a DCF?
