Intrinsic Valuation: DCF Flashcards
What are some of the main valuation methods, and what are the advantages and disadvantages of each?
Walk me through a DCF
What does the discount rate represent?
The discount rate represents the rate of return required by investors to compensate them for the risk of an investment.
Minimum return threshold based on comparable investments with similar risks.
Higher discount rate make a company’s cash flows less valuable
What is the 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 - Change in WC - Debt Repayments + New Debt
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 a default free security 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?
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?
Which method tends to lead to the highest valuation?
What is a football field of valuation results?
Starting with revenue, what is the formula to arrive at FCFs, and then to equity holders?
Starting with Net Income, what is the formula to arrive at FCFs, and then to equity holders?
When using the CAPM to calculate a company’s cost of equity, how can we find a public company’s equity beta and a private company’s?
