Key Rule 1 Flashcards
5 main topics
- What it is, how to use and walk through
- How to calculate and project FCF, distinguish between Levered and Unlevered
- How to calculate the discount rate in a DCF, and how to apply to concepts like WACC and Cost of Equity
- How to calculate Terminal value, what it means, and its contribution to DCF
- How different factors impact the output of a DCF and what changes have biggest effect.
Key Rule 1 - DCF concept and Walking through it
Basic concept = company is worth the Present Value of its future cash flows.
Why discount cash flow
Money worth today more than worth tomorrow because can invest money today and earn interest.
- so have to discount all these future cash flows back to their present value to account for that cost - the time value of money.
Simple example of cash flows
- estimate 100, 120, 140 in year 1,2, 3.
Discount cash at 10% each year because you could earn 10% by investing money elsewhere
Year 1: 100/(1 + 10%) = 91
Year 2: 120/(1+10%)^2 = 99
Etc
Add up = NPV = 295
How does this basic DCF get more complicated
- companies don’t just ‘stop’ operating after a few years.
- need a way to estimate cash flow and discount them far into the future
Divide into 2 parts: projection period (near future), terminal value (distant value) - we can project for 5-10 years and add up
- beyond that, we can come up with an approximation (TV) of how much the company might be worth into the distant future
Why can it get more tricky?
- How do you project cash flows for a company?
- What’s the appropriate discount rate to use?
- How do you estimate TV?
How to walk through DCF in interview?
In a DCF analysis, value a company with the PV of its free cash flows plus the PV of its TV, 6 steps:
1. Project company’s free cash flows over a 5-10 period
2. Calculate company’s discount rate, using WACC
3. Discount and sum up the company’s free cash flows
4. Calculate the company’s TV
5. Discount the TV to its PV
6. Add the discounted free cash flows to the discounted TV
