Valuation and DCF Analysis

Question 1

Again, what are valuation multiples?

Answer 1

Shorthand for cash flow-based valuation

Question 2

What is a Discounted Cash Flow Analysis (DCF)?

Answer 2

aka intrinsic valuation (because valuing company based on its CF rather than external factors such as other companies)

Project the company’s discount rates for the next 5-15 years and discount them to their PV and sum up the PVs

Calculate the company’s Terminal value by assuming the discount rate and CF growth rate stays the same indefinitely/in the terminal period (i.e.: far-future period). Discount the company’s terminal value to its PV

Add the two PVs together

DCF is the most theoretically correct way to value a company

Question 3

What is relative valuation?

Answer 3

Collect a set of comparable companies and/or M&A transactions, calculate their valuation multiples and apply those multiples to the company you’re valuing

Question 4

Walk me through a DCF.

Answer 4

1. Project the company’s CF in the explicit forecast period (i.e.: next 5-10 years or maybe 15-20 or even 30+, depending on company and industry)
2. Discount each year’s projected UFCF by the appropriate discount rate and sum up the PVs
3. Calculate Terminal Value and discount it back to its PV
4. Add together the PVs to get the Implied EV

Question 5

Why use UFCF in DCF Analysis?

Answer 5

Consistency because capital structure neutral

Ease of projecting because don’t have to project items such as debt, cash, interest expense, etc. - essentially faster and less research

Question 6

What does Change in Working Capital mean?

Answer 6

Does the company generate more cash than expected as it grows or does it require more cash to fuel its growth

Question 7

What are some checks you can do when projecting UFCF to ensure accuracy?

Answer 7

1. CapEx % Revenue > D&A % Revenue
2. Growth rates for Revenue, EBIT, UFCF, and EBITA approaching low, single-digit percentages
3. EBIT margin and other items that are percentages of revenue should stabilize by the end of forecast

Question 8

Again, what does the discount rate represent?

Answer 8

The opportunity cost for the investor: what they could earn each year by investing in other, similar companies

A higher discount rate means the risk and potential returns are higher and makes companies less valuable because it means the investor has better options elsewhere

Question 9

True or False: Since companies have multiple sources of capital, they also have different discount rates and each part of the capital structure has a different rate

Answer 9

True.

Question 10

What is Cost of Equity?

Answer 10

Represents the “opportunity cost” for the company’s common stock (i.e.: what investors could earn from stock price increases and dividends)

Tells you how much the company’s stock should return each year on average over the long-term, factoring in both stock price appreciation and dividends

Question 11

What is Cost of Debt?

Answer 11

For the company’s outstanding debt, it represents the “yield” investors could earn from interest payments and the difference between the market value of the debt and the amount the company will repay upon maturity.

Represent the rate the company would pay if it issued additional debt

Question 12

What is the Cost of Preferred Stock?

Answer 12

Similar to the cost of debt

Preferred Stock tends to have higher coupon rates and Preferred Dividends are not tax-deductible - therefore Preferred Stock is more expensive than Debt

• Preferred stock is a hybrid between equity and debt because dividends, higher claim than common shareholders, limited or no voting rights

Represent the rate the company would pay if it issued additional preferred stock

Question 13

What is WACC?

Answer 13

The overall discount rate for the entire company. If you invest proportionally in the company’s entire capital structure, WACC gives you the expected, long-term annualized return.

WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt * + Cost of Preferred Stock * % Preferred Stock

WACC always pairs with Unlevered FCF because WACC and Unlevered FCF both represent all the investors in the company.

Question 14

What methods can you use to calculate the cost of debt?

Answer 14

Coupon Rates

YTM Method

Risk-free rate (usually the yield on a 10-year or 20-year government bond) + default spread (based on company’s expected credit rating after it issues additional debt)

Question 15

How do you calculate Cost of Equity?

Answer 15

You usually use the Capital Asset Pricing Model (CAPM) to estimate the Cost of Equity

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

Or the easy method:

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Company’s Historical Levered Beta
^ but might produce a value more closely resembling its current value vs. implied value which defeats the point of a valuation

Question 16

What is the Risk-Free Rate?

Answer 16

Represents what you could earn on “safe” government bonds denominated in the same currency as this company’s financial statements

Question 17

What is Levered Beta? How do you calculate Beta?

Answer 17

Tells you how volatile this stock is relative to the market (typically the S&P 500) as a whole, factoring in both the intrinsic business risk and the risk introduced by the leverage (Debt)

If Beta is 1.0, when the market goes up by 10%, this company’s stock goes up by 10%. If Beta is 2.0, when the market goes up by 10%, this company’s stock goes up by 20%. If Beta is 0.5, when the market goes up by 10%, this company’s stock goes up by 5%.

You could calculate Beta based on the company’s stock-price history or via analysis of peer companies. Sources such as Capital IQ, Bloomberg, and Google, and Yahoo Finance also offer estimates of Beta for individual companies.

Question 18

What is the Equity Risk Premium?

Answer 18

Represents the percentage the stock market will return each year, on average, above and beyond the yield on “safe” government bonds

Disagreement on how to calculate ERP (I.e.: use historical or projected numbers, use arithmetic or geometric mean, how far back do you go - 10, 20, 30 years, etc.)

ERP numbers range from 3% to 11%, based on source and calculation method

Rather than arguing for one single, correct number, we look at a few data sources (e.g., Statista, Big 4 firms, and Damodaran’s annual data) and pick a reasonable range of values. In the sensitivities, we’ll look at what happens at lower and higher values.

ERP should be higher when risk and potential returns are both higher

Question 19

What two risks does Beta reflect?

Answer 19

Inherent business risk and risk from leverage

Corp Fin: Firm-specific risk and market-wide risk (i.e. economic expansions, recessions, etc.)

Question 20

Why do you unlever beta?

Answer 20

To remove the risk from leverage (which varies across comparable companies because all have differing capital structures) and isolate the inherent business risk

Unlevered Beta = Levered Beta / (1 + Debt / Equity * (1 – Tax Rate) + Preferred / Equity)

The result (1-Unlevered Beta) indicates the % of the company’s risk that comes from Debt. Remember, the tax-deductibility of interest reduces the risk of Debt.

Question 21

Why do you relever unlevered beta?

Answer 21

To make it reflect the risk from leverage of the company you are valuing

Levered Beta = Unlevered Beta * (1 + Debt / Equity * (1 – Tax Rate) + Preferred / Equity)

*use the company’s optimal capital structure

Question 22

True or False: If a company as no debt and no preferred stock, its unlevered beta should equal its levered beta

Answer 22

True

Question 23

What is an Optimal Capital Structure?

Answer 23

Mix of Debt, Equity, and Preferred Stock that minimizes WACC

It’s impossible to observe or calculate, but you could use the median capital structure percentages of the comparable companies and apply them to your company to estimate its “optimal” or “targeted” structure.

Question 24

What is Terminal Value? Name at least one way to calculate it.

Answer 24

The company’s value in the terminal period (far-future period). It can be calculated using the Perpetuity Growth Model or Gordon Growth Model:

Terminal Value = Unlevered FCF in Year 1 of Terminal Period / (WACC – Terminal Unlevered FCF Growth Rate)

or

Terminal Value = Final Forecast Year UFCF * (1 + Terminal UFCF Growth Rate) / (Discount Rate – Terminal UFCF Growth Rate)

*The Terminal UFCF Growth Rate should be low – below the long-term GDP growth rate of the country, and perhaps in-line with the rate of inflation. If the economy is growing at 3% per year, no single company could grow at 5% forever. If it did, eventually, it would be bigger than the entire economy!

Question 25

True or False: The UFCF growth rate at the end of the explicit forecast period should be fairly close to the Terminal UFCF Growth Rate; the projections must logically support the Terminal Value assumptions.

Answer 25

True

Question 26

Name another way to calculate Terminal Value.

Answer 26

Multiples Method.

Terminal Value = Terminal EBITDA or EBIT or NOPAT or UFCF Multiple * Relevant Metric

Question 27

How can you back into Implied Terminal UFCF Growth Rate?

Answer 27

Implied Terminal FCF Growth Rate = (Terminal Value * Discount Rate – Final Year FCF) / (Terminal Value + Final Year FCF)

Question 28

What two drivers or assumptions do you sensitize in a DCF?

Answer 28

Discount Rate vs. the Terminal Growth Rate or Terminal Multiple (because both make a big impact)

Question 29

What criteria can you use to select comparable companies?

Answer 29

Industry, geography, financial size (i.e.: revenue, EBITDA, etc.)

A list of 5-10 is a good target

Picking similar companies is important because it increases chances that discount rates and cash flow figures will be similar therefore, in theory, if one company trades at higher multiples than another, its Cash Flow Growth Rate should be higher

Question 30

What are some issues with using comparable companies to value companies?

Answer 30

It’s impossible to pick a set of comparable companies with the same Cash Flow figures, which illustrates one of the problems with comparable companies as a methodology.

Using market data/the views of the market to determine the implied value of the company you’re valuing and the market could be wrong

As such, public comps should be supplemental

Question 31

What is the value of both historical and forward multiples/metrics?

Answer 31

Historical metrics are useful because they’re based on reality, but they can also be deceptive if there are non-recurring items, acquisitions, or divestitures

Projected metrics are useful because they assume that the company will operate in a “steady state,” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable.

Question 32

What is the precedent transaction methodology?

Answer 32

Calculate valuation multiples based on what acquirers have paid to buy other companies

The criteria screen is based on the seller and also includes time (i.e.: in the last 2-3 years) and transaction value for the financial criteria (vs. revenue, EBITDA, EBIT, etc.)

Can be useful if public comps are lacking or a company has difficult to forecast cash flows

Question 33

Which produces higher multiples? Precedent transactions or public comps?

Answer 33

Precedent transactions because of the control premium built into M&A deals

Question 34

What is the control premium?

Answer 34

To acquire 100% of another company, the buyer must offer a premium above the seller’s current share price.

Extra amount above the seller’s current share price - usually between 10 and 30% based on industry, geography, etc.

Question 35

What are some challenges with Precedent Transactions?

Answer 35

Can produce the most random output with the widest range of valuation multiples - less reliable than other methodologies (and therefore should be even more supplemental than public comps)

Data tends to be less consistent because companies get acquired for very different reasons. A “strategic acquirer” (i.e., a normal company) might pay a ridiculous amount because the CEO is having an affair with the VP of Sales at the target company or because the CFO dreams about unicorns delivering synergies via magical rainbows. But a private equity acquirer would take a more analytical approach and pay based on the company’s financial value.

M&A deals can be structured in different ways, which also creates issues with Precedent Transactions. For example, some deals include earn-outs where a portion of the purchase price is paid out several years into the future if the seller meets certain financial goals (e.g., the seller receives $200 million upfront and $100 million in 3 years if it reaches $50 million in EBITDA by then).

It’s also worth noting if a deal is stock, cash, or a mix of both; buyers might pay higher prices if they issue stock to do deals because stock often seems like “fake money” to executives.

Question 36

What is a football field?

Answer 36

Visual representation of valuation ranges using different valuation methods

IBC Answer: DCF, Precedent Transactions, Comps and explain each

More advanced: LBO + 52 Week Range

Even More Advanced: Sum of the Parts, Premium Paid

Question 37

What might you advise an overvalued company to do?

Answer 37

Raise Equity or Make Add-On Acquisitions

Question 37

What might you advise an overvalued company to do?

Answer 37

Raise Equity or Make Add-On Acquisitions

Companies benefit from issuing stock when they trade at higher multiples and premiums to their intrinsic values; stock issuances produce less dilution in those cases because the company can issue fewer shares to raise the same amount of capital. Steel Dynamics could also use its highly-priced stock to acquire smaller companies and assets and dilute itself less in the process.

Question 38

What is a Levered DCF?

Answer 38

Calculate FCF available only to equity investors in the company and discount by the cost of equity

Calculate the company’s equity value directly

Calculate terminal value with P/E or other equity-based multiples

Include items in TEV to Equity value bridge in the FCFs instead

Question 39

What are some challenges of the Levered DCF method?

Answer 39

Takes more time and effort (because have to project the company’s cash and debt balances, net interest expense, changes in debt principal, etc.)

The FCF numbers are more volatile than those produced by an Unlevered DCF because the Debt principal repayments could be $0 in some years and massive in others. The company’s capital structure will heavily influence its implied value.

You will NOT get the same results from a Levered DCF analysis because it is almost impossible to pick assumptions that are “equivalent” to those in an Unlevered DCF.

There’s disagreement about how to calculate Levered FCF. Some people factor in all Debt issuances and repayments, some factor in all repayments but no issuances, and some factor in only mandatory repayments.

An Unlevered DCF is easier to set up and produces more consistent results that depend far less on a company’s capital structure.

Question 40

What is Adjusted PV? Disadvantages?

Answer 40

Similar to an Unlevered DCF, but it values the “tax shield” from a company’s Debt and adds the value of that tax shield to the company’s Implied Enterprise Value.

No Downside for Debt: It’s incorrect to include only the benefits of Debt without also factoring in its major downside: the increased risk of bankruptcy.

Overstated Values for Firms with High Debt Balances: The APV method will produce high values for companies with high Debt balances because of the Interest Tax Shield. But companies with high Debt balances should have lower implied values because the risk of bankruptcy starts to outweigh the tax benefits of Debt above a certain level.

The Requirement to Project the Interest Expense: It takes extra time and effort to forecast the company’s Interest Expense because you must project its Debt and Cash balances.

Question 41

What are some additional valuation methods?

Answer 41

Net Asset Value (NAV) (aka Liquidation Valuation): Assigns MVs to the companies assets and liabilities directly

• difficult to determine MVs
• undervalues healthy and growing companies
• best for distressed companies

Dividend Discount Model (DDM): use company’s dividends and cost of equity (vs. UFCF and WACC)

• calculate terminal value (corresponds to stock-price appreciation potential) based on P/E multiple
• idea behind DDM: if you buy shares in a company, you can benefit from the company’s Dividends and its stock-price appreciation. Metrics such as Unlevered FCF, Levered FCF, and EBITDA do not mean anything in terms of your real-life cash flow because companies do not distribute any of those to shareholders.
• only works well for companies that issue consistent, recurring dividends using most of their cash flows
• tend to produce lower valuations than DCFs (bc lower numerator (dividends < UFCF) and higher denominator (cost of equity>WACC)

M&A Premiums Analysis: find a set of M&A deals and calculate the premium each acquirer paid over each seller’s pre-deal share price and use these premiums to value your company.

• which premium to use?
• only works for public companies

Future Share Price Analysis: apply a current multiple (i.e. NTM multiple) to a future financial metric, back into the future share price and discount it to the future

• offers little over public comps
• useful if a company considering a capital structure change such as a leveraged recap and wants to assess the impact of this change

Sum of the Parts Valuation: value each division of a company separately, add up the Implied Enterprise Values for all the divisions, and then back into the Implied Equity Value and Implied Share Price for the entire company.

• best for companies with very different divisions (because have different risk/return profiles and would trade at different multiples as independent entities) such as conglomerates that operate across many industries
• useful for potential divestitures or spin-offs
• takes more time and effort
• may not have enough information to do it

LBO: value a company by assuming that a private equity firm buys it, runs it for several years, sells it in the future, and targets a specific IRR or multiple with the investment.

Question 42

How do companies create value?

Answer 42

Invest in projects that beat their WACC (i.e.: exceeding investors expectations)

ROIC > WACC

Question 43

Pros and cons of main valuation methods

Answer 43

DCF: more specific to company, most theoretically/pure correct but super variable, sensitive to input

Comps: a lot of things affect comps (don’t know everything that goes into it), but real market data

Question 44

Why use Perpetuity Growth Method vs. Terminal Multiples to calculate terminal value?

Answer 44

Company might not actually grow forever

Company growing very quickly - use multiples because contains market assumptions

Question 45

What is the formula for Beta?

Answer 45

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known, as well as the variance of the market returns.
​

Beta= Covariance / Variance​

where:
Covariance=Measure of a stock’s return relative
to that of the market
Variance=Measure of how the market moves relative
to its mean

Covariance measures how two stocks move together. A positive covariance means the stocks tend to move together when their prices go up or down. A negative covariance means the stocks move opposite of each other.

Variance, on the other hand, refers to how far a stock moves relative to its mean. For example, variance is used in measuring the volatility of an individual stock’s price over time. Covariance is used to measure the correlation in price moves of two different stocks.

The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark, divided by the variance of the return of the benchmark over a certain period.

Question 46

Three places where taxes have an effect in a DCF?

Answer 46

NOPAT

WACC

Beta (when unlevering and relevering)

Question 47

How would you value PwC?

Question 48

How would your DCF differ if you calculated Levered FCF instead of Unlevered FCF?

Answer 48

Difference between 2: UFCF goes to all providers of capital vs. levered only goes to equity holders

LFCF will return equity value (and not EV like UFCF)

LFCF = UFCF - Interest - Debt Repayments

Discount rate is the cost of equity