DCF Technicals
What is the Equity Risk Premium?
= Market Return Rate - Risk Free Rate Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets
Formula for Terminal Value using Gordon Growth
= [Year 5 FCF * (1 + Growth Rate)]/[(Discount Rate - Growth Rate)]
How do you know if your DCF is too dependent on future assumptions?
If significantly more than 50% of the company's Enterprise Value comes from its Terminal Value
Why would you use Gordon Growth rather than the Multiples Method?
In banking you almost always use the Multiples Method -It's much easier to get appropriate data for exit multiples because they're based on Comparable Companies -Picking a long term growth rate is very hard *However, you might use Gordon Growth if there are no good Comps or if you believe that multiples in the industry will change significantly down the road (ex: cyclical industries should use this method)
Which has a greater impact on a company's DCF valuation: a 1% change in revenue or a 1% change in the discount rate?
It could go either way, but in this case the discount rate is likely to have a bigger impact on the valuation
Let's say you use LFCF rather than UFCF in your DCF. What's the effect?
LFCF gives you Equity Value, whereas UFCF gives you Enterprise Value
What do you usually use for the discount rate?
Use WACC (Weighted Average Cost of Capital) if you're finding UFCF Use Cost of Equity if you're finding LFCF
What should you do if you don't believe management's projections for a DCF model?
-Create your own projections -Modify management's projections downward to make them more conservative -Show a sensitivity table based on different growth rates and margins
What's the relationship between debt and Cost of Equity?
-More debt means more risk, so the company's levered Beta will be higher -So additional debt raises the Cost of Equity and less debt lowers the Cost of Equity
Why do you use 5 or 10 years for DCF projections?
-That's usually as far as you can reasonably predict into the future -Less than 5 years would be too short to be useful and over 10 years is too difficult to predict
What's the flaw with basing terminal multiples on what public Comps are trading at?
-The median multiple may change dramatically in the next 5-10 years so it may no longer be accurate -This is why you look at a wide range of multiples
Why do you have to unlever and re-lever Beta?
-When you look up Betas online, they will be levered to reflect the debt already assumed by each company -But each company's capital structure is different and we want to look at how "risky" a company is regardless of its capital structure -To get that, we need to unlever Beta each time -At the end of the calculation, we need to re-lever it because we want the Beta used on the Cost of Equity calculation to reflect the true risk of the company (taking it's capital structure into account)
How do you select the appropriate exit multiple when calculating Terminal Value?
-You look at Comps and pick the median of the set -You always show a range of exit multiples and what the TV looks like over that range
How do you get to Beta in the Cost of Equity calculation?
1) Look up Beta for each Comparable Company 2) Unlever each one 3) Take the median of the set 4) Re-lever it based on your company's capital structure Use this levered Beta in the Cost of Equity Calculation
How do you calculate Terminal Value?
1) Multiples Method: apply an exit multiple to the company's Year 5 EBITDA, EBIT, or FCF 2) Gordon Growth Method: to estimate a company's value based on its growth rate into perpetuity
How do you get from Revenue to Free Cash Flow?
1) Start with Revenue and subtract COGS to get Gross Profit 2) Subtract Operating Expenses (SGA and R&D) from Gross Profit to get EBIT (aka: Operating Profit) 3) Subtract taxes from EBIT to get NOPAT (Net Operating Profit After Taxes) 4) Subtract D&A, Change in Working Capital, and CAPEX from NOPAT to get UFCF 5) Subtract Interest Expense from UFCF and add Interest Tax Shield to get LFCF
DCF Definition
A DCF values a company based on the PV of its cash flows and the PV of its terminal value
Would you expect a manufacturing company or a technology company to have a higher Beta?
A tech company because the tech industry is viewed as "riskier"
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently than other companies and do not reinvest it in the business (they use it to create products instead) Also, interest is a critical part of banks' business models and working capital takes a huge part of their Balance Sheets -So a DCF just doesn't really make sense here
What is Beta?
Beta = risk (ie: volatility) Beta is calculated based on the "riskiness" of Comparable Companies
Walk me through a DCF
DCF is the PV of the company's future cash flows + the PV of the terminal value 1) Project the company's financials, making assumptions about revenue/expense growth and working capital to get FCF for each year 2) Discount using the WACC and sum up to get NPV 3) Find company's terminal value and discount it using WACC 4) Add the two to get Enterprise Value
What type of sensitivity analyses would we look at in a DCF?
Example sensitivities: 1) Revenue Growth vs. Terminal Multiple 2) EBITDA Margin vs. Terminal Multiple 3) Discount Rate vs. Terminal Multiple 4) Discount Rate vs. Long-Term Growth Rate And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate)
Which method of calculating Terminal Value will give you a higher valuation?
Hard to generalize In general, Multiples Method will be more variable than the Gordon Growth because exit multiples span a wider range than possible long-term growth rates
Should WACC be higher for a $5bil or $500mil market cap company?
It depends on whether they have the same capital structure -If yes, then WACC should be higher for the smaller company (because it's "riskier" -If no, then it could go either way depending on how much debt/preferred structure each one has and the interest rates
Which has a greater impact on a company's DCF valuation: a 10% change in revenue or a 1% change in the discount rate?
It depends, but most of the time the 10% difference in revenue will have more of an impact. -Change in revenue affects the current year's revenue and Revenue/EBITDA multiple far into the future and even the terminal value
Should Cost of Equity be higher for a $5bil or $500mil market cap company?
It should be higher for the $500mil company -Because smaller companies are expected to outperform large companies in the stock market (and therefore be "more risky") -Using a "Size Premium" in your calculation would also ensure that Cost of Equity will be higher for the smaller company
Cost of Equity tells us what kind of return an equity investor can expect for a given company--but what about dividends? Should we factor dividend yield into the formula?
No: dividend yields are already factored into Beta because Beta describes returns in excess of the market as a whole -- and those returns include dividends
What's an appropriate growth rate to use when calculating Terminal Value?
Normally you use the country's long term GDP growth rate, the rate of inflation, or something similarly conservative For companies in mature economies, a long-term growth rate over 5% would be aggressive because most developed economies are growing at less than 5% per year
Calculate Cost of Equity
Risk-Free Rate + Beta Equity * (Market Return Rate - Risk Free Rate)
What is the Risk-Free Rate?
Risk-Free Rate represents how much a 10-year or 20-year US Treasury bond should yield
What's an alternate way to calculate FCF?
Take Cash Flow from Operations and subtract CAPEX -- this gets you to Levered Cash Flow To get to Unlevered Cash Flow, you need to add back the tax-adjusted interest expense and subtract the tax-adjusted interest income
How can we calculate Cost of Equity without using CAPM?
There is an alternate formula: (Dividends per Share/Share Price) + Growth Rate of Dividends *Used for companies where dividends are important or when you lack information about Beta
How do you calculate WACC for a private company?
This is hard because private companies don't have market caps or Betas In this case, you would estimate WACC based on: 1) Work done by auditors or valuation specialists 2) WACC for comparable public companies
Two companies are exactly the same, but one has debt and the other doesn't. Which will have a higher WACC?
This is tricky -- the one without debt will have a higher WACC up to a certain point because debt is "less expensive" than equity Why? 1) Interest on debt is tax-deductible 2) Debt is senior to equity in a company's capital structure -Debt holders would be paid first in a liquidation or bankruptcy 3) Interest rates on debt are usually lower -As a result, the Cost of Debt portion of WACC will contribute less to the total figure *However, this is only true to a certain point. If the debt goes up dramatically, so will the interest rate *It's a U-shaped curve where debt decreases WACC to a point, then starts increasing it
A company has a high debt load and is paying off a significant portion of its principal each year. How can you account for this in a DCF?
Trick question: you don't account for this at all in a DCF because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement -BUT in a DCF, we only take Cash Flow from Operations and subtract CAPEX from it to get to Free Cash Flow *If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years because the principal is being paid off
If you use LFCF, what should you use as the Discount Rate?
You would use Cost of Equity as opposed to WACC since we're not concerned with Debt or Preferred Stock
Calculate WACC
[Cost of equity (E/D+E)] + [Cost of debt (1 - tax rate) * (D/D+E)]
