Discounted Cash Flows
Which method of calculating terminal value will give you a higher valuation?
Both are highly dependent on the assumptions you make, but typically the multiples method because exit multiples span a larger range than long-term growth rates
Internal Rate of Return
Discount rate is also known as _____________________.
Present
Discount rate is the rate that is applied to the annual cash flows in order to convert them to __________ value.
Bank Discount Yield
Discount/Face Value x 360/Days to Maturity
Time-weighted rate of return
It measures compound growth, and is the rate at which $1 compounds over a specified performance horizon.
5
Step 1: Selecting a holding period for the investment (typically _______ years)
Cash Flow
Step 2: Forecast future _______________ (income and expenses) by developing annual operating statements.
Operating
Step 2: Forecast future cash flow (income and expenses) by developing annual _____________ statements.
Present
Step 3: Convert future cash flows into ___________ value by discounting each annual amount by an appropriate discount factor.
Discount
Step 3: Convert future cash flows into present value by discounting each annual amount by an appropriate _____________ factor.
Reversion
Step 4: Determine the ______________ of the investment by dividing the discounted year 6 cash flows by an appropriate capitalization rate (Ro).
Add
Step 5: _________ the present value of future benefits to the reversion amount.
What is an alternate way to calculate FCF aside from taking NI, adding DEP and subtracting CAPEX?
Take CF from operations and subtract CAPEX to get levered CF. To get unlevered you need to add back the tax adjusted interest expense and subtract tax adjusted interest income.
Gordon Growth Method equation:
Terminal value= year 5 FCF*(1+growth rate)/(discount rate- growth rate)
What do you usually use for the discount rate?
WACC, although you could use Cost of Equity.
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 most of the time the change in the discount rate will have more of an effect.
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 typically a 10% change in revenue will have the most impact because that change in revenue will affect the company's revenue/EBITDA far into the future and even the Terminal value.
What is the relationship between debt and the cost of equity?
More debt means the company will be more risky thus driving its levered beta higher. All else equal more debt should raise the cost of equity and less debt should lower it.
Why do you use 5 or 10 years for a DCF?
Anything beyond 10 years is too difficult to predict for most companies.
Discounted
A future benefit is ________________ to present value by calculating the amount that, if invested today, would grow with compound interest at a satisfactory rate to equal the future payments.
Which would you expect to have a higher beta a tech company or a manufacturing company?
A technology company because the technology industry is seen as riskier then the manufacturing industry
IRR rule
Accept a project if IRR > required rate of return
NPV rule
Accept a project if NPV > 0
How can we calculate the cost of equity without CAPM
Alternatively we could use the formula COE=(dividends per share/share price)+growth rate of dividends. This is typically used in companies where dividends are more important or when you lack information on beta
Money Market Yield
HPR x 360/days to maturity
How do you calculate WACC?
Cost of Equity *% of capital structure composed of equity+ cost of debt* % of capital structure composed of debt*(1-tax rate) + cost of preferred*% of capital structure composed of preferred
two
DCF is _____ or more years of net income are discounted back to present value to arrive at a value of the investment
Opportunity
Discounting is the benefits received in the future are worth less that the same benefits received today because of _______________ cost.
Should the dividend yield be factored in to the Cost of Equity formula?
Dividend yields are already factored into Beta because Beta describes returns in the excess to the market as a whole and those returns include dividends.
Walk me through a DCF
First, you project out the company's financials using assumptions for revenue growth, expenses and working capital. Then you get FCF for each year which you sum up and discount to a NPV based on your discount rate, usually the WACC. Then you determine the company's terminal value using either the multiples method or the Gordon Growth Method and dicount that back to NPV using WACC. Add the two together to get the estimated EV.
Choosing NPV vs IRR rules
For independent projects the rules produce the same decision. For mutually exclusive projects choose the project with higher NPV as long as it is positive.
Money-weighted rate of return
IRR calculated using periodic cash flows into and out of an account and is the discount rate that makes the PV of cash inflows equal to the PV of cash outflows.
Differences between money- and time-weighted rates of return
If funds are added to a portfolio just before a period of poor performance, the money-weighted return will be lower than the time-weighted return. Time-weighted return is the preferred measure of an ability to select investments. If the manager controls the money flows in and out, the money-weighted return is the more appropriate performance measure.
Why would you use the Gordon Method over the multiples method
In banking, you almost always use the multiples method as it is much easier to get data on exit multiples since they are based on comparable companies.Picking a long term growth rate is always a shot in the dark. You might use the GGM if you have no good comparables.
How do you know if your DCF is too dependent on future assumptions?
If significantly more than 50% of your company EV comes from its terminal value then it is probably too dependent. In reality most all DCF's are too dependent on future assumptions and it is rare to find one in which terminal value is less than 50% of EV. When it gets to be 80-90% however, you may need to rethink some assumptions.
Should cost of equity be higher for a $5b or a $500m market cap company?
It should be higher for the $500m company because small cap companies, in general, are expected to outperform large cap companies, although they are more risky.
Why do you have to un-lever and re-lever beta?
Levered beta reflects the debt already assumed by each company but since each company's capital structure is different and if we want to see how risky the company is regardless of debt structure then we must un-lever the beta. In the end beta will be re-levered because we want the cost of equity to reflect the true risk
What is the effect of using levered cash flow vs unlevered cash flow in your DCF?
Levered cash flow gives you equity value rather than enterprise value since the cash flow is only available to equity investors (debt investors have already been paid with interest payments)
5
Many investors typically use a __________ year holding period in their DCF analysis.
How do you select appropriate exit multiples when calculating Terminal Value?
Normally you look at comparable companies and pick the median of the set. You would want to select a range of exit multiples and show what the TV looks like over that range. For example if the median EBITDA multiple is 8x you would want to show all TV from 6x to 10x
Interest or Yield
Opportunity Cost is the amount of _______________ that a current amount of capital could earn if invested in another asset.
How do you get from revenue to FCF?
Revenue-COGS-Operating Expenses to get to EBIT. Then multiply by (1-Tax Rate), add back Depreciation and other non-cash charges and subtract CAPEX and the change in Working Capital. (This is unlevered FCF since we went off of EBIT rather than EBT).
Holding Period
Reversion is the value of the investment at the end of the __________________.
What is risk premiuim
The % by which stocks are expected to out-perform risk-less assets
IRR
The ________ is similar to a lender's effective interest rate, a bond yield to maturity, and an investor's required return on equity.
Satisfactory Rate
The ______________ is the discount rate or internal rate of return.
Discounted to Present Value
The anticipated net income of an investment is ________________________ and added to the discounted value of the investment at the end of the ownership period.
Added
The anticipated net income of an investment is discounted to present value and _________________ to the discounted value of the investment at the end of the ownership period.
Two companies are exactly the same but one has debt and one does not, which will have a higher WACC?
The company without debt will have a higher WACC TO A CERTAIN POINT because debt is less expensive than equity, interest on debt is tax deductible, debt is senior to equity in a company's capital structure. HOWEVER once a company's debt gets high enough interest rates will rise dramatically to reflect the increase in risk and it might become higher than the COE and increase WACC.
Internal Rate of Return (IRR)
The discount rate that makes the NPV = 0 (which equates the PV of the expected future cash flows to the project's initial cost)
What is the flaw in basing terminal multiples on what public comparables are trading at?
The median multiples could change greatly in the next 5-10 years so it may no longer be accurate to assume those multiples.
A DCF values a company based on:
The present value of its cash flows and the present value of its terminal value.
Will WACC be higher for a $5b or a $500m market cap company?
This is highly dependent upon if the capital structure is the same for both companies. If it is the same in terms of interest rates and percentages then it should be higher for the $500m company because it would typically be expected to outperform the large cap company. If it is not the same then it could go either way depending on much debt/preferred stock each one has and what its interest rates are.
How do you calculate WACC for private companies?
This is tough because you do not have beta or a market cap. You would typically try to use comparable public companies or work done by auditors.
Holding Period Yield (HPY)
Total return of holding an investment over a period of time
True
True or False: The investment is almost always worth something at the end of the holding period and will be sold.
What is an appropriate growth rate to use for terminal value
Typically the nation's long term GDP growth rate, rate of inflation or something similar that is conservative. Anything over 5% would be seen as very aggressive.
What is the Risk free rate
Typically the yield on 10 or 20 year T-bond
How do you get Beta in the Cost of Equity calculation?
Unlevered beta= levered beta/(1+(1-tax rate)*(total debt/total equity) Levered Beta= unlevered beta*(1+(1-Tax rate)*(total debt/total equity)
How do you calculate cost of equity
Use the Capital Asset Pricing Model = Risk free rate +beta *Equity risk premium
A company has a high debt load and is paying off a significant portion of its principle each year, how would we account for that in a DCF.
We would not because paying off debt shows up in CF from Financing but we only go down to CF from operations and then subtract CAPEX to get FCF.
Cost of Equity tells us:
What kind of return an investor can expect
How do you calculate terminal value?
You can either use the multiples method in which you apply an exit multiple to the company's year 5 EBITDA, EBIT or FCF or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity
If you use levered FCF what should you use as the discount rate?
You would use the cost of equity rather than the WACC since we are not concerned with the debt or preferred stock in this case
Discounting
______________ is the benefits received in the future are worth less that the same benefits received today because of opportunity cost.
Holding Period
______________ is the length of time in years that the investment is expected to be owned.
Return on Investment
_______________ compensates the investor for foregoing immediate benefits and accepting future benefits.
Opportunity Cost
_______________ is the amount of interest or yield that a current amount of capital could earn if invested in another asset.
Reversion
_______________ is the value of the investment at the end of the holding period.
Discount Rate
_________________ is the rate that is applied to the annual cash flows in order to convert them to present value.
Discounted Cash Flow
______________________ is two or more years of net income are discounted back to present value to arrive at a value of the investment
