IB — Discount Cash Flow Questions
How do you calculate the Cost of Equity?
Cost of Equity = Risk Free Rate + Beta*Equity Risk Premium The Risk-free rate represents how much a 10 year or 20 year US treasury should yield — Beta is calculated from Comp Companies and Equity Risk Premium is the % by which stocks are expected to outperform "risk-less" assets. Normally pulled from a publication called Ibbotson's This formula does not tell the whole story — sometimes you add a size premium or industry premium since some will out-perform based on these metrics. Small outperforms large etc.
Walk me through a DCF
A DCF values a company based on the PV of its cash flows and the PV of its Terminal Value. First you project a company's financial using assumptions for revenue growth, expenses, and working capital; then you get down to free cash flows for each year, which you then sum up and discount to a Net Present Value, based on your discount rate — usually the Weighted Average Cost of Capital. Once you have PV of cash flows — determine the company's terminal value using either multiples method or Gordon/Perpetuity growth method and then also discount that back to its NPV using WACC. Finally, you add the two together to determine the company's EV.
Would you expect a manufacturing company or a technology company to have a higher beta?
A technology company, because technology is viewed as a "riskier" industry than manufacturing.
How can we calculate CoE without CAPM?
Alternate formula based on dividends — CoE = (Dividends per Share/Share Price) + Growth Rate of Dividends This is less common but you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating CoE with CAPM
Walk me through how you get from Revenue to Free Cash Flow in the projections.
Ask whether if you are supposed to find unlevered Free Cash Flow or not - you probably are. Subtract COGS and Operating Expenses to get Operating Income (EBIT). Then, multiply by (1-Tax Rate), and add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the Change in Working Capital
What about WACC —will the value be higher for $5 billion or $500 million company?
Ask whether the two companies have the same capital structure in terms of interest rates — if so then WACC should be higher for $500 million company. If the structure is not the same, then it could possibly go either way depending on debt% and interest rates.
Why would you not use DCF for a bank or other financial institution?
Banks use debt differently as they do not re-invest it in the business but use it to create their products (loans) Changes in working capital can be much larger than bank's net income Interest is a critical part of a bank's business model. Therefore traditional measures of cash flow don't tell you much. Use a Dividend Discount Model or Residual Income Model instead.
What should you do if you don't believe managements projections for a DCF model?
Create your own projections Modify a management's projections downward to make them more conservative. Show a sensitivity table based on different growth rates and margins You would probably do all of this gif you had unrealistic projections
How do you calculate the Terminal Value?
Either apply and fit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow or use the Gordon Growth method to estimate its value based on a chosen growth rate into perpetuity Terminal Value = Year 5 FCF * (1+Growth Rate)/(Discount Rate - Growth Rate).
Which has a greater impact on a company's DCF valuation — a 1% change in revenue vs a 1% change int eh discount rate?
Here, again the start should be "It could go either way, but most of the time" the discount rate is likely to have a bigger impact due to the compounding effect of discounting to the present over multiple years.
If I'm working with a public company in a DCF, how do I calculate its per-share value
If I'm working with a public company in a DCF, how do I calculate its per-share value Implied EV + Cash - Debt - Preferred Stock - Non-controlling Interest to get EV Then you need to use circular calculation that takes into account common shares, options, warrants, convertibles, other dilutive securities (circular as dilution is circular) to find a per share price.
When you're calculating WACC, let's say the company has convertible debt. Do you count this as debt when calculating Levered Beta?
If ITM then you count this as equity so Equity Value is higher and the convertible debt contributes to dilution. If its OTM then you count it as debt and use the interest rate.
Why use Gordon Growth over Multiples?
In banking you almost always use multiples method as its much easier to get appropriate data since they are based on comparable — a long term growth rate is always a shot in the dark You might use growth if you have no good comparable or believe that multiples will change significantly in the industry several years down the road — for example if the industry is very cyclical.
We are creating a DCF for a company that is planning to buy a factory for $100 in cash in Year 4. Current EV is $200, what would the new EV be?
In year for, CapEx would be $100 higher so this would reduce FCF by $100. Therefore EV would fall by the present value of that $100 decrease in year 4 cash flow. We calculate this by dividing $100 by (1+Discount Rate)^4
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 a 10% difference in revenue will have more of an impact — that change in revenue doesn't only affect only the current year's revenue, but also revenue and thus EBITDA far into the future due to growth/multiples being applied to the higher number
Which method of calculating Terminal Value will give you a higher valuation?
Its hard to generalize because both are highly dependent on the assumptions you make. In general, the multiples method will be more variable than the Gordon Growth method because exit multis tend to span a wider range than possible long-term growth rates.
Lets say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow DCF — what is the effect?
Levered Free 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 the interest payments that are included in Levered Cash flow)
Whats the relationship between debt and CoE
More debt means the company is more risky, so the company's Levered Beta will be higher, all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.
How do you select the appropriate exit multiple when calculating Terminal Value?
Normally you look at comp companies and pick the median or something close to it. As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than one specific number. So if median EBITDA multiple were 8x, you might show a range of multiples from 6x to 10x
What do you usually use for the discount rate?
Normally you use WACC, though you might also use Cost of Equity depending on how you've set up the DCF. You would use cost of equity if the cash flows used in the model already account for interest/debt financing and thus belong only to equity investors.
What's an appropriate growth rate to use when calculating the 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 quite aggressive since most developed economies are growing at less than 5% per year.
What types of sensitivity analyses would we look at in a DCF?
Revenue Growth vs Terminal Multiple EBITDA Margin vs Terminal Multiple Terminal Multiple vs. Discount Rate Growth Rate vs Discount Rate You create a matrix table of these two values and determine the resulting implied share price or implied EV at them.
Should CoE be higher for a $5 billion or $500 million market cap company
Should be higher for the $500 million company, because all else being equal smaller companies are expected to outperform large companies in the stock market (and therefore may be more risky) — using a size premium in your calculation would ensure this result.
What is another way to calculated Unlevered Free Cash Flow besides the normal way?
Take CFO and subtract CapEx and mandatory debt repayments to get Levered Cash Flow Then add back tax-adjusted interest expense and subtract the tax-adjusted interest income.
Why do you use 5 or 10 years for DCF projections?
That's usually about 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 for most companies.
How do you calculate WACC?
The formula is — CoE * (%Equity) + CoD * (%Debt) *(1-Tax Rate) + Cost of Preferred *(%Preferred) For Cost of Equity you use CAPM
What's the flaw with basing terminal multiples on what public companies are trading at?
The median multiples may change greatly within the next 5-10 years so they may no longer be accurate by end of period. This is why you normally look at a range and do sensitivity to see how valuation changes. This method is particularly problematic with cyclical industries (e.g. semiconductors)
Two companies are exactly the same, but one has debt and one does not — which one will have the higher WACC?
The one without debt will generally have a higher WACC because debt is "less expensive" than equity. Why? Interest on debt is tax-deductible Debt is senior to equity in a company's capital structure — debt holders are first paid in liquidation Intuitively, interest rates on debt are usually lower than CoE numbers (usually over 10%) as a result cost of debt portion of WACC will contribute less to total figure than CoE portion will. Theoretically, two much debt will result in CoD to increase and potentially become greater than CoE, but that is extremely rare — the company without debt has higher WACC in 99% of all cases.
What discount period numbers would I use for mid-year convention if I have a stub period. E.g. Q4 of Year 1 in my DCF?
The rule is that you divide the stub discount period by 2, and then you simply subtract the normal discount periods for future years Normal with Stub — 0.25, 1.25, 2.25, 3.25 Mid Year with Stub — 0.125, 0.75, 1.75, 2.75 Notice how the stub period is 0.125, and then Year 1 is 1.25-0.50 to get 0.75
How do you know if your DCF is too dependent on future assumptions
The standard answer — if significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions In reality, almost all DCFs are good dependent on future assumptions — quite rare to see less than 50% — however in the 80-90% range you know you may need to re-think your assumptions.
How do you calculate WACC for a private company?
This is problematic because without market caps or betas you can't really calculate — you would likely estimate based on work done by auditors or valuation specialists, or based on comparable WACC from public companies.
Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company — but what about dividends? Shouldn't we factor dividend yield into the formula?
Trick question — dividend yields are already factored into Beta, because Beta describes returns in excess of the market and those returns include dividends.
Why do you have to un-lever and re-lever Beta?
When you look up Betas on Bloomberg, they will be levered to reflect the debt structure assumed by each company. In order to compare the companies between capital structure, we want to look at risk independent of %debt or equity. To get that, we need to un-lever Beta — then after we unlevered beta we can reliever it taking into account our company's capital structure
How does the terminal value calculation change when we use the mid-year convention?
When you're discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or the Gordon Growth Method: Multiples Method: You add 0.5 to the final year discount number to reflect the fact that you're assuming the company gets sold at the end of the year. Gordon Growth Method — You use the final year discount number as is, because you assuming the cash flows grow in perpetuity and that they are still be received through the year rather than just at the end.
A company has a high debt load and is paying off a significant portion of its principle each year. How do you account for this in a DCF?
You don't account for this at all in Unlevered DCF as this debt principle shows up in cash Flow from Financing on Cash Flow statement but we only take into account EBIT * (1-Tax Rate) etc. If you were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to principal being paid off — the mandatory debt repayments would also reduce levered Free cash Flow — repaying debt really does reduce the cash flow that can go to equity investors.
How do you get to Beta in Cost of Equity calculation?
You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company's capital structure. This is the Levered Beta you use. Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Explain why we would use the mid-year convention in a DCF
You use it to represent the fact that a company's cash flow does not come 100% at the end of each year ‚ instead it comes evenly through each year. With mid year convention we instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year when considering a discount period number
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
You would use Cost of Equity rather than WACC since we are not concerned with Debt or Preferred Stock in this case — we are calculating Equity Value, not Enterprise Value