Discounted Cash Flow

What is Beta?

Beta is a measure of the volatility of a company's returns relative to the market return. If a company has a beta of 1, they are perfectly matched with the market. Companies that are more volatile than the market will have a beta greater than 1.

What is the appropriate numerator for a revenue multiple?

Enterprise Value because revenue is an unlevered (or pre-debt) measure of profitability

How do you get to Beta in the cost of equity calculation?

You look up the beta for comparable companies, un-lever each one (take away the effect of capital structure), take the median of the set, and then lever it based on your company's capital structure. Then you use this levered beta in the cost of equity calculation.

What is the relationship between debt and Cost of Equity?

More debt means that the company is more risky - so all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

Walk me through a DCF

Break it down into 3 steps 1) Forecasting the FCFs for a 5-10 year projection period. FCFs calculated by taking EBIT (1-tax rate), +Depreciation, -Capex, -Net Change Working Capital. The rate at which you project FCFs will depend on assumptions about revenue and expense growth for the company. 2) Calculate the terminal value, which is a number that encapsulates the value of the firm beyond the projection period. Can use either Gordon Growth Method or Exit Multiples, but Multiples Method is more commonly used in banking. Using the multiples method, you arrive at a multiple based on what comparable companies are trading at, and multiply that by the company's EBITDA or FCF at the end of the projection period. 3) Must discount the FCFs and the terminal value back to the present day using the discount rate. Discount rate will depend on what type of DCF you are doing. If you are doing an unlevered DCF, you would use WACC because you are calculating Enterprise Value. And for a levered DCF, you would use the cost of equity because you want to arrive at Equity Value.

Would WACC be higher for a $5 billion or $500 million market cap company?

Depends on the capital structure of the companies. If the companies have different capital structures, it could go either way depending on how much debt each one has and what their interest rates are. If the capital structures are the same, then the $500 million market cap company would have a higher WACC because its cost of equity is higher.

Should cost of equity be higher for a $5 billion or $500 million market cap company?

It should be higher for the $500 million market cap company because smaller companies are expected to outperform large companies in the stock market, and therefore they are "more risky."

How would you value a company with negative historical cash flows?

Negative profitability will make most multiples analyses meaningless, so a DCF valuation approach is most appropriate to use in this situation.

What is the appropriate discount rate to use in an unlevered DCF analysis?

Since the FCFs in an unlevered DCF are pre-debt, the cost of cash flows relate to both the lenders and the equity providers of capital. Thus, the discount ate is the WACC.

Two companies are exactly the same, but one has debt and one does not - which one will have a higher WACC?

The company without debt will have a higher WACC because debt is less expensive than equity. However, that is only true up to a certain point because once a company's debt goes up high enough, the interest rate could rise dramatically to reflect the additional risk and Cost of Debt would start to increase and eventually get high enough that it is higher than Cost of Equity.

What is typically higher - the cost of debt or the cost of equity?

The cost of equity is typically higher than the cost of debt because 1) cost associated with debt (interest expense) is tax deductible and 2) equity investors are not guaranteed fixed payments and are last in line at liquidation

Rank the 3 valuation methodologies from highest to lowest expected value.

You know that precedent transactions will be higher than comps/multiples because of the control premium built into acquisitions. DCF is the most variable because it is the most dependent on assumptions.

When should you value a company using a revenue multiple vs EBITDA?

You should value a company using a revenue multiple if they have negative profits, because negative profits will make most EBITDA multiples meaningless.