Discounted Cash Flow
What are the 6 basic steps of a DCF?
1) Project the company's free cash flow over 5-10 years 2) calculate the company's discount rate - usually WACC 3) Discount and sum up the company's free cash 4) Calculate the company's terminal value 5) Discount the terminal value to the present value 6) add the discounted free cash flows to the discounted terminal
The "cost" of Debt and Preferred Stock make intuitive sense because the company is paying for interest or for the Preferred Dividends. But what about the Cost of Equity? What is the company really paying?
1) The company is paying equity through dividends 2) The company is paying equity by giving up stock appreciation rights to equity investors.
How do you calculate Beta in the Cost of Equity calculation?
1) for a set of public comps, we need to find the levered beta for each company. Unlever it and find the mediam unlevered beta. Then we lever the unlevered based on the company's captial structure.
What is WACC affected by debt, preferred stock, and equity?
1) increase debt, decrease wacc: tax saving 2) increase preferred, increase wacc 3) increase equity, increase wacc
What should you do if you don't believe management's projections for a DCF model?
1) make your own projections 2) make adjustments to management's projects
. What's an appropriate growth rate to use when calculating the Terminal Value?
Commonly, we use the country's long term GDP growth rate or rate of inflation (usually something converservative)
What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?
Even with a negative cash flow or EBIT, we can still run a DCF as we have before. The only effect will be that the present value of the firm will be less than if the cash flow or EBIT is not negative.
What does more debt cause to cost of equity?
increased leverage, increases cost of equity
Which method of calculating Terminal Value will produce a higher valuation?
no one general rule that always applies, could go either way depending on the assumptions that we make.
Would you expect a manufacturing company or a technology company to have a higher Beta?
technology company, because technology is viewed as a "riskier" industry than manufacturing.
If we are using levered free cash flows, what discount rate should we use?
we would use the cost of equity to find the value of the firm to the equity investors
How do we find the terminal value?
Terminal Value = Final Year Free Cash Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate).
What's the basic concept behind a Discounted Cash Flow analysis?
The foundation of a DCF is that we want to find the net present value of the company based on its future free cash flows. We need to discount everything back to the present value because money today is worth more than money tomorrow. (TVM)
How do you calculate WACC?
WACC = Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred)
For unlevered free cash flows, what discount rate should we use?
Wacc, because we care about all parts of the company's capital structure and we want to find the value to all investors
Why do we add back depreciation and amortization to free cash flow formula?
because depreciation and amortization are non-cash expenses
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
cost of equity
Compare cost of equity of firms in emerging and fast-growing geographies and markets to those in stable markets?
cost of equity of firms in emerging and fast-growing geographies and markets will be higher
what if the company's capital structure changes in the future?
ideally we would use the company's targeted or planned capital structure rather than the one they currently have... if we have access to that information. (no one "knows" how a company's capital structure will change far in advance.)
Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%?
It could really go either way. The discount rate because the discount rate affects everything. Discount rate affects the present values of the terminal value and the FCF.
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 usually, the change in revenue would have a greater impact since it affects current revenue, and terminal value.
What's the relationship between Debt and Cost of Equity?
More debt, cost of equity increases
Let's talk more about how you calculate Free Cash Flow. Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section?
Most of time, it is correct to leave it out since expenses other than CapEx are commonly non-recurring in a predictable manner. But if we do know for sure there will be a recurring predictable expense either from financing or investing, then we could include it in our calculations to FCF.
What types of sensitivity analyses would we look at in a DCF?
(foundation: terminal multiple vs long-term growth rate) 1) discount rate vs the long term growth rate 2) revenue growth vs terminal multiple
An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?)
1) Project revenue and expenses for 5-10 years and find the terminal value 2) Instead of finding FCF, we find dividends issued by assuming dividend as a percentage of net income. 3) Discount the dividends and the terminal value back to present value using cost of equity. Unlike the DCF where we find the enterprise value, DDM gives us the equity value.
What's an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?
1) EBIT(1-t) + non-cash charges - Change in NWC - CapEx 2) Cash from operations + Tax-adjusted net interest expense - CapEx 3) Net income + Tax-adjusted net interest expense + non-cash expenses - Changes in NWC - CapEx
If I'm working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?
1) Find the equity value = Enterprise value + cash & cash equivalent - debt - preferred stock - noncontrolling interest 2) Find the per share price = Equity value / number of shares outstanding
What about alternate ways to calculate Levered Free Cash Flow?
1) Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments 2) if we don't have net income, but have EBIT : (EBIT - Net Interest Expense) * (1 - Tax Rate) + Non-Cash Charges Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments 3) =Cash Flow from Operations - CapEx - Mandatory Debt Repayments
Walk me through a DCF.
1) Project out the company's free cash flows for 5-10 years based on our growth rate assumptions. We want to keep it short because our estimations will be more accurate. Free cash flow = EBIT (1-t) - CapEx + Dep & Amort - change in NWC 2) Find the terminal value of the company either through the terminal multiple method or the gordon growth method. 3) Discount the free cash flow and the terminal value back to the present value by using the discount rate - usually the wacc PV = FCFn / (1+wacc)^n *drawbacks of DCF
What are drawbacks of DCF?
1) one assumption is that we assume we will collect the cash at the end of each year. But companies generate cash throughout the year. To account for this, we need to use the mid-year discounting period. 2) Second assumption with the DCF is that we assume that when we discount a value, we discount the value for a whole year. (For instance, for our free cash flow in year 1, we assume that we are in Jan 1 and we have until Dec 31 to collect the money. But what if we only have half a year to discount the value?) In this case, we need to use a sub-period will help us to categorize the time period of this cash flow.
Cost of Equity tells us the return that an equity investor might expect for investing in a given company - but what about dividends? Shouldn't we factor dividend yield into the formula under CAPM?
1) rE = rU + (rU-rd)BLev BLev = Bunlev*(1+(1-t)(1+D/E) Dividend yield is already considered in Beta. Beta describes the return in excess of the market, which includes the dividend yield.
What are two formulas for find cost of equity?
2 WAYS: 1) CAPM: (capital asset pricing model) rE = rU + (rU-rd)BLev BLev = Bunlev*(1+(1-t)(1+D/E) rE = D1/P0 + g
What is the terminal multiple approach?
= EBITDA * Exit multiple = EBIT * Exit Multiple
What is the Gordon Growth Model?
= FCF ending year (1+g) / (wacc-g) if ending year is yr5, = FCF 5 (1+g) / (wacc-g)
You're looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year. Which one has the higher net present value?
A because you are able to get your money sooner. Since money today is worth more money than tomorrow, generating higher cash flows earlier increases net present value.
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently than other companies and do not re-invest 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 up a huge part of their Balance Sheets - so a DCF for a financial institution would not make much sense. (for financial institutions, it may make more sense to use the dividend discount model)
Why do we subtract capex in our formula to find free cash flow?
Because we incur an expense to maintain the operations of our business
What happens to cost of equity when there is additional equity?
Cost of equity decreases because there is less debt - less risky
What about WACC - will it be higher for a $5 billion or $500 million company?
Depends on the capital structure of the firm. If capital structure is the same, then WACC should be higher for the $500 because cost of equity is higher. If the captial structure is different, then we can't really say anything.
As an approximation, do you think it's OK to use EBITDA - Changes in Operating Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow?
EBITDA ignores taxes all together. While it can work as a quick approximation, it would be better to consider: EBITDA - Changes in Operating Assets and Liabilities - CapEx - TAXES
Let's say we do this and find that the Implied per Share Value is $10.00. The company's current share price is $5.00. What does this mean?
First, we need to look at a range of outputs from the DCF instead of 1 single number. If we find that the company's current share price is consistently lower than the Implied, then the company may be undervalued. Otherwise, the company may be overvalued.
When would you use a DDM?
For a financial institution or a bank
What do you usually use for the Discount Rate?
For an unlevered DCF analysis, we would use the WACC (weighted average cost of capital). WACC reflects the cost of equity, debt, and preferred stock. For an levered DCF analysis, we would use cost of equity.
Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company?
Higher for $500 million because it means that the company has a smaller market cap, a smaller company than the other. Smaller company are always more risky and thus equity investors will demand higher rate.
Is there a valid reason why we might sometimes project 10 years or more anyway?
If the company is a cyclical company. For instance, a biotech company. Then, we may want to project out the company father into the future to show the entire cycle from low to high free cash flow.
Let's take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease?
In a economic downtown, companies became less valuable. CFFA decrease CFFA = FCF / (1+wacc) So, investors would demand higher compensation for the higher risk. Increase wacc.
If a firm is losing money, do you still multiply the Cost of Debt by (1 - Tax Rate) in the WACC formula? How can a tax shield exist if they're not even paying taxes?
In practice, we would still multiple it by (1-t). What is important is not if debt is currently giving the firm a tax-saving, but there is a possible potential for that to occur in the future.
Shouldn't you use a company's targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?
In theory if we know the targeted capital structure, we should use that. But since we rarely know this info in advance, it is alright to base our calculations based on the current capital structure.
What is the difference between leveraged and unlevered free cash flows?
Leveraged: includes interest expenses, interest income, and mandatory debt repayments. unleveraged: doesn't include those
Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what changes?
Levered FCF: will give the equity value (only avaliable to equity investors) Unlevered FCF: give the enterprise value
Why do you add back non-cash charges when calculating Free Cash Flow?
Non - cash expenses, such as depreciation and amortization are tax-deductible. Thus, they are added back to reflect the tax saving that companies realize.
How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense?
One way we can check if our assumptions for the terminal value is to calculate the terminal value using one method and then check what the implied long term growth rate is with the other method. For instance, with an
What are some drawbacks from the gordon growth method?
Since it assumes that the company will be growing forever, may not give an accurate terminal value since we haven't really witnessed a company is has been growing forever. So, we often just use the gordon growth method to check.
Let's say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company's Cash, Debt, and so on to calculate its implied Equity Value. Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses by the same?
Since it is challenging to pick equivalent assumptions for the two methods to get the same equity value, it will be very rare to get the same implied equity value. But if we could pick equivalent assumptions, we could in theory arrive at the same implied equity value. The reason why it is hard to pick equivalent assumptions is because for a levered DCF, the terms of debt impacts the FCF. This gives a different interest rate or repayment schedule that changes the equity value.
A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?
Since paying off the principle is an financing activity, the DCF is not affected. It would simply show up on the Cash flow statement.
How do you treat Preferred Stock in the formulas above for Beta?
Since preferred dividends are not tax-deductible, it is considered as equity.
How do you calculate WACC for a private company?
Since private companies don't have market caps or betas, we would rely on the WACC down by auditors or estimate based on what the WACC is for similar public companies.
Comparing smaller and bigger companies, who have a higher cost of equity?
Smaller companies - more risky - higher return
Wait a minute, so are you saying that a company that does not take on Debt is at a disadvantage to one that does? How does that make sense?
The company without debt is not really at a disadvantage. It is just that the value won't be as high as the one with debt. With increased debt, there is also increased cost of debt. So the company isn't really at a disadvantage. (Note: if the company has no reason to take on debt, it won't take on debt)
What's the flaw with basing the Terminal Multiple on what the Public Comps are trading at?
The flaw by basing the terminal multple on public comps is that the median multiple may change dramatically within the next 5-10 years. So, by the end of the period, the multiple may no longer be accurate. Therefore, we always want to look at a range of multiples and run sensitivity tests to see how the variables change.
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 because with more debt, they are able to realize a tax shield that the other is not able to realize.
What is the terminal value?
The present value of the company's free cash flows from the final final year into infinity.
What's the point of Free Cash Flow, anyway? What are you trying to do?
The reason why we calculate the free cash flow is we want to replicate the cash flow statement by only including recurring, predictable items. This is why, only CapEx is included from cash flow from financing investing activity. And for unlevered FCF, financing activities are not considered. For levered FCF, only mandatory Debt is considered.
How do you know if a DCF is too dependent on future assumptions?
There isn't one perfect rule, but if the terminal value accounts for over 90% of the company's value, then maybe the DCF is too depend on our future assumptions.
. Why would you use the Gordon Growth Method rather than the Multiples Method to calculate the Terminal Value?
There may be a few reasons why we may want to use the gordon growth method. 1) if there are no good comparable companies 2) if the industry is cyclical, it may be better to use the long term growth rate instead of the exit multiples (Note: In banking, we always want to use the multiples method to find the terminal value because it does not involve estimating the growth rate)
How do you determine a firm's Optimal Capital Structure? What does it mean?
To maximize the value of the firm, we need to find a combination of capital structure that Min WACC. This will often be when the marginal benefit of the tax saving = to the marginal cost of bankruptcy or financial distress. The min wacc depends on the company, the industry, and the market.
Walk me through how you get from Revenue to Free Cash Flow in the projections
Unlevered FCF 1) EBIT = Revenue - (COGS + Operating expenses) 2) = EBIT (1-t) - CapEx + Dep & Amort - change in NWC Levered FCF: = (EBIT-net interest expense)(1-t) - CapEx + Dep & Amort - change in NWC - mandatory debt repayments
Wait a second, would you still use Levered Beta with Unlevered Free Cash Flow? What's the deal with that?
We always use levered beta to find the cost of equity since more leverage increases cost of equity. We also always use cost of equity for levered and unlevered FCF to find WACC.
How do you select the appropriate exit multiple when calculating Terminal Value?
We can select the appropriate exit multiple by looking at public comps and picking the median of the set. We always want to show a range of the exit multiples and what the terminal value looks like over that range instead of picking 1 number. (Ex: if the median EBITDA multiple of the set is 8x, then we may want to show a range of 6x-10x)
Why do you use 5 or 10 years for the "near future" DCF projections?
We want to keep our projections as short as possible to make accurate estimations. Often less than 5 years would be too short and longer than 10 years may be too hard to predict.
Why do you have to un-lever and re-lever Beta when you calculate it based on the comps?
We want to un-lever beta because we want to find out the business risk of each company. After finding the avg business risk for each, we want to then find the total risk by levering beta, taking into account the company's capital structure.
Can Beta ever be negative? What would that mean?
Yes, in theory, a negative beta means that the company is a counter-cyclical one. When the economy is thriving, the business is struggling and vise versa.
What's the point of that "Changes in Operating Assets and Liabilities" section? What does it mean?
When the change in asset is greater than the change in liabilities, cash flow decreases. Else, cash flow increases. (new inventory cost 100, and liabilities increase by 50, WC = 100-50 = 50: reduce of cash by 50) So, we need to take into consideration the change from the balance sheet and its effects of the cash flow.
Wait a second: why isn't the present value of the Terminal Value, by itself, just the company's Enterprise Value? Don't you get Enterprise Value if you apply a multiple to EBITDA?
While we can get the enterprise value by applying the multiple, it only is the enterprise value of the far in the future value. DCF is composed of near and far in the future values. So, if we only consider the enterprise value from the terminal value, we exclude the free cash flows leading up to the terminal value.
