Discounted Cash Flow
What's the flaw with basing terminal multiples on what public company comparables are trading at?
Multiples can change a lot in 5-10 years, so the median multiple you find may no longer be accurate. [This is why you use a range and do a Sensitivity Analysis This is very prevalent in cyclical industries like restaurants and luxury goods]
Walk me through how you get from Revenue to Free Cash Flow in the projections.
Starting with Revenue, Subtract COGS and Operating Expenses to get to EBIT Multiply by (1-Tax Rate) to get to NoPat Add back Noncash Expenses, Subtract Capex and Change in Net Working Capital This gets you to Unlevered Free Cash Flow
How do we calculate WACC?
WACC = Cost of Equity*(%Equity) + Cost of Debt*(%Debt)*(1-Tax Rate) + Cost of Preferred*(%Preferred)
Why do you have to un-lever and re-lever Beta?
You want to un-lever beta to separate your comps' volatility from their capital structure. You can then reapply the median of the isolated Betas to your company by re-levering it.
What about a 1% change in revenue vs. a 1% change in the discount rate?
It could go either way, but most of the time it will be a change in the discount rate.
What about WACC - will it be higher for a $5 billion or $500 million company?
It depends on the capital structure. If the capital structure is the same, it should be higher for the $500 million company because smaller companies have larger Betas. [If it's not the same, it could go either way depending on how much debt/preferred stock each company has and what interest rates are]
Which method of calculating Terminal Value will give you a higher valuation?
It depends on the multiples and growth rate you select. [The Multiples Method will typically be more variable, since the Growth Rates are always similar]
How does terminal value calculation change when we use mid-year convention?
It depends on whether you use the Multiples Method or the Gordon Growth Method. If you're using the Multiples Method, you must change the period back to the 'Normal' Discount Period Number by adding 0.5 because you are assuming that the company is being sold at the end of the year. If you're using the Gordon Growth Method, you use the final year's discount number as is because you're assuming that the company is growing into perpetuity.
Which has a greater effect on a company's DCF valuation - a 10% change in revenue or a 1% change in the discount rate?
It depends, but a 10% change in Revenue will typically affect the valuation more because it affects the Revenue far into the future, as well as the Terminal Value of the company.
What type of sensitivity analysis would we look at in a DCF?
Any combination of: -Revenue Growth -Terminal Multiple -Discount Rate -and Long-Term Growth Rate except for Terminal Multiple vs. Long-Term Growth Rate
Walk me through a DCF.
A DCF is a Discounted Cash Flow. You start by projecting a company's financials for 5-10 years, calculating their Free Cash Flow for each year. You then use WACC to discount the Free Cash Flows for each year and add the values together to get the Net Present Value. Next, you need to calculate the company's Terminal Value. You use the final year's projected cash flows and apply either the Multiples Method or the Gordon Growth Method, and then use WACC to discount back to your Terminal Value. Finally, you add the Net Present Value to the Terminal Value to reach your Enterprise Value.
Would you expect a manufacturing company or a technology company to have a higher Beta?
A technology company because tech is seen as a riskier industry.
How can we calculate Cost of Equity WITHOUT using CAPM?
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
How do you calculate the Cost of Equity?
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium [Risk-Free Rate: 10/20 Year Treasury yield Beta: 'riskiness' of comparables Equity Risk Premium: % at which stocks are expected to outperform riskless assets (pulled from Ibbotson's)]
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?
Dividend yields are already factored into Beta.`
Why do you use 5 or 10 years for DCF projections?
Generally speaking, anything less than 5 years would be too short to be relevant, while anything over 5 years would be too long to predict.
How do you select appropriate multiples when calculating Terminal Value?
Generally, you look at the Comps and select the median of the set to base your range off of. [Everything is range-based. If the median multiple is 8x, you might choose 6-10x]
When you're calculating WACC, let's say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?
If the Convertible Debt is in-the-money, you count it as equity. If it's out-of-the-money, you count it as debt.
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?
If we're looking at Unlevered Free Cash Flow, the model won't account for this. If we're looking at Levered Free Cash Flow, our Interest Expense would decline as the years went on and the debt repayments would reduce Levered Free Cash Flow.
Should Cost of Equity be higher for a $5 billion company or a $500 million company?
It should be higher for a $500 million company because smaller companies have higher Betas.
What's an appropriate growth rate to use when calculating the Terminal Value?
It's good to use a the country's long-term GDP growth rate or the inflation rate. [You want to be conservative here. Anything over 5% is very aggressive]
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
It's very similar to a DCF, but you use Dividends instead of Free Cash Flow. 1. Project out Earnings down to EPS 2 Assume a Divided Payout Ratio 3. Use the ratio to calculate dividends over the next 5-10 years 4. Make sure the firm still meets capital requirements 5. Discount dividends in each year using COST OF EQUITY 6. Calculate the TV using P/BV and the final year, and discount it to Present Value using Cost of Equity 7. Sum the present value of the Terminal Value and the Present Values of the dividends to get the company's NPV per share
Let's say that you use Levered Free Cash Flow instead of Unlevered Free Cash Flow in your DCF - what is the effect?
Levered Free Cash Flow gives you Equity Value, while Unlevered Free Cash Flow gives you Enterprise Value.
What do you usually use for the discount rate?
Normally, you use WACC. [You might also use Cost of Equity]
If I'm working with a public company in a DCF, how do I calculate its per-share value?
Once you've reached Enterprise Value, ADD Cash and subtract Debt, Preferred Stock, and Noncontrolling Interest to get to Equity Value. Then divide Equity Value by Shares Outstanding to get your share price. [If you need to factor in dilutive securities, use the Iteration function in Excel to calculate a share price that allows you to calculate the dilutive shares outstanding]
What's the relationship between debt and Cost of Equity?
The more debt, the riskier the company - so the company's Levered Beta would be higher. So with all else equal, more debt would raise the Cost of Equity and less debt would lower it.
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 typically have a lower WACC because debt is more expensive than equity. [Interest on debt is tax-deductible. Debt is senior to Equity in the Capital Stack Interest rates are typically lower than COE #s]
What should you do if you don't believe management's projections for a DCF model?
There are a couple of adjustments you could make. You could start by creating your own projections. You could also just tweak the management's projections down a bit. You could create a Sensitivity Table that shows the valuation with management's projections vs. more conservative estimations.
Why would you use the Gordon Growth rather than the Multiples Method to calculate the Terminal Value?
When you can, you want to use the Multiples Method because it's based on your company's Comps and the Gordon Growth Method is a less-accurate assumption of value. However, the Gordon Growth Method is viable if you have no good comparables or reason to believe your multiples will change significantly.
How do you know if your DCF is too dependent on future assumptions?
When your Terminal Value gets much higher than your Net Present Value. [Most DCFs have a TV much higher than NPV. When it starts to reach 70%, you might want to rethink your assumptions]
How do you calculate the Terminal Value?
You can either use the multiples method in which you apply an exit multiple to the company's Final Year FCF or you can use the Gordon Growth method where you apply a growth rate to the Final Year FCF. [Exit Multiple comes from the company's Comps. Gordon Growth: TV = FY FCF * (1+Growth Rate)/(Discount Rate - Growth Rate)]
What's the alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets/Liabilities and CapEx?
You can start with Cash From Operations, and then subtract CapEx and Mandatory Debt Repayments to get to Levered Free Cash Flow. To get to Unlevered Free Cash Flow, you have to add back Tax-Adjusted Interest Expense and subtract Tax-Adjusted Interest Income.
How do you get to Beta in the Cost of Equity calculation?
You start with the Betas of your comps, un-lever them, take the median of your set, and then re-lever it according to your company's capital structure. [Un-Levered Beta = Levered Beta / (1+((1-Tax Rate) x (Total Debt/Equity))) Levered Beta = Unlevered Beta x (1+((1-Tax Rate) x (Total Debt/Equity)))]
Explain why we would use the mid-year convention in a DCF.
You use the Mid-Year Convention because it represents the fact that the FCF comes in evenly throughout the year, not just at the end of the year. [Using Mid-Year Convention: 1st year: 0.5 2nd year: 1.5 3rd year: 2.5]
What discount period numbers would I use for the mid-year convention if I have a stub period - e.g. Q4 of Year 1 - in my DCF?
You would divide the Stub Period's discount period number by 2. To get the Mid-Year Convention period number, you add 1 to the 'Normal' Stub Period, and then subtract 0.5. [Example: You have a Q4 Stub. It's 'Normal' Discount Period is 0.25; it's Mid-Year Convention Discount Period is 0.125 Year 1's 'Normal' Discount Period would be 1.25; you would subtract .5 from that to get its Mid-Year Convention Discount Period of .75]
We're creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the factory purchase, and what would our new Enterprise Value be?
You would have to discount the $100 to Present Value, and then subtract that from your Year 4 Free Cash Flow. [Present Value of this expenditure = $100 / ((1+Discount Rate)^4) ***4 represents Year 4***]
How do you calculate WACC for a private company?
You would have to use whatever information you could get your hands on. If you had absolutely no materials, you would use the WACC of the Comps.
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
You would use Cost of Equity instead of WACC because we're not concerned with debt holders.
Why would you not use a DCF for a bank or other financial institution?
You wouldn't use a DCF for a bank because their Debt and Working Capital serve different roles, and would give you funny Free Cash Flow numbers. [Banks make money from Interest Income, which does not affect UFCF Changes in Working Capital can be much larger than Net Income for banks]