Discounted Cash Flow
How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company's business model?
Change in Working Capital show whether a company needs extra cash to fund it's future operations or if they will generate extra cash as it grows The Change in WC could increase or decrease the company's Free Cash Flow, but it's rarely a major value driver because it's fairly small for most companies
What is the Discount Rate
Discount Rate represents the opportunity cost for other investors if they invested in other companies of similar risk Higher DR: higher risk, higher potential return, lower valuation Lower DR: lower risk, lower potential return, higher valuation
What is the difference between the explicit forecast period and the Terminal Period in a DCF?
Explicit Forecast Period: different growth rate based on how CFs are changing and growing Terminal Period: assuming a constant growth rate as the company matures, "steady growth"
If your DCF seems wrong, what are the easiest ways to fix it?
Extend the explicit forecast period check to make sure you're not double counting reduce Terminal Value by reducing terminal growth rate or multiple
beta
systematic risk of a security compared to the broader market; covariance between expected returns on the asset and the market
which is higher, the cost of debt or the cost of equity
the cost of equity is higher because the costs associated with borrowing debt is tax-deductible
Do you still un-lever and re-lever Beta even when you're using Unlevered FCF?
unlevering and relevering beta have nothing to do with unlever FCF, you have to do it regardless A company's capital structure affects both the Cost of Equity and WACC, so you un-lever and relever Beta regardless of the type of Free Cash Flow you're using.
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.
Walk me though how you get from Revenue to Free Cash Flow in the projections
Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.
Unlevered Beta
Systematic Risk only, intrinsic business risk
Levered Beta
Systematic risk + Nonsystematic risk intrinsic business risk + leverage risk how volatile a company's stock price is relative to the stock market as a whole,
What's the intuition behind the Gordon Growth formula for Terminal Value?
Terminal Cash Flow (1 + Growth Rate) / (Discount Rate - Growth Rate) A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher The company is worth more when you have worse investment options elsewhere and worth less when you have better investment options elsewhere.
What are some signs that you might be using the incorrect assumptions in a DCF?
Terminal Value represents too high of a percentage of the forecasted cash flows If the Multiples are wrong/growth rate wrong double-counting items Mismatched Final Year Growth Rate and Terminal Growth Rate
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.
WACC reflects the company's entire capital structure, so why do you pair it with Unlevered FCF? WACC is not capital structure-neutral!
WACC is available to all investors, same as UFCF
Why might you include a "stub period" in a DCF, and what does it mean?
You might include a "stub period" if you're valuing a company midway through the year, and it has already reported some of its financial results for the year. A DCF is based on expected future cash flow, so you should subtract these previously reported results and adjust the discount periods as well.
Which has a greater impact on a company's DCF valuation - a 10% change in revenue or a 1% change in the discount rate?
You should start by saying, "it depends" but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn't affect only the current year's revenue, but also the revenue/EBITDA far into the future and even the terminal value.
How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?
below the country GDP, around the inflation rate
The formulas for Beta do not factor in the interest rate on Debt. Isn't that wrong? More expensive Debt should be riskier
debt/equity ratio is a proxy for interest rate on debt risk isn't proportional with the interest rate
How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?
effects the company only if the company has debt If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt, and WACC. It's easy to see why it reduces the Cost of Debt: since you multiply by (1 - Tax Rate), a higher tax rate reduces the after-tax cost. But it also reduces the Cost of Equity for the same reason: with a greater tax benefit, Debt is less risky even to Equity investors. If both of these Costs are lower, WACC will also be lower. However, the Implied Value from a DCF will also be lower because the higher tax rate reduces the FCF and the Terminal Value, and these changes outweigh a lower WACC. The opposite happens with a lower tax rate: the Cost of Equity, Cost of Debt, and WACC are all higher, and the Implied Value is also higher.
What does the discount rate represent
expected return on an investment based on its risk profile; minimum return threshold of an investment based on comparable investments with similar risks
Two companies produce identical total Free Cash Flows over 10 years, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow every year. Which company will have the higher Implied Value in a DCF?
It depends how they calculate FCF: if it's just the series of cash flows, Company A would have a higher FCF bc of TV money However, Company B will almost certainly have a much higher Terminal Value because it has a much higher FCF in Year 10. So, if the Implied Value = PV of FCFs + PV of Terminal Value, Company B will have the higher Implied Value
If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect its WACC?
It depends on how you're calculating WACC. If you're using the company's current capital structure, WACC will most likely increase because 20% Debt is a fairly low level. At that low level, the benefits of Debt tend to outweigh its risks, so less Debt will increase WACC. But if you're using the targeted, optimal, or median capital structure from the comparable companies, this change won't affect WACC because you're not using the company's current capital structure at all
What's the relationship between debt and Cost of Equity?
More debt means that 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 does the Cost of Preferred Stock compare with the Cost of Debt and the Cost of Equity?
More expensive than debt, less expensive than equity: it offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity.
Suppose you're calculating WACC for two similarly sized companies in the same industry, but one company is in a developed market (DM), and the other is in an emerging market (EM). Will the EM company always have a higher WACC?
Most likely yes, because an EM company tends to have higher risk, cost of debt, and higher risk free rate and equity risk premium However, there are cases where differences in the capital structure or strange results for Levered Beta might result in a similar or lower WACC for the EM company. For example, if the government heavily controls the company's industry in the emerging market, Levered Beta might be lower for the EM company due to the reduced volatility.
Does a DCF ever make sense for a company with negative cash flows?
A DCF is based on a company's expected future cash flows, so even if the company is cash flow-negative right now, the analysis could work if the company starts generating positive cash flows in the future. Yes, if a company is projected to have positive cash flows in the future
How does the mid-year convention affect the output of a DCF?
A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower. Will produce higher values because the Year # of the first period would be 1.0 without the midyear convention but 0.5 with the mid-year convention.
Walk me through a DCF
A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow 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 the present value of the Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC. Finally, you add the two together to determine the company's Enterprise Value. 1. forecast free cash flow for 5-10 years 2. find the terminal value gordon growth + multiple 3. discount both the values back unlevered: WACC levered: cost of equity 4. sum discounted terminal value and discounted free cash flow for enterprise value
Should the Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?
Assuming that both companies have the same capital structure percentages, the Cost of Equity and WACC should be higher for the $500 million company. All else being equal, smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains why the Cost of Equity will be higher. Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt (and Preferred) also tends to be higher. And since all these Costs tend to be higher for smaller companies, WACC should be higher as well, assuming the same capital structure percentages.
Cost of Equity Meaning
Average percentage of return a stock should expect in the long term average annualized percentage an equity investor might expect over the long term To a company, the Cost of Equity represents the cost of funding its operations by issuing additional shares to investors
How do you calculate the Equity Risk Premium
Average return of the market - risk free return (Market: S&P500)
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's more common to use a dividend discount model for valuation purposes.
Why do you build a DCF analysis to value a company?
Build DCF to value a company based on current and future cash flows You have to build a an explicit forecast period and a terminal period
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 based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you pull the Equity Risk Premium from a publication called Ibbotson's. Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is according to its market cap or industry. Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.
Which assumptions make the biggest impact on a DCF?
Discount Rate and the Terminal Value
Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?
Discount Rate increase because this affects all the years' PV
Should you ever include items such as asset sales, impairments, or acquisitions in FCF?
For the most part no, because you can't accurately predict one time charges If the company explicitly announced in the near future, it can be included in the FCF for the year
What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?
If it's UFCF: you have the Enterprise Value so you add cash, subtract debt, subtract NCI, subtract changes in Working Capital Levered FCF: go straight from Equity Value to get to implied share price by dividing EV by share outstanding
Could Beta ever be negative
If the company's returns move in the opposite direction of the market for example gold
What's the relationship between subtracting an expense in the FCF projections and the Implied Equity Value calculation at the end of the DCF?
If you subtract a certain expense in FCF, then you should ignore the corresponding Liability when moving from Implied Enterprise Value to Implied Equity Value at the end. For example, with U.S.-based companies, you normally subtract the Rental Expense on Operating Leases in the FCF projections because Rent is a standard operating expense. Therefore, you ignore the Operating Lease Liability in the Enterprise Value bridge at the end. But if you exclude or add back the Rental Expense in FCF, you do the opposite and subtract the Operating Lease Liability in the bridge. This rule also explains why you subtract Debt in the bridge for an Unlevered analysis: UFCF excludes the corresponding Interest Expense on the Debt.
Should you include inflation in the FCF projections?
In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you include inflation, you also need to forecast inflation far into the future and adjust all figures in your analysis. That's rarely worthwhile because of the uncertainty and extra assumptions required.
How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?
Increase in debt would increase the cost of equity and the cost of debt, increasing the WACC Initially, if the company did not have a lot of debt, the WACC would initially decrease because the additional debt is not as risky as equity, increasing debt past the optimal ratio would increase chances of bankruptcy making it more costly and risky
Should Cost of Equity be higher for a $5 billion or $500 million market cap company?
It 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 be "more risky"). Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.
Why is Equity more expensive than Debt
It's riskier: lower on the capital structure so if the company files for bankruptcy, lower chance of getting money back
Will you get the same results from an Unlevered DCF and a Levered DCF?
NO: The value of debt makes a difference The simplest explanation is that an Unlevered DCF does not directly factor the Cost of Debt into the FCF projections, while a Levered FCF does. The Unlevered DCF indirectly accounts for it via the WACC calculation, but it won't be equivalent to the Levered version.
What do you usually use for the discount rate?
Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you've set up the DCF.
If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions?
Public Comps, Precedent Transactions include a control premium
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 Long-Term Growth Rate vs. Discount Rate
What are some different ways to calculate Beta in the Cost of Equity calculation?
Some people argue that you should use the Predicted Beta instead of the Historical Beta because the Cost of Equity relates to expected future returns. If you use the historical data, you could use the company's Historical Beta or the re-levered Beta based on the comparable companies. And if you re-lever Beta, you could do it based on the company's current capital structure, its targeted or "optimal" structure, or the capital structure of the comparable companies. Most of these methods produce similar results, but they're useful for establishing the proper range of values for the Cost of Equity and WACC
What's one problem with using TEV / EBITDA multiples to calculate Terminal Value?
The biggest issue is that EBITDA ignores CapEx. Two companies with similar TEV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if they have similar TEV / EBITDA multiples. You may get better results by using TEV / EBIT, TEV / NOPAT, or TEV / Unlevered FCF, but those multiples create other issues, such as less comparability across peer companies. This problem is one reason why the Gordon Growth Method is still the "real" way to calculate Terminal Value
How do you calculate WACC?
The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred). In all cases, the percentages refer to how much of the company's capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM - see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.
What's the proper tax rate to use when calculating FCF - the effective tax rate, the statutory tax rate, or the cash tax rate?
The company's Free Cash Flows should reflect the cash taxes it pays. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company's real cash taxes. It's most common to use the effective tax rate and then adjust for the Deferred Taxes based on historical trends.
How can you determine which assumptions to analyze in sensitivity tables for a DCF?
The same assumptions make a big impact in any DCF: the Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the key operational drivers that affect the company's revenue growth and margins. These drivers could be entire scenarios or specific numbers, such as the long-term price of steel, depending on the model setup. It doesn't make sense to sensitize much else - the assumptions for CapEx and the Change in Working Capital, for example, tend to make a small difference. There may also be industry-specific assumptions that are worth sensitizing, such as the patent expiration dates for drugs in the biotech/pharmaceutical industry.
How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC calculation, and what do they mean?
These Costs represent what the company would pay if it issued additional Debt or additional Preferred Stock. There is no way to observe these costs directly, but you can estimate them. For example, you could calculate the weighted average coupon rate on the company's existing Debt or Preferred Stock or the median coupon rate on the outstanding issuances of comparable public companies.
How should CapEx and Depreciation change within the explicit forecast period?
They should change as a percentage of revenue: For a growing company, CapEx should decrease as company matures If the company's FCF is growing, CapEx should always exceed Depreciation, but there may be a smaller difference by the end
How do you calculate Terminal Value in a DCF, and which method is best?
Two Methods: Gordon Growth Method and Multiples Method Gordon Growth/Perpetuity Growth: determine a rate that the company can grow for forever, and apply it to the formula FCF(1*GR)/DR-GR Multiples Method: Using an EBITDA, EBIT multiple and apply to terminal value The Gordon Growth Method is better from a theoretical perspective because growth always slows down over time; all companies' cash flows eventually grow more slowly than GDP.
What are the formulas for un-levering and re-levering Beta, and what do they mean?
Unlever: levered beta / (1 + (debt/equity)(1-tax)) Lever: unlevered beta * (1 + (debt/equity)(1-tax)) The formulas reduce Levered Beta to represent the removal of risk from leverage, but they increase Unlevered Beta to represent the addition of risk from leverage
Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?
Unlevered Free Cash Flow represents money available to all investors in Core Operating Assets: Have to get rid of items that are not core operating, not available to all investors, ant not recurring
WACC meaning intuitively
Weighted Average Cost of Capital represent a discount rate and the opportunity cost of other investments with similar risk and size WACC is similar to Cost of Equity, but it's the expected annualized return if you invest proportionately in all parts of the company's capital structure - Debt, Equity, and Preferred Stock.
Should you ever use *different* Discount Rates for different years in a DCF?
Yes, if you believe that as the company grows and matures becoming more stable, the discount rate should decrease
Would it ever make sense to use a negative Terminal FCF Growth Rate?
Yes. For example, if you're valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, it might be reasonable to assume that the company never replaces the lost revenue from this drug, which results in declining cash flow. A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually (even if it happens decades into the future).
Why do you need to discount the Terminal Value back to its Present Value?
You are trying to find the value in current terms as of today
How do you calculate the Terminal Value?
You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity. The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).
How do you interpret the results of a DCF?
You compare the company's Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued. You do this over a range of assumptions because investing is probabilistic. For example, if you believe that the company's Implied Share Price is between $15.00 and $20.00, but its Current Share Price is $8.00, then that is good evidence that the company may be undervalued. But if its Current Share Price is $17.00, then it may be valued appropriately.
How do you get to Beta in the 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. Then you use this Levered Beta in the Cost of Equity calculation. For your reference, the formulas for un-levering and re-levering Beta are below: 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)))
Should you use the company's current capital structure or optimal capital structure to calculate WACC?
You should use the optimal is the one that minimizes its WACC So, in practice, you'll often use the median capital structure percentages from the comparable public companies as a proxy for the "optimal" capital structure. It's the same as the logic for un-levering and re-levering Beta: you want to capture what this company's capital structure should be, not what it is right now. It's better to use this expected capital structure because the company's Implied Value in a DCF is based on its expected future cash flows.
Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?
You unlever the Beta of comparable companies in order to find the intrinsic business risk of the industry without any impacts of the capital structure of comparables, and then you relever the Beta using the capital structure of your company to come to the Cost of Equity. What the volatility of this company's stock price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company's capital structure.
Why do you use the mid-year convention in a DCF analysis?
You use it because a company's cash flows do not arrive 100% at the end of each year - the company generates cash flow throughout each year. Using 1, 2, 3, 4 for the discount periods implies that the first year's cash flow arrives after one entire year has passed. If you use 0.5, 1.5, 2.5, 3.5 instead, you assume that only half a year passes before the first cash flow is generated, which is closer to real life. more accuracy
If the company's capital structure is expected to change, how do you reflect it in FCF?
You'll reflect it directly in a Levered DCF because the company's Net Interest Expense and Debt principal will change over time. You'll also change the Cost of Equity over time to reflect this. The changing capital structure won't show up explicitly in the projections of an Unlevered DCF, but you will still reflect it with the Discount Rate - WACC will change as the company's Debt and Equity levels change.
How can you check whether or not your Terminal Value estimate is reasonable?
you start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by calculating the Growth Rates or Multiples they imply. If it seems wrong, you adjust the range of Terminal Multiples or Terminal FCF Growth Rates until you get more reasonable results.