DCF - Basic Concepts

4. How can we calculate Cost of Equity without using CAPM?

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends Use when company is guaranteed to issue dividends (utility companies) or if info on Beta is unreliable.

9. Implied per Share Value is $10. The company's current share price is $5. What does this mean?

Could mean that the company is undervalued - but you have to look at a range of outputs from a DCF, so you would see what the implied per share value is under different assumptions for the discount rate, revenue growth, margins, etc.

8. How do you treat Preferred Stock in the formulas above for Beta?

Count as Equity because Preferred Dividends are not tax-deductible unlike interest paid on Debt.

3. Walk me through how you get from Revenue to FCF in the projections.

For Unlevered FCF (FCFF): Subtract COGS and OpEx from Revenue to get to Operating Income (EBIT) Ebit*(1-T) + D&A (and other non-cash charges) - Changes in Operating Assets and Liabilities. Then subtract CapEx. Levered FCF (FCFE) Subtract Net Interest Expense to get EBT before multiplying by (1-T), and you must also subtract Mandatory Debt Repayments at the end

4. Alternate ways to calculate Levered FCF?

1. (EBIT - Net Interest Expense)*(1-T) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments 2. Cash Flow from Operations - CapEx - Mandatory Debt Repayments 3. Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments

5. How do you calculate Beta in the Cost of Equity calculation?

1. Could just take the company's Historical Beta, based on its stock performance vs. the relevant index. For a new Estimate: 1. Find comps 2. Unlever each Beta - UB = LB/ (1+((1-T)*(D/E))) 3. Find the median 4. Relever based on the target company's capital structure - LB = UB*(1+((1-T)*(D/E)))

3. What's an alternate method for calculating Unlevered FCF?

1. EBIT*(1-T) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx 2. Cash Flow from Operations + Tax Adjusted Net Interest Expense - CapEx 3. Net Income + Tax Adjusted Net Interest Expense + Non-cash Charges - Changes in Operating Assets and Liabilities - CapEx Tax numbers will be slightly different as a result of when you exclude the interest

1. How do you calculate Terminal Value?

1. Multiples Method - apply exit multiple to Year 5 EBITDA, EBIT, or FCF 2. Gordon Growth Method TV = Final Yr FCF * (1+ Growth Rate) / (Discount Rate - Growth Rate) Estimating the PV of FCFs from the final year into infinity as of the final year.

10. What are the most common sensitivity analyses to use for a DCF?

1. Revenue Growth vs. Terminal Multiple 2. EBITDA Margin vs. Terminal Multiple 3. Terminal Multiple vs. Discount Rate 4. Terminal Growth Rate vs. Discount Rate

15. Companies during the crisis (or any downturn) - Does WACC increase or decrease?

1. Risk Free Rate would decrease because governments would drop interest rates to encourage spending 2. Equity Risk Premium would increase by a good mount as investors demand higher returns before investing in stock 3. Beta increases due to volatility 4. Cost of Equity would increase Cost of Debt and Preferred would both increase as it would become more difficult for companies to borrow money. 1. D/E would increase because share prices fall, so Equity Value decreases while Debt stays the same 2. Debt and Preferred would make up a higher percentage of a company's capital structure 3. But Cost of debt and preferred both increase, so the shift doesn't matter that much 4. WACC increases because all these variables push it up - only one that pushes it down is the reduced Risk Free Rate. Did companies become more or less valuable during the crisis? Less: the market discounted their future cash flows at higher rates, so WACC must have increased.

2. Walk me through a DCF

A DCF values a company based on the PV of its FCFs and the PV of its Terminal Value 1. Project a company's FCFs over a 5-10 year period 2. Calculate Discount Rate (WACC) 3. Discount and sum up FCFs 4. Calculate Terminal Value 5. Discount Terminal Value to PV 6. Add discounted FCFs to the discounted Terminal Value "Project a company's financials using assumptions for revenue growth, margins, and the change in operating assets and liabilities. Then, calculate FCF for each year, which you discount and sum up to get to NPV. The Discount Rate is usually the WACC. Determine a company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then discount that back to its NPV using the Discount Rate

9. The FCFs in the projection period of a DCF analysis increase by 10% each year. How much will the company's Enterprise Value increase by?

A percentage that's less than 10%, for two reasons: 1. Time value of money - we discount FCFs. So the PV change is less than 10% 2. Terminal value hasn't increased by 10%. Can't give an exact number without knowing the rest of the numbers (Discount Rate, Terminal Value) in the analysis

12. If you're using Levered FCF to value a company, is the company better off paying Debt quickly or repaying the bare minimum required?

Bare minimum. Interest rates around 10-15% - the decrease in FCF used to pay down debt isn't worth the decrease in the amount of interest payment.

2. How do you calculate Cost of Equity?

CAPM Cost of Equity = Risk-free Rate + Equity Risk Premium * Levered Beta rf = 10-20 year US Treasury bond Beta - riskiness of comps Premium - percentage by which stocks are expected to out-perform risk-less assets like US Treasuries Ibbotson's Size premium, industry premium to account for additional risk and expected returns Small caps should outperform large caps, some industries outperform others

10. How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense?

Calculate the Terminal Value using one method, then see what the implied long-term growth rate or implied multiple via the other method would be. Ex: Calculate TV with long-term growth rate of $5. TV = $10,000. Divide that by final year EBITDA and get 15x, but Public Comps are only trading at median of 8x. You should reduce the long-term growth rate

1. Two companies produce identical total FCFs over a 5-year period. Company A Generates 90% of its FCF in the first year and 10% over the remaining 4 years. Company B generates the same amount of FCF in each year. Which one has the higher NPV?

Company A, because money today is worth more than money tomorrow. Generating higher cash flow earlier on will always boost a company's value in a DCF.

3. Will WACC be higher for a $5bn or $500mm company?

Depends on whether or not the capital structure is the same for both companies. If same, WACC should be higher for $500mm. If not the same, could go either way

7. Would you still used Levered Beta with Unlevered FCF?

Different concepts: You always use Levered Beta with Cost of Equity because debt makes the company's stock riskier You always use that same Cost of Equity for both Levered FCF, where Cost of Equity is the Discount Rate, and for Unlevered, where Cost of Equity is a component of the Discount Rate (WACC)

3. Should we factor dividend yield into the Cost of Equity formula?

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include Dividends?

6. Can you explain the Gordon Growth Formula in more detail?

Growth increases effective return. The higher the expected growth, the more we can afford to pay upfront See pg 45 in DCF guide

8. 10% Growth, 10% Discount Rate. Which would have a bigger impact: changing growth to 1% or changing the discount rate to 9%?

Growth, since you've changed it by 90%, but the DR has only changed by 10%. Lower revenue growth will push down the PV of FCF and TV.

6. What's the point of the "Changes in Operating Assets and Liabilities" section? What does it mean?

If Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow. If Liabilities are increasing by more than Assets, the company is increasing its cash flow. If it places a huge order of Inventory, sells products, and records revenue, but haven't received cash from customers yet, Inv and AR both go up and represent uses of Cash. We need to take into account the cash changes from these operationally-lined BS items.

6. Why might we sometimes project 10 years or more?

If It's a cyclical industry - may be important to show the entire cycle from low to high

9. How do you know if a DCF is too dependent on future assumptions?

If the PV of the Terminal value accounts for 80-90% of the company's value. Some people says over 50%, but that's very common in all DCFs.

2. Why would you use the Gordon Growth Method

If you don't have any good comps or if you believe the multiples will change significantly in the industry. If cyclical (chemicals or semiconductors) (You almost always use the multiples Method. It's easier to get appropriate data for exit multiples)

5. Which method of calculating Terminal Value will produce a higher valuation?

Impossible to say. Depends on assumptions. Assumptions for Multiples - revenue, growth, EBITDA, etc. GGM - growth rate

7. What do you use for the Discount Rate?

In an Unlevered DCF, you use WACC, which reflects the cost of Equity, Debt, and Preferred Stock. In a Levered DCF, you use cost of Equity instead.

13. If a firm is losing money, do you still multiply the Cost of Debt by (1-T) in the WACC? How can a tax shield exist if they're not even paying taxes?

In practice, you still multiply by (1-T) because Debt has POTENTIAL to reduce the company's taxes in the future.

2. Should Cost of Equity be higher for a $5bn or $5mm market cap company?

It should be higher for the $500mm company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and are therefore "riskier". Also less liquid

8. If you use Levered FCF rather than Unlevered in your DCF, what changes?

Levered FCF gives you Equity Value since the cash flow is only available to Equity Investors. Debt investors have already been paid with the interest payments and principal repayments.

3. What's an appropriate growth rate to use when calculating the Terminal Value?

Long-term GDP Growth rate, rate of inflation

4. How do you select the appropriate exit multiple when calculating Terminal Value?

Look at the Public Comps and pick the median of the set. Always show a range of multiples and what TV looks like over that range.

4. What's the relationship between Debt and Cost of Equity?

More Debt means that the company is riskier, so the company's Levered Beta will be higher. All else being equal, Cost of Equity would increase.

10. You use Unlevered FCF in a DCF to calculate Enterprise Value. Then you work backwards and use the comapany's Cash, Debt, and so on to calculate its implied Equity Value. Then you use Levered FCF instead and calculate Equity VAlue at the end. Will the implied Equity Value be the same?

Most likely, it won't be the same. Hard to pick equivalent assumptions in practice. In Unlevered FCF, you use the same numbers for Cash, Debt, etc. But in Levered FCF, the terms of Debt will impact FCF - simply by assuming a different interest rate or repayment schedule, you'll alter the Equity Value.

1. Is it always correct to leave out most of the CF from Investing section and all of the CF from Financing section?

Most of the time, yes, because all items other than CapEx are generally non-recurring, or do not recur in a predictable way.

6. Since the company that has debt has a lower WACC, does that mean a company that is without debt is at a disadvantage?

No, but it won't be valued as highly because of the way the WACC formula works.

5. Is it okay to use EBITDA - Changes in Operating Assets and Liabilities - CapEx to approximate Unlevered FCF?

No; excludes taxes completely. Better to use EBITDA - Taxes - Changes - CapEx

7. What happens in the DCF if FCF is negative? What if EBIT is negatie?

Nothing "happens" because you can still run the analysis as-is. The company's value will decrease if one or both of these is negative, because the PV of FCF will decrease as a result. DCF can still work if the company turns CF-positive after a point

8. How to move from Enterprise Value to Implied Share Value

Once you get to Enterprise Value, ADD Cash and SUBTRACT debt, preferred stock, and noncontrolling interests to get to equity value. Then you divide equity value by the company's share count (factoring in all dilutive securities) to determine the implied per share price

4. What's the point of FCF?

Replicating CFS, but only including recurring, predictable items. That's why everything in CFI except CapEx is excluded, and why CFF is excluded (except for mandatory debt repayments for Levered FCF)

2. Why do you add back non-cash charges when calculating FCF?

Same reason you add them back on the CFS: You want to reflect the fact that they save the company on taxes, but that hte company does not actually pay the expense in cash

10. How is the Dividend Discount Model (DDM) different from a DCF?

Setup is similar - still project revenue and expenses over a 5-10 year period, and you still calculate Terminal Value. Difference is you do NOT calculate FCF - instead, you stop at Net Income and assume that Dividends Issued are a % of Net Income, and you discount those Dividends back to PV using Cost of Equity. Then you add those up and add them to the PV of of the Terminal Value, which you might base on a P/E multiple instead. DDM gives you Equity Value because you're using metrics (NI) that include interest income and expense.

10. Would you expect a manufacturing company or a tech company to have a higher Beta?

Tech, because tech is viewed as a riskier industry than manufacturing

5. Why do you use 5 to 10 years for the near future DCF Projections?

That's about as far as you can reasonably predict for most companies.

7. Assume 10% revenue growth and 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%?

The Discount Rate will almost certainly have a bigger impact because it affects everything fron the PV of FCF to the PV of TV.

14. How do you determine a firm's Optimal Capital Structure?

The combination of Debt, Equity, and Preferred Stock that minimizes WACC. No real way, because debt should always be 100% since it's always cheaper, but all companies need some amount of Equity. Taking on additional debt will impact the cost of equity and preferred, so it's a multivariable equation with no solution. You can approximate the optimal structure by looking at different scenarios and seeing how WACC changes, but there's no mathematical solution.

12. Cost of Equity - what is the company really paying?

The company pays for Equity in two ways: 1. it may issue Dividends to its common shareholders, which is a cash expense 2. It gives up stock appreciation rights to other investors, so it's losing upside. Tricky to estimate the impact of those, so we use CAPM

7. What's the flaw with basing the Terminal Multiple on what the Public Comps are trading at?

The median multiples may change greatly in the next 5-10 years, so they may no longer be accurate by the end of the period you're looking at. This is why you look at a wide range of multiples and run sensitivity analyses to see how these variables impact the valuation.

5. 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, because: 1. Interest on Debt is tax-deductible: (1-T) 2. Debt is senior to Equity in a company's capital structure - debt investors would be paid first in bankruptcy 3. Interest rates are usually lower than Cost of Equity, so the Cost of Debt portion contributes less to the total figure than the Cost of Equity Portion.

9. If you use Levered FCF, what should you use as the Discount Rate?

Use Cost of Equity - we're ignoring debt and preferred stock and only care about Equity Value for Levered FCF.

1. How do you calculate WACC?

WACC = Cost of Equity x % Equity + Cost of Debt x % Debt x (1-T) + Cost of Preferred x % Preferred Cost of Equity - CAPM For others, look at comparable companies and comparable debt issuances and interest rates and yields issued by similar companies

6. Why do you have to un-lever and re-lever Beta?

When you look up Betas, they will already be levered because a company's previous stock price movements reflect the Debt they've taken on. But each company's capital structure is different, and we want to look at how risky a company is regardless if what % debt or equity it has. We want to find the inherent business risk separate from the risk created by Debt. We need to re-lever because we want the Beta to reflect the total risk of the company, taking into account capital structure this time

11. Shouldn't you use a company's target capital structure rather than its current when calculating Beta and the Discount Rate?

Yes, if you know that a company's capital structure is definitely changing in a certain, predictable way in the future. But in practice, you rarely know this information in advance, so it might be impractical to make the assumption.

9. Can Beta ever be negative? What would that mean?

Yes: If Beta is -1, this means that the asset moves in the opposite direction from the market as a whole. If the market goes up by 10%, the Asset would go down by 10%. Rarely see negative Betas; something labeled as counter-cyclical might have a Beta of 0.5 or 0.7

11. A company has a high Debt balance and is paying off a significant portion of its Debt principal each year. How does that impact a DCF?

You don't account for this in an Unlevered DCF because you ignore interest expense and debt principal repayments. In a Levered DCF, you reduce the interest expense each year as the Debt goes down, and you reduce FCF by the mandatory repayments each year. Exact impact (whether implied Equity Value) goes up or down) depends on the interest rate and the principal repayment percentage each year; in most cases, the principal repayments far exceed the net interest expense, so the Equity Value will most likely decrease because Levered FCF will be lower each year.

8. Why isn't the PV of the Terminal Value, by itself, just the company's Enterprise Value?

You get Enterprise Value, but only for the far in the future period. If you leave out the PV of cash flows in the projection period, it's like saying "For the next 5 years, the company has no value. But at the end of year 5, it's miraculously worth something!"

1. What's the basic concept behind a DCF analysis?

You value a company based on the PV of its FCF far into the future. You divide the future into a near-term period of 5-10 years and then calculate, project, discount, and add up those FCFs. Then there's a long-term future beyond that which you can approximate using different approaches. You need to discount everything back to its PV because money today is worth more than money tomorrow.