Interview Prep

Net Change in Working Capital

relates to timing differences between recording revenue and receiving it in cash, and recording expenses and paying for them in cash

Capital Expenditures

represent purchase of long-term items that will last more than 1 year and benefit the business for many years to come

Deferred Income Tax Def

represents difference between taxes on income statement and what the company actually pays in cash

Terminal Value Def

Represents company's projected value 10 years into the future

Unlevered Free Cash Flow (EQ)

NOPAT +/- Deferred Income Taxes +/- Net Change in Working Capital - CapEx

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 a company's financials using assumptions for revenue growth, margins, and the Change in Operating Assets and Liabilities; then you calculate Free Cash Flow for each year, which you discount and sum up to get to the Net Present Value. The Discount Rate is usually the Weighted Average Cost of Capital. Once you have the present value of the Free Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then you discount that back to its Net Present Value using the Discount Rate. Finally, you add the two together to determine the company's Enterprise Value."

Why do you use FCF instead of edit / edbitda?

"Free Cash Flow" means: how much after-tax cash flow the company generates on a recurring basis, after you've taken into account non- cash charges, changes in Operating Assets and Liabilities, and required Capital Expenditures. You calculate and use Free Cash Flow in a DCF because that closely corresponds to the actual cash flow that you, as the investor, would receive each year if you bought the entire company. It is far more accurate than metrics like Net Income and EBITDA, because those leave out big uses of cash like CapEx, and because those don't take into account changes in cash due to items like Accounts Receivable, Accounts Payable, Inventory, and more.

Terminal Value (EQ)

(Final Year UFCF * (1 + Terminal UFCF Growth Rate)) / (WACC - Terminal UFCF Growth Rate)

Implied FCF Growth Rate

(Terminal Growth Rate * Discount Rate - Final Year FCF) / (Terminal Value + Final Year FCF)

How are the three main financial statements connected?

-net income flows from the is into cash flow from operations on the cf statement -net income minus dividends is added to retained earnings from the prior periods balance sheet to come up with retained earning on the current periods balance sheet -beginning cash on the cf statement is cash on the current periods balance sheet

How to calculate FCF steps

1) First, you project the company's revenue growth, i.e. the percentage it grows revenue by each year over that 5-10 year "near future" period. From that, you can determine the company's projected annual revenue based on the most recent historical numbers. 2) Next, you need to assume an operating margin for the company so that you can calculate its EBIT, or Operating Income, each year. Usually you base this on historical margins. So if they have $1 billion in revenue and a 30% EBIT Margin, that's $300 million in EBIT. 3) Now, you apply the company's effective tax rate to calculate its Net Operating Profit After Tax, or NOPAT. Continuing with this example, if the tax rate is 40% then the NOPAT is $300 million * (1 - 40%), or $180 million. 4) Once you have this, you move to the Cash Flow Statement and project the 3 key items there that impact Free Cash Flow: Non-Cash Charges, Changes in Operating Assets and Liabilities, and Capital Expenditures. 5) The main Non-Cash Charges are Depreciation & Amortization; you may also project others, such as Stock-Based Compensation. You add them back here because you want to reflect how the company saves on taxes, but does not actually pay any cash for them. You can make these percentages of revenue. If we assumed they were equal to 5% of revenue here, we'd add back $50 million here. 6) Next, you estimate the change in Operating Assets and Liabilities. What this really means is, "If the company's Operating Assets increase more than its Operating Liabilities, it needs extra cash to fund that... so it reduces cash flow. If its Liabilities increase more, that adds to cash flow." You can make this a percentage of revenue as well - so if it's 3% of revenue and Assets increase more than Liabilities, then we subtract $30 million here. 7) Finally, you estimate Capital Expenditures each year, which always reduces cash flow. You might average previous years' numbers, assume a constant change, or make it a percentage of revenue. In this case if CapEx is $50 million, that reduces cash flow by $50 million.

Equity costs the company something in two ways: Name them

1. If the company issues Dividends to common shareholders, that is an actual cash expense. 2. By issuing Equity to other parties, the company is giving up future stock price appreciation to someone else rather than keeping it for itself.

6 steps to calculating DCF

1. Project a company's Free Cash Flows over a 5-10 year period. 2. Calculate the company's Discount Rate, usually using WACC (Weighted Average Cost of Capital). 3. Discount and sum up the company's Free Cash Flows. 4. Calculate the company's Terminal Value. 5. Discount the Terminal Value to its Present Value. 6. Add the discounted Free Cash Flows to the discounted Terminal Value."

6 Items in Unlevered Cash Flow

1. Revenue 2. COGS and Operating expenses 3. Taxes 4. Depreciation and Amortization (and sometimes other non-cash charges) 5. Change in working capital 6. Capital Expenditures

Main idea behind a DCF

A company is worth the PV of all future CFs. It is irrelevant what the market thinks in this case. ​

The Free Cash Flows 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. Remember that we discount all those Free Cash Flows - so even if they increase by 10%, the present value change is less than 10%. 2. There's still the Terminal Value and the present value of that. That has not increased by 10%, so neither has the company's total value.

Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company, because technology is viewed as a "riskier" industry than manufacturing.

All else being equal, do larger or smaller companies have high DRs. How do emerging markets companys DR look?

All else being equal, smaller companies tend to have higher Discount Rates than larger, more mature companies because investors expect that they will grow more and deliver higher growth, profits, and returns in the future. And they're also "riskier" than large companies. Companies in emerging markets also have higher Discount Rates than companies in developed markets, because the potential growth, returns, and risk (the government could collapse, mercenaries could take over, etc.) are all higher.

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

All it means is that if Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow, whereas if Liabilities are increasing by more than Assets, the company is increasing its cash flow. For example, if it places a huge order of Inventory, sells products, and records revenue, but hasn't receive the cash from customers yet, Inventory and Accounts Receivable both go up and represent uses of cash. Maybe some of its Liabilities, such as Accounts Payable and Deferred Revenue, also increase... but think about what happens: if the Assets increase by, say, $100, and the Liabilities only increase by $50, it's a net cash flow reduction of $50. So that is what this section is for - we need to take into account the cash changes from these operationally-linked Balance Sheet items.

Risk Free Premium

Amount above risk free rate investment is expected to return

Risk Free Rate Def

Amount the stock market is expected to return each year, on average, above the rate on "safe" government bonds. Like risk free rate look at stock market of company's operating country

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?

Break it down and think of the individual components of WACC: Cost of Equity, Cost of Debt, Cost of Preferred, and the percentages for each one. Then, think about the individual components of Cost of Equity: the Risk-Free Rate, the Equity Risk Premium, and Beta. • The Risk-Free Rate would decrease because governments worldwide would drop interest rates to encourage spending. • But then the Equity Risk Premium would also increase by a good amount as investors demand higher returns before investing in stocks. • Beta would also increase due to all the volatility. • So overall, we can guess that the Cost of Equity would increase because the latter two increases would likely more than make up for the decrease in the Risk-Free Rate. Now, for WACC: • The Cost of Debt and Cost of Preferred Stock would both increase as it would become more difficult for companies to borrow money. The Debt to Equity ratio would likely increase because companies' share prices would fall, meaning that Equity Value decreased for most companies while Debt stayed the same... • So proportionally, yes, Debt and Preferred would likely make up a higher percentage of a company's capital structure. • But remember: the Cost of Debt and Cost of Preferred both increase, so that shift doesn't matter too much. • As a result, WACC almost certainly increases because almost all these variables push it up - the only one that pushes it down is the reduced Risk-Free Rate. There's a simpler way to think about it as well: all else being equal, did companies become more valuable or less valuable during the financial crisis? Less valuable - because the market discounted their future cash flows at higher rates. So WACC must have increased.

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?

By itself, this does not mean much - you have to look at a range of outputs from a DCF rather than just a single number. So you would see what the Implied per Share Value is under different assumptions for the Discount Rate, revenue growth, margins, and so on. If you consistently find that it's greater than the company's current share price, then the analysis might tell you that the company is undervalued; it might be overvalued if it's consistently less than the current share price across all ranges.

Company Value (Terminal Value)

Cash Flow / (Discount Rate - Cash Flow Growth Rate)

WACC (Equation)

Cost of Equity * % equity + Cost of Debt * (1 - tax rate) * % Debt + Cost of Preferred Stock * % Preferred Stock

How to assume cost of equity in a business with predictable / stable dividends

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

How can we calculate Cost of Equity WITHOUT using CAPM?

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends This is less common than the "standard" formula but sometimes you use it when the company is guaranteed to issue Dividends (e.g. Utilities companies) and/or information on Beta is unreliable.

What is the cost of equity... how about debt?

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta (can use a companies historical beta) Cost of debt = intrest rate

What are some implications of the WACC formula

Debt will almost always push down WACC because the Cost of Debt is almost always lower than the Cost of Equity - interest rates on Debt are lower and the interest is tax-deductible. • Preferred Stock is generally cheaper than Equity, but not as cheap as Debt because Preferred Dividends are not tax-deductible. • Equity tends to "cost" the most, which makes sense intuitively: would you expect to earn more investing in the stock market over the long-term, or by investing in bonds?

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EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx • Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx • Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx

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

First off, note that you don't have to calculate anything - you could just take the company's Historical Beta, based on its stock performance vs. the relevant index. Normally, however, you come up with a new estimate for Beta based on the set of Public Comps you're using to value the company elsewhere in the Valuation, under the assumption that your estimate will be more accurate. 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 that median based on the company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation. The formulas for un-levering and re-levering Beta are below (see the Rules section above for explanations). • Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) • Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Walk me through how you get from Revenue to Free Cash Flow in the projections.

First, confirm that they are asking for Unlevered Free Cash Flow (Free Cash Flow to Firm). If so: Subtract COGS and Operating Expenses from Revenue to get to Operating Income (EBIT) - or just use the EBIT margin you've assumed. Then, multiply by (1 - Tax Rate), add back Depreciation, Amortization, and other non-cash charges, and factor in the Change in Operating Assets and Liabilities. If Assets increase by more than Liabilities, this is a negative; otherwise it's positive. Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow. Levered Free Cash Flow (FCFE) is similar, but you must also subtract the Net Interest Expense before multiplying by (1 - Tax Rate), and you must also subtract Mandatory Debt Repayments at the end.

Why do you add back non-cash charges when calculating Free Cash Flow?

For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact that they save the company on taxes, but that the company does not actually pay the expense in cash.

Includes what amount of information

Free Cash Flow to all Investors. Cash flow available to all investors

Why do we use Unlevered Free Cash Flow?

Gets the most consistent results

If you could use only one financial statement to evaluate the financial state of a company, which would you choose?

I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating. The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business. And the Balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF Statement would show.

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 - so all else being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity.

If you are using Levered CF what is your DR

If you're using Levered FCF (Free Cash Flow to Equity) instead, you use Cost of Equity as the Discount Rate instead because you only care about Equity investors there, and you're calculating Equity Value rather than Enterprise Value. Think: "Free Cash Flow to Equity Cost of Equity Equity Value."

What do you usually use for the Discount Rate?

In a Unlevered DCF analysis, you use WACC (Weighted Average Cost of Capital), which reflects the "Cost" of Equity, Debt, and Preferred Stock. In a Levered DCF analysis, you use Cost of Equity instead.

Why would you use the Gordon Growth Method rather than the Multiples Method to calculate the Terminal Value?

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate involves more guesswork. However, you might use Gordon Growth if you have no good Comparable Companies or if you believe that multiples will change significantly in the industry several years down the road. For example, if an industry is cyclical (e.g. chemicals or semiconductors) you might be better off using long-term growth rates rather than exit multiples.

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, yes. If you know that a company's capital structure is definitely changing in a certain, predictable way in the future, sure, go ahead and use that. In practice, you rarely know this information in advance, so it's not terribly practical to make this kind of assumption.

What about if we change revenue growth to 1%? Would that have a bigger impact, or would changing the Discount Rate to 9% have a bigger impact?

In this case the change in revenue growth is likely to have a bigger impact because you've changed it by 90% but you've only changed the Discount Rate by 10% - and that lower revenue growth will push down the present value of the Terminal Value (EBITDA and the FCF growth rate will both be lower) as well as the present value of the Free Cash Flows.

Why don't you include change cash in your FCF analysis

It is already being calculated a the bottom of the CF statement

What does an inc in working capital (operating assets - operating liabilities) mean?

It means you had CA inc more than CL and that takes cash since inv costs money and receiving AR means you are not receiving cash

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

It should be counted as Equity there because Preferred Dividends are not tax- deductible, unlike interest paid on Debt.

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 are therefore "riskier").

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

It's always better to pay the bare minimum. Think about the math for a second: interest rates on Debt rarely go above 10-15%... let's just assume that they're 10%, and that the company has $1,000 in Debt. Initially, it pays $100 in interest expense, and after taxes that's only $60 ($100 * (1 - 40%)). So Levered Free Cash Flow is reduced by $60 each year assuming no principal repayment. What happens if the company decides to repay $200 of that Debt each year? Levered Free Cash Flow is down by at least $200 each year, and the company still pays interest, albeit lower interest, until the end of the period. So the company is always better off, valuation-wise, waiting as long as possible to repay Debt.

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

It's impossible to say because it could go either way depending on the assumptions. There's no general rule here that always applies, or that even applies most of the time.

Explain the gordon growth method

Let's say that we know for certain that we'll receive $100 every year indefinitely, and we have a required return of 10%. That means that we can "afford" to pay $1,000 now ($100 / 10%) to receive $100 in year 1 and $100 in every year after that forever. But now let's say that that stream of $100 were actually growing each year - if that's the case, then we could afford to invest more than the initial $1,000. Let's say that we expect the $100 to grow by 5% every year - how much can we afford to pay now to capture all those future payments, if our required return is 10%? Well, that growth increases our effective return... so now we can pay more and still get that same 10% return. We can estimate that by dividing the $100 by (10% - 5%). 10% is our required return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2,000. This corresponds to the formula above: $100 represents Final Year Free Cash Flow * (1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate. The higher the expected growth, the more we can afford to pay upfront. And if the expected growth is the same as the required return, theoretically we can pay an infinite amount (you get a divide by zero error in the equation) to achieve that return.

· Unlevered Beta (EQ)

Levered Beta / (1 + Debt/Equity Ratio) * (1 - Tax Rate) + Preferred/Equity Ratio)

Discount Rate Def

Measures risk and potential annualized returns; higher rate means more risks but also higher potential returns

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 the time, yes, because all items other than CapEx are generally non- recurring, or at least do not recur in a predictable way. If you have advance knowledge that a company is going to sell or buy a certain amount of securities, issue a certain amount of stock, or repurchase a certain number of shares every year, then sure, you can factor those in. But it's extremely rare to do that.

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?

No, most likely it will not be the same. In theory, you could pick equivalent assumptions and set up the analysis such that you calculate the same Equity Value at the end. In practice, it's difficult to pick "equivalent" assumptions, so these two methods will rarely, if ever, produce the same value. Think about it like this: when you use Unlevered FCF and move from Enterprise Value to Equity Value, you're always using the same numbers for Cash, Debt, etc. But in a Levered FCF analysis, the terms of the Debt will impact Free Cash Flow - so simply by assuming a different interest rate or repayment schedule, you'll alter the Equity Value. That's why it's so difficult to make "equivalent assumptions."

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

Normally you look at the Public Comps and pick the median of the set, or something close to it. You always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples ranging from 6x to 10x.

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 developed countries, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

Nothing "happens" because you can still run the analysis as-is. The company's value will certainly decrease if one or both of these turn negative, because the present value of Free Cash Flow will decrease as a result. The analysis is not necessarily invalid even if cash flow is negative - if it turns positive after a point, it could still work. If the company never turns cash flow-positive, then you may want to skip the DCF because it will always produce negative values.

If I'm working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?

Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and Noncontrolling Interests (and any other debt-like items) to get to Equity Value. Then you divide by the company's share count (factoring in all dilutive securities) to determine the implied per-share price.

Unlevered vs. Levered Free Cash Flow

One final point: how does this calculation change if we're using Levered Free Cash Flow (Free Cash Flow to Equity) rather than Unlevered Free Cash Flow (Free Cash Flow to Firm)? The main difference is that you need to subtract interest expense and add interest income right after you calculate EBIT. So effectively, you use something closer to Net Income rather than NOPAT. And then you also need to subtract mandatory debt repayments after you subtract CapEx - so if the company must repay, at the minimum, $20 million in debt per year, that would be subtracted in the Levered FCF calculation. Projecting Levered FCF can be considerably more time-consuming because you need to know how the company's Debt and Cash balances change from year to year - so you need to track those as well. And then you need to hunt through its filings to find the required debt repayments each year. To make things even more confusing, sometimes you'll see alternate definitions for Levered FCF: some people will add additional borrowings (debt issuances) and subtract even optional debt repayments, for example.

What makes the biggest impact on DCF calculations

Overall Impact: The Discount Rate and Terminal Value tend to have the biggest impact here. Yes, if a company's revenue growth rate or margins change dramatically, those could change the DCF significantly. But even a 1% increase or decrease in the Discount Rate makes far more of an impact than a 1% increase or decrease in revenue or revenue growth or EBIT margins because that Discount Rate affects everything in the analysis. A Discount Rate difference of 1% will impact the analysis far more than a 1% increase or decrease in Terminal Value because Terminal Value is a large number and 1% is tiny. It gets trickier with questions like, "Well, what about a 10% change in revenue vs. a 1% difference in the Discount Rate?" You're better off "hedging" your answer here and saying that at a certain level, the revenue increase or decrease will make more of a difference than the new Discount Rate, but it varies greatly by company and by the specific assumptions you've made.

Cost of Equity (Formula)

Risk Free Rate + Risk Free Premium * Levered Beta

Do you use a companies targeted or current capital structure for WACC calculation

So if this comes up in interview, say, "Yes, 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."

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

Some people claim that if over 50% of a company's value comes from the present value of the Terminal Value, the DCF is too dependent on future assumptions. The problem, though, is that in practice this is true in almost all DCFs. If the present value of the Terminal Value accounts for something like 80-90%+ of the company's value, then maybe you need to re-think your assumptions.

Why do you use 5 or 10 years for the "near future" DCF projections?

That's about as far as you can reasonably predict for most companies. Less than 5 years would be too short to be useful, and more than 10 years is too difficult to project for most companies.

How do you determine a firm's Optimal Capital Structure? What does it mean?

The "optimal capital structure" is the combination of Debt, Equity, and Preferred Stock that minimizes WACC. here is no real way to determine this formulaically because you'll always find that Debt should be 100% of a company's capital structure since it's always cheaper than Equity and Preferred Stock... but that can't happen because all companies need some amount of Equity as well. Plus, taking on additional Debt will impact the Cost of Equity and the Cost of Preferred, so effectively it is a multivariable equation with no solution. You may be able to approximate the optimal structure by looking at a few different scenarios and seeing how WACC changes - but there's no mathematical solution.

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%?

The Discount Rate change will almost certainly have a bigger impact because that affects everything from the present value of Free Cash Flows to the present value of Terminal Value - and even a 10% change makes a huge impact.

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?

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 in effect it's losing some of that upside - a non-cash but very real "cost."

What's the basic concept behind a Discounted Cash Flow analysis?

The concept is that you value a company based on the present value of its Free Cash Flows far into the future. You divide the future into a "near future" period of 5-10 years and then calculate, project, discount, and add up those Free Cash Flows; and then there's also a "far future" period for everything beyond that, which you can't estimate as precisely, but which you can approximate using different approaches. You need to discount everything back to its present value because money today is worth more than money tomorrow.

What's the point of Free Cash Flow, anyway? What are you trying to do?

The idea is that you're replicating the Cash Flow Statement, but only including recurring, predictable items. And in the case of Unlevered Free Cash Flow, you also exclude the impact of Debt entirely. That's why everything in Cash Flow from Investing except for CapEx is excluded, and why the entire Cash Flow from Financing section is excluded (the only exception being Mandatory Debt Repayments for Levered FCF).

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.

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

The most common method here is to calculate Terminal Value using one method, and then to see what the implied long-term growth rate or implied multiple via the other method would be. Example: You calculate Terminal Value with a long-term growth rate assumption of 4%. Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and get an implied EBITDA multiple of 15x - but the Public Comps are only trading at a median of 8x EBITDA. In this case your assumption is almost certainly too aggressive and you should reduce that long- term growth rate.

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 one without Debt is not "at a disadvantage" - but it won't be valued as highly because of the way the WACC formula works. Keep in mind that companies do not make big decisions based financial formulas. If a company has no reason to take on Debt (e.g. it is very profitable and does not need funds to expand its business), then it won't take on Debt.

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?)

The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still calculate Terminal Value. The difference is that you do not calculate Free Cash Flow - instead, you stop at Net Income and assume that Dividends Issued are a percentage of Net Income, and then you discount those Dividends back to their present value using the Cost of Equity. Then, you add those up and add them to the present value of the Terminal Value, which you might base on a P / E multiple instead. Finally, a Dividend Discount Model gets you the company's Equity Value rather than its Enterprise Value since you're using metrics that include interest income and expense.

Can Beta ever be negative? What would that mean?

Theoretically, yes, Beta could be negative for certain assets. If Beta is -1, for example, that would mean that the asset moves in the opposite direction from the market as a whole. If the market goes up by 10%, this asset would go down by 10%. In practice, you rarely, if ever, see negative Betas with real companies. Even something labeled as "counter-cyclical" still follows the market as a whole; a "counter-cyclical" company might have a Beta of 0.5 or 0.7, but not -1.

What is the link between the Balance Sheet and the Income Statement?

There are many links between the Balance Sheet and the Income Statement. The major link is that any net income from the Income Statement, after the payment of any dividends, is added to retained earnings. In addition, debt on the Balance Sheet is used to calculate the interest expense on the Income Statement, and property plant and equipment will be used to calculate any depreciation expense.

Do you use multiples of terminal prerpiuity formula when calculating perpituity?

There is no one specific one to use you should most definetly take an average of the 2

Wait a second, would you still use Levered Beta with Unlevered Free Cash Flow? What's the deal with that?

They are different concepts (yes, the names get very confusing here). You always use Levered Beta with Cost of Equity because Debt makes the company's stock riskier for everyone involved. And you always use that same Cost of Equity number for both Levered Free Cash Flow, where Cost of Equity itself is the Discount Rate, and also for Unlevered Free Cash Flow, where Cost of Equity is a component of the Discount Rate (WACC).

What about WACC - will it be higher for a $5 billion or $500 million company?

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates, then WACC should be higher for the $500 million company for the same reasons as mentioned above. If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

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?

This is a good point, but in practice you will still multiply by (1 - Tax Rate) anyway. What matters is not whether the Debt is currently reducing the company's taxes, but whether there's potential for that to happen in the future.

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?

This is inaccurate because it excludes taxes completely. It would be better to use EBITDA - Taxes - Changes in Operating Assets and Liabilities - CapEx. If you need a very quick approximation, yes, this formula can work and it will get you closer than EBITDA by itself. But taxes are significant and should not be overlooked.

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?

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

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?

Trick question. You don't account for this at all in an Unlevered DCF because you ignore interest expense and debt principal repayments. In a Levered DCF, you factor it in by reducing the interest expense each year as the Debt goes down and also by reducing Free Cash Flow by the mandatory repayments each year. The exact impact - i.e. whether the implied Equity Value goes up or down - depends on the interest rate and the principal repayment percentage each year; however, 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.

How Valuation multiples are used for company valuation

Used as shorthand for the company's valuation

How to calculate WACC

WACC = Cost of Equity * % Equity + Cost of Debt * % Debt * (1 - Tax Rate) + Cost of Preferred Stock * % Preferred Stock.

How do you calculate WACC?

WACC = Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred) In all cases, the percentages refer to how much each component comprises of the company's capital structure. 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 and comparable debt issuances and the interest rates and yields issued by similar companies to get estimates.

Why do you have to un-lever and re-lever Beta when you calculate it based on the comps?

When you look up the Betas on Bloomberg (or whatever source you're using) 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 of what % debt or equity it has. To do that, we need to un-lever Beta each time. We want to find the inherent business risk that each company has, separate from the risk created by Debt. But at the end of the calculation, we need to re-lever the median Unlevered Beta of that set because we want the Beta used in the Cost of Equity calculation to reflect the total risk of our company, taking into account its capital structure this time as well.

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?

Yes, you do get Enterprise Value - but that only represents the company's "far in the future" value. Remember that in a DCF, a company's value is divided into "near future" and "far future." If you leave out the present value of Free Cash Flows in the projection period, you're saying, "For the next 5 years, this company has no value. But then at the end of year 5, the company is miraculously worth something again!" And that doesn't make sense.

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 the value based on the company's growth rate into perpetuity. The formula for Terminal Value using the Gordon Growth method: Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate). Note that with either method, you're estimating the same thing: the present value of the company's Free Cash Flows from the final year into infinity, as of the final year.

Is there a valid reason why we might sometimes project 10 years or more anyway?

You might sometimes do this if it's a cyclical industry, such as chemicals, because it may be important to show the entire cycle from low to high.

Why do you use WACC as IR for enterprise value

You multiply by (1 - Tax Rate) for Debt because interest payments are tax- deductible and so Debt will (almost) always cost a company less than Equity or Preferred Stock (Preferred Dividends are not tax-deductible). If you're using Unlevered FCF (Free Cash Flow to Firm), you use WACC as the Discount Rate because you care about all parts of the company's capital structure - Debt, Equity and Preferred - because you're calculating Enterprise Value, which includes all investors.

What is operating working capital(what are operating current assets and operating current liabilities)

You use Operating Working Capital more commonly in finance, and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt).

What is the most common type of beta and how do you get it

You use public comps beta for other companies since you are not concerned with what a companies beta is but what a companies beta will be... to do this you take a beta and unlever it to remove the risk from debt (exclude capital strcuture) Unlevered Beta = Levered Beta / (1 + (1 - Tax Rate) * (Debt / Equity Value)) Debt = outstanding debt Equity value = market cap We're removing the additional risk from Debt with this formula. The bottom part is saying, "Let's assume that this risk from Debt is directly proportional to the company's Debt / Equity ratio. But remember that interest paid on Debt is also tax-deductible, and as a result that helps reduce the risk from Debt slightly, since we save on taxes." After getting avg unlevered beta you relever to a specific company sicne you can t ignore its capital strcuture Levered Beta = Unlevered Beta * (1 + (1 - Tax Rate) * (Debt / Equity Value)) (says lets increase beta by the additional risk poised from the debt

Levered Beta Def

how volatile this stock is relative to the market as a whole

Terminal value can be calculated by

multiples or perpetuity formula

Cost of Equity Def

potential returns from just the company's common stock price and dividends, and how much it "costs" the company to issue shares (Factor in dividends paid)

Intrinsic Valuation method

the Discounted Cash Flow (DCF) Analysis is the best example

Some rules thumb for determining WACC / answering questions

• Assuming that the companies all have identical capital structures, the first two points above about Cost of Equity also apply to WACC - it's higher for smaller companies and those in emerging markets. • Additional Debt reduces WACC because Debt is less expensive than Equity. Yes, Levered Beta will go up, but the additional Debt in the WACC formula more than makes up for the increase. • Additional Preferred Stock also generally reduces WACC because Preferred Stock tends to be less expensive than Equity (Common Stock). • Higher Debt Interest Rates will increase WACC because they increase the Cost of Debt.

Some rules thumb for determining Cost of equity / answering questions

• Smaller companies generally have a higher Cost of Equity than larger companies because expected returns are higher. • Companies in emerging and fast-growing geographies and markets also tend to have a higher Cost of Equity for the same reason. • Additional Debt raises the Cost of Equity because it makes the company riskier for all investors. • Additional Equity lowers the Cost of Equity because the percentage of Debt in a company's capital structure decreases. • Using Historical vs. Calculated Beta doesn't have a predictable impact - it could go either way depending on the set of comps.

Terminal value prepituity formula =

• Terminal Value = Final Year Free Cash Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate). You must use the correct Terminal Growth Rate. It should always be very low - less than or equal to the country's GDP growth rate, the rate of inflation, or something else like that. Otherwise, eventually the company's FCF will exceed the GDP of the entire country, which wouldn't make sense.