DCF

What impact does the mid-year convention make?

-A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower. -A formula like this: Present Value = $100 / ((1 + 10%) ^ Year#) -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. -We begin by projecting FCF for 5 or 10 years. We start with EBIT (based off of precedent margins), multiply it by (1-T) to get NOPAT, add D&A, less capex and change in NWC. -We next project a Terminal Value, using either a comparable company analysis multiple or perpetuity/Gordon growth method (Terminal growth rate, rate of econ growth/inflation (2-3%), last year (FCF * 1 + g)/WACC-g). -Next, we discount these cash flows, using the Weighted Average Cost of Capital, or WACC. -Finally, you compare this Implied Value to the company's Current Value, usually its Enterprise Value, and you'll often calculate the company's Implied Share Price so you can compare it to the Current Share Price.

Should you use the company's current capital structure or optimal capital structure to calculate WACC?

-A company's "optimal" capital structure is the one that minimizes its WACC. But there's no way to calculate it because you can't tell in advance how the Costs of Equity, Debt, and Preferred will change as the capital structure changes. -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?

-Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from whatever source you're using) they will be levered to reflect the debt already assumed by each company. -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 get that, we need to un-lever Beta each time. -But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Should 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, Cost of Equity and WACC should both 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 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 the Costs tend to be higher for smaller companies, WACC must be higher, assuming the same capital structure percentages.

What are the formulas for un-levering and re-levering Beta, and what do they mean?

-Assuming the company has only Equity and Debt: -Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 - Tax Rate)) -Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 - Tax Rate)) -If the company has Preferred Stock, you add another term for the Preferred / Equity Ratio. -You use a "1 +" in front of Debt / Equity Ratio * (1 - Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta. -And you multiply the Debt / Equity Ratio by (1 - Tax Rate) because the tax-deductibility of interest reduces the risk of Debt. -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 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 is Equity more expensive than Debt?

-Because it offers higher risk and higher potential returns. -Expected stock market returns (plus dividends) exceed the interest rates on Debt in most cases, which already makes the Cost of Equity higher. But the interest on Debt is also tax-deductible, which further reduces its cost. -In developed markets like the U.S., the average annualized stock market return is around 10- 11%. So, a company with a Beta of 1.0 will have a Cost of Equity in that range. -For the Cost of Debt to be higher, the Pre-Tax Cost would have to be ~17-18% at a 40% tax rate. Hardly any Debt has interest rates that high.

Why do you need to discount the Terminal Value back to its Present Value?

-Because the Terminal Value represents the Present Value of the company's cash flows from the very end of the explicit forecast period into perpetuity. In other words, it represents the company's value IN a future period AT a point in the future. -Valuation tells you what a company is worth TODAY, so any "future value" must always be discounted back to its Present Value. -If you did not discount the Terminal Value, you'd greatly overstate the company's Implied Value because you'd be acting as if its Year 6, 11, or 16 cash flows arrived next year

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. -Stocks are riskier and have higher potential returns than government bonds, so you take the rate of return on those government bonds, add the extra returns you could get from the stock market, and then adjust for this company's specific risk and potential returns.

You're valuing a company on April 30th , and you want to include both the stub period and the mid-year convention in your analysis. How would you change the company's Free Cash Flow, and which discount periods would you use?

-For the FCF, you would exclude everything generated between January 1st and April 30th and include only the projected FCF to be generated between April 30th and December 31st . -Since most companies report only quarterly results, you would most likely exclude the first quarter, not exactly the first 4 months. -To reflect both the stub period and the mid-year convention, you would divide the stub period of the first year by 2. And then in each year after that, you would subtract 0.5 from the "normal" discount period. -In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the "normal" stub discount period is 0.67. -You would divide that by 2 to get 0.34. You would then use that 0.34 period to discount the company's FCF from April 30th to December 31st . -The "normal" discount period of the next year would be 0.67 + 1.00, or 1.67. So, you would take the 1.67 and subtract 0.50 to get 1.17. -For the next year after that, the "normal" discount period is 0.67 + 2.00, or 2.67, so you would subtract 0.50 to get 2.17. You would continue that for the rest of the years in the forecast.

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

-For the most part, no. You certainly shouldn't make speculative projections for these items - they are all non-recurring. -If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year. -And if it's an acquisition or divestiture, you'll have to adjust FCF to reflect the cash spent or received, and you'll have to change the company's cash flow after the deal takes place.

How do convertible bonds factor into the WACC calculation?

-If the company's current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula. -But if the bonds are not currently convertible, you count them as Debt and use the coupon rate (or YTM, or another method) to calculate their Cost. -Convertible bonds offer lower coupon rates than standard corporate bonds, so you should use the rate on equivalent, non-convertible bonds. -Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt is lower than the Cost of Equity.

How can the terminal value be sanity-checked if the exit multiple approach was used?

-If the exit multiples approach was used to calculate the terminal value, it's important to cross-check the amount by backing out into an implied growth rate to confirm it's reasonable. -Implied g = (Terminal Value × r - FCF Final Year )/ (Terminal Value + FCF Final Year ) -Likewise, the implied exit multiple can be calculated from the perpetuity growth rate. -Implied TV Exit Multiple = Terminal Value Perpetuity Method/EBITDA Final Year

What's the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

-If you include an income or expense line item in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you exclude). -For example, if you capitalize the company's operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher. -This rule also explains why you factor in Cash and Debt when moving to the Implied Equity Value in an Unlevered DCF: You've excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?

-If you're building a Levered DCF analysis, you're almost done because this summation gives you the company's Implied Equity Value. The last step is to divide the company's Implied Equity Value by its diluted share count to get its Implied Share Price (if the company is public). -In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows equals the company's Implied Enterprise Value, so you have to "back into" the Implied Equity Value and then calculate its Implied Share Price. -You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting Liability and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling Interests, etc.). -Then, you divide by the company's diluted share count to get its Implied Share Price.

How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from the Unlevered DCF?

-In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E. -You don't back into Implied Equity Value at the end because the analysis produces the Implied Equity Value directly. -An APV Analysis is similar to a traditional Unlevered DCF, but you value the company's Interest Tax Shield separately and add the Present Value of this Tax Shield at the end. -You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median Unlevered Beta from Public Comps). -You then project the Interest Tax Shield each year, discount it at that same Discount Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.

Why would you use Gordon Growth 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 much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contrast, is always a shot in the dark. -However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Should you reflect 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 reflect inflation, then 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, extra work, and extra explanations required.

The diluted share count includes dilution from the company's in-the-money options. But what about its out-of-the-money options? Shouldn't you account for them in a DCF?

-In theory, yes. Some professors, such as Damodaran, use Black-Scholes to value these out-ofthe-money options and then subtract them to determine the company's Implied Equity Value. -In practice, banks rarely include out-of-the-money options in a DCF. These options tend to make a small impact on most companies, and options valuation is tricky and requires inputs that you may or may not have. So, it is usually not worth the time and effort.

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?

-In this scenario, you would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow. -The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) - the "4" just represents year 4 here. Then you would subtract this amount from the Enterprise Value.

Continuing with the same example, how would the Terminal Value and PV of Terminal Value change with this April 30th valuation?

-It depends on how you calculate the Terminal Value. With the Multiples Method, the Terminal Value calculation stays the same since it's based on the company's EBITDA (or another metric) in the final projected year times an appropriate multiple. -When you discount the Terminal Value, the stub period affects the discount period, but the mid-year convention does not because the Terminal Value is as of the END of the last projected year. -So, if the valuation date is April 30th , and there are 10 years in the projection period, you would use 9.67 for the discount period to calculate the PV of the Terminal Value. -With the Gordon Growth Method, if you're using the mid-year convention, you must adjust the Terminal Value by multiplying it by (1 + Discount Rate) ^ 0.5. -You do this because the normal formula - FCF in Year 1 of Terminal Period / (Discount Rate - Terminal Growth Rate) - gives you the Present Value at Year 10.5 if you're using the mid-year convention. -When you multiply by (1 + Discount Rate) ^ 0.5, you "move back the Terminal Value" to Year 10.0 instead. -Discounting the Terminal Value works the same way as it does with the Multiples Method: Only the stub period affects it. So, you would also use 9.67 for the discount period.

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 still 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 does the Cost of Equity mean intuitively?

-It tells you the average percentage a company's stock "should" return each year, over the very long term, factoring in both stock-price appreciation and dividends. -In a valuation, it represents the percentage an Equity investor might earn each year (averaged over decades). -To a company, the Cost of Equity represents the cost of funding its operations by issuing additional shares to investors. -The company "pays for" Equity via potential Dividends (a real cash expense) and also by diluting existing investors (thereby giving up stock-price appreciation potential).

How can you check whether or not your Terminal Value estimate is reasonable?

-It's an iterative process: 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, then you adjust the range of Terminal Multiples or Terminal FCF Growth Rates until you get more reasonable results. -Example: You start by picking 10x EV / EBITDA for the Terminal Multiple. At a Discount Rate of 12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high. -So, you reduce it to 6x EV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to 1%, which is too low. -So, you guess 8x EV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more reasonable since it's below the expected long-term GDP growth rate, but it's also slightly above the inflation rate. -This 8x figure might be your "Baseline Terminal Multiple," so you would start there and go slightly above and below it in the sensitivity tables.

Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase the Discount Rate from 9% to 10%?

-It's harder to tell here. Doubling a company's revenue growth could make a bigger impact than changing the Discount Rate by 1%, but when the changes are this different, you'd have to run the numbers to tell. -These operational changes make a bigger impact in longer projection periods than they do in shorter ones, so you would see more of a difference in a 10-year DCF than a 5-year one.

How should CapEx and Depreciation change within the explicit forecast period?

-Just like the company's Free Cash Flow growth rate should decline in the explicit forecast period, the company's CapEx and Depreciation should also decline. -High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from "growth" to "maintenance." -If the company's FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end. -Also, if the company's FCF is growing, CapEx should not equal Depreciation - even in the Terminal Period. -That's partially due to inflation (capital assets purchased 5-10 years ago cost less), and partially because Net PP&E must keep growing to support FCF Growth in the Terminal Period. -If you're assuming that the company's FCF stagnates or declines, then you might use different assumptions.

What does Beta mean intuitively?

-Levered Beta tells you how volatile a company's stock price is relative to the stock market as a whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt). -If Beta is 1.0, when the market goes up 10%, this company's stock price also goes up by 10%. -If Beta is 2.0, when the market goes up 10%, this company's stock price goes up by 20%. -Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it's always less than or equal to Levered Beta.

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions?

-Neither one - you just use them as starting points in the analysis, and then you adjust once you've calculated the Terminal FCF Growth Rates implied by the selected multiples. -It's better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don't want to reflect the control premium inherent in Precedent Transactions, at least not if you're completing a standalone valuation of the company. -Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, adjust it up or down as necessary.

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It's a noncash add-back on the Cash Flow Statement.

-No! You should consider SBC a cash expense in the context of valuation because it creates additional shares and dilutes the existing investors. -By contrast, Depreciation & Amortization relate to timing differences: The company paid for a capital asset earlier on but recognizes that payment over many years. -Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context is different: Accounting rather than valuation. -In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back, you should reflect the additional shares by increasing the company's diluted share count, which will reduce the Implied Share Price. -Most DCFs get this completely wrong because they use neither approach: They pretend that SBC is a normal non-cash charge that makes no impact on the share count (wrong!).

When you discount the Terminal Value, why do you use the number of the last year in the forecast period for the discount period (for example, 10 for a 10-year forecast)? Shouldn't you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?

-No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it's the Present Value as of the very end of Year 10. -You would use 11 for the discount period only if your explicit forecast period went to Year 11 and the Terminal Period started in Year 12.

Will you get the same results from an Unlevered DCF and a Levered DCF?

-No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on the company's Debt, while the Levered DCF does. - -That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes in Debt principal) will also contribute; it's very difficult to pick "equivalent assumptions" in both analyses.

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

-Normally you look at the Comparable Companies and pick the median of the set, or something close to it. -As with almost anything else in finance, 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 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 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.

If I'm working with a public company in a DCF, how do I calculate its per-share value?

-Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock, and minority interest (and any other debt-like items) to get to Equity Value. -Then, you need to use a circular calculation that takes into account the basic shares outstanding, options, warrants, convertibles, and other dilutive securities. It's circular because the dilution from these depends on the per-share price - but the per-share price depends on number of shares outstanding, which depends on the per-share price. -To resolve this, you need to enable iterative calculations in Excel so that it can cycle through to find an approximate per-share price.

What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?

-One option is to take the Risk-Free Rate in a country that is "risk-free," like the U.S. or U.K., and then add a default spread based on your country's credit rating. -For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a spread of 11.2% for Greece based on its current credit rating. -That rate of 13.7% represents how yields are much higher in Greece due to the significant chance of government default.

How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?

-Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity. -That's because the coupon rates on Preferred Stock tend to be higher than the rates on Debt, and Preferred Dividends are not tax-deductible. -But these rates are still lower than expected stock market returns. The risk is also lower since Preferred Stock investors have a higher claim on the company's Assets than Equity investors.

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 do use historical data, you could use the company's Historical Beta or the re-levered Beta based on 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, and you always use a range of values when calculating Cost of Equity and WACC.

Should you use Total Debt or Net Debt to determine the capital structure percentages in the WACC calculation?

-Some textbooks claim that you should use Equity Value + Debt + Preferred Stock - Cash, rather than Equity Value + Debt + Preferred Stock, for the denominator of the capital structure percentages. -However, we disagree with this approach for several reasons: 1) Cash Does Not "Offset" Debt - For example, many forms of Debt do not allow for early repayment or penalize the company for early repayment. So, a high Cash balance doesn't necessarily reduce the risk of Debt on a 1:1 basis. 2) You May Get Nonsensical Results with High Cash Balances - For example, if the company's Cash exceeds its Debt, Debt as a Percentage of Total Capital will be far too low. This will artificially inflate the Discount Rate since Equity is more expensive than Debt for most companies.

How do you calculate the Equity Risk Premium?

-Stock-market returns differ based on the period and whether you use an arithmetic mean, a geometric mean, or other approaches, so there's no universal method. -Many firms use a publication called "Ibbotson's" that publishes Equity Risk Premium data for companies of different sizes in different industries each year; some academic sources also track and report this data. -You could also take the historical data for the U.S. stock market and add a premium based on the default spread of your country/market. -For example, if the historical U.S. premium is 7%, you might add 3% to it if your country's credit rating is Ba2, and that rating corresponds to a 3% spread. -Finally, some groups use a "standard number" for each market, such as 5-6% in developed countries.

Walk me through 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. -Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You might want to confirm that this is what the interviewer is asking for.

What impact does the Normalized Terminal Year make?

-Technically, it could go either way, but in most cases, the Normalized Terminal Year will reduce a company's Implied Value because you often adjust down the company's growth rates and margins in this year (and remove non-cash adjustments that might have benefited the company in previous periods).

How do you know if your DCF is too dependent on future assumptions?

-The "standard" answer: if significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. -In reality, almost all DCFs are "too dependent on future assumptions" - it's actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value. -But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions...

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company's business model?

-The Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth. -It's related to whether a company records expenses and revenue before or after paying or collecting them in cash. -For example, retailers tend to have negative values for the Change in Working Capital because they must pay for Inventory upfront before they can sell products. -But subscription-based software companies often have positive values for the Change in Working Capital because they collect cash from long-term subscriptions upfront and recognize it as revenue over time. -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.

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

-The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors. -As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt. -However, the exact impact depends on where you are on that curve. If the company already has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt, WACC is more likely to decrease with more Debt.

How do those figures change as the company uses less Debt?

-The Cost of Equity and Cost of Debt decrease for the reasons stated above: Less Debt means a lower risk of bankruptcy and, therefore, less risk for all investors. -WACC could go either way depending on where you are on the curve. If the company already has a very high level of Debt, WACC will likely decrease with less Debt; if its Debt level is much lower, WACC will likely increase with less Debt.

Which assumptions make the biggest impact on a DCF?

-The Discount Rate and Terminal Value make the biggest impact on the DCF. -That's because the Discount Rate affects the PV of everything and because the PV of the Terminal Value often represents 50%+ of the company's Implied Value. -The assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above. Other items, such as CapEx, Working Capital, and non-cash adjustments, make a smaller impact.

What does the Discount Rate mean?

-The Discount Rate represents the opportunity cost for the investors - what they could earn by investing in other, similar companies in this industry. -A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate means lower risk and lower potential returns. -A higher Discount Rate makes a company less valuable because it means the investors have better options elsewhere; a lower Discount Rate makes a company more valuable.

What's one problem with using EV / EBITDA multiples to calculate Terminal Value?

-The biggest issue is that EBITDA ignores CapEx. Two companies with similar EV / 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 EV / EBITDA multiples. -You may get better results by using EV / EBIT, EV / NOPAT, or EV / 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.

For forecasting purposes, do you use the effective or marginal tax rate?

-The choice between whether to use the effective or marginal tax rate boils down to one specific assumption found in valuation methods such as the DCF: the tax rate assumption used will be the tax rate paid into perpetuity. In most cases, the effective tax rate will be lower than the marginal tax rate, mainly because many companies will defer paying the government. -Hence, line items such as deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are created. If you use the effective tax rate, you implicitly assume this deferral of taxes to be a recurring line item forever. But this would be inaccurate since DTAs and DTLs unwind, and the balance eventually becomes zero. -The recommended approach is to look at the historical periods (i.e., past 3-5 years) and base your near-term tax rate assumptions on the effective tax rate. But by the time the 2nd stage of the DCF is approaching, the tax rate should be "normalized" and be within close range of the marginal tax rate.

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

-The company's Free Cash Flow Growth Rate, and possibly its Discount Rate, change over time in the explicit forecast period since the company is still growing and changing. -But in the Terminal Period, you assume that the company remains in a "steady state" forever: Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

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. -So, it doesn't matter which rate you use as long as the cash taxes are correct. -For example, you could use the company's effective tax rate (Income Statement Taxes / Pre-Tax Income), and then include Deferred Taxes within the non-cash adjustments. -Or you could calculate and use the company's "cash tax rate" and skip the Deferred Tax adjustments. -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 Deferred Taxes based on historical trends.

How do you calculate WACC, and what makes it tricky?

-The formula for WACC is simple: -WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock -But it's tricky to calculate because of the ambiguity with many of these items: 1. Cost of Debt: Do you use the weighted average coupon rate on the company's bonds? Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies? 2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company's current capital structure, "optimal" structure, or targeted structure? Or do you use the median percentages from the comparable public companies? 3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the Equity Risk Premium

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

-The mechanics are the same as a DCF, but we use dividends rather than free cash flows: 1. Project out the company's earnings, down to earnings per share (EPS). 2. Assume a dividend payout ratio - what percentage of the EPS actually gets paid out to shareholders in the form of dividends - based on what the firm has done historically and how much regulatory capital it needs. 3. Use this to calculate dividends over the next 5-10 years. 4. Discount each dividend to its present value based on Cost of Equity - NOT WACC - and then sum these up. 5. Calculate terminal value based on P / E and EPS in the final year, and then discount this to its present value based on Cost of Equity. 6. Sum the present value of the terminal value and the present values of the dividends to get the company's net present per-share value

What's the flaw with basing terminal multiples on what public company comparables are trading at?

-The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range. -This method is particularly problematic with cyclical industries (e.g. semiconductors).

What are some signs that you might be using the incorrect assumptions in a DCF?

-The most common signs of trouble are: 1. Too Much Value from the PV of Terminal Value - It usually accounts for at least 50% of the company's total Implied Value, but it shouldn't account for, say, 95% of its value. 2. Implied Terminal Growth Rates or Terminal Multiples That Don't Make Sense - If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country's long-term GDP growth rate is 3%, something is wrong. 3. You're Double-Counting Items - If an income or expense line item is included in FCF, you should not count the corresponding Asset or Liability in the Implied Enterprise Value Implied Equity Value "bridge" at the end. And if a line item is excluded from FCF, you should count the corresponding Asset or Liability in the "bridge" at the end. 4. Mismatched Final Year FCF Growth Rate and Terminal Growth Rate - If the company's Free Cash Flow is growing at 15% in the final year, but you've assumed a 2% Terminal Growth Rate, something is wrong. FCF growth should decline over time and approach the Terminal Growth Rate by the end of the explicit forecast period.

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?

-The rule is that you divide the stub discount period by 2, and then you simply subtract 0.5 from the "normal" discount periods for the future years. -Example for a Q4 stub: Q4 Year 1 Year 2 Year 3 Year 4 Year 5 Normal Discount Periods with Stub: 0.25 1.25 2.25 3.25 4.25 5.25 Mid-Year Discount Periods with Stub: 0.125 0.75 1.75 2.75 3.75 4.75

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 revenue growth and margin figures. -It doesn't make sense to sensitize much else - the assumptions for CapEx and 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.

If your DCF seems off, what are the easiest ways to fix it?

-The simplest method is to extend the explicit forecast period so that the company's Free Cash Flow contributes more value, and so that there's more time for FCF growth to slow down and approach the Terminal Growth Rate. -So, if you're using a 5-year forecast period, extend it to 10-15 years and reduce the company's FCF growth in those extra years as it approaches maturity. -To avoid double-counting items... look at what you're doing and don't double count! -Finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower Terminal Multiple. Terminal Value tends to be overstated in financial models because people don't understand the theory behind it.

How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

-The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rate doesn't matter because there's no tax benefit to interest paid on 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 rate always 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. And if both of these are lower, WACC will also be lower. -However, the Implied Value from a DCF will also be lower because the higher tax rate reduces FCF and the company's Terminal Value. Those 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.

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

-The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results than the other methods. -With the other methods, you have to project the company's Cash and Debt balances, Net Interest Expense, and changes in Debt principal, all of which require more time and effort. -The Levered DCF sometimes produces odd results because Debt principal repayments can spike the Levered FCF up or down in individual years. -The APV Analysis is flawed because it doesn't factor in the main downside of Debt: Increased chances of bankruptcy. You can try to reflect this risk, but no one agrees on how to estimate it numerically. -The Unlevered DCF solves this issue because WACC decreases with additional Debt, at first, but then starts increasing past a certain level, which reflects both the advantages and disadvantages of Debt.=

What's the intuition behind the Gordon Growth formula for Terminal Value?

-The typical formula is: -Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate) -But it's more intuitive to think of it as: -Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate - Terminal FCF Growth Rate) -A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher. -For example, let's say the company's FCF is not growing, and its Discount Rate is 10%. It has $100 in FCF in the first year of the Terminal Period. -You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the Discount Rate falls to 5%, now you'd pay $100 / 5%, or $2,000. If it increases to 20%, you'd pay $100 / 20%, or $500. -The company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere. - Now let's say the company's FCF is growing. If it grows by 3% per year, you'd be willing to pay $100 / (10% - 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you'd be willing to pay $100 / (10% - 5%), or $2,000, for it -Higher growth lets you achieve the same targeted return even when you pay more.

How does the Pension Expense factor into Free Cash Flow?

-There are different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments. -The Service Cost is an operating expense and should always be included in the company's Free Cash Flow. -In an Unlevered DCF, you exclude the Interest Expense, Expected Return on Plan Assets, and Amortization of Net Losses or Gains, and then subtract the Unfunded portion of the Pension Obligation when moving from Implied Enterprise Value to Implied Equity Value. -Some companies embed these items within Operating Expenses on the Income Statement, so you may have to review the filings to calculate EBIT properly. -If company contributions into the pension plan are tax-deductible (varies by country), you have to multiply the Unfunded Pension by (1 - Tax Rate) as well.

How can we calculate Cost of Equity WITHOUT using CAPM?

-There is an alternate formula: -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 for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

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 the rates a company would pay if it issued additional Debt or additional Preferred Stock. -There is no way to observe these rates 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. -You could also use the Yield to Maturity (YTM), which reflects the market prices of the bonds (a bond with a coupon rate of 5% that's trading at a discount to par value will have a YTM higher than 5%). -Finally, you could also take the Risk-Free Rate and add a default spread based on the company's expected credit rating if it issues more Debt or Preferred Stock. If you think its credit

How should operating leases be treated in a DCF valuation?

-They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar to debt obligations than to a simple expense (i.e., tenants should present the lease obligation as a liability on their balance sheet as they do for long-term debt). In fact, the option to account for leases as an operating lease was eliminated starting in 2019 for that reason. -Therefore, when operating leases are significant for a business (retailers and capital-intensive businesses), the rent expense should be ignored from the free cash flow build-up, and instead, the present value of the lease obligation should be reflected as part of net debt.

WACC reflects the company's entire capital structure, so why do you pair it with Unlevered FCF? It's not capital structure-neutral!

-Think of Unlevered FCF as "Free Cash Flow to Firm," or FCFF, instead. -And think of this relationship as: "Unlevered FCF, or FCFF, is available to ALL investors, and WACC represents ALL investors. Therefore, you pair WACC with Unlevered FCF." -No Discount Rate can be "capital structure-neutral" since each part of a company's capital structure affects the other parts. -"Capital-structure neutrality" is a property of Free Cash Flow, not the Discount Rate.

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?

-This growth rate should be below the country's long-term GDP growth rate and in-line with other macroeconomic variables like the rate of inflation. -For example, if you're in a developed country where the expected long-term GDP growth rate is 3.0%, you might use numbers ranging from 1.5% to 2.5% for the range of Terminal Growth Rates. -You should NOT pick a rate above the country's long-term GDP growth rate because the company will become bigger than the economy as a whole after a certain point! -You can then check your work by calculating the Terminal Multiples implied by these growth rates.

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 and such, 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.

Two companies produce identical total Free Cash Flows over a 10-year period, 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 in every year. Which company will have the higher Implied Value in a DCF?

-This is a trick question because it depends on what you count toward the Implied Value. If it's just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: The cash flows arrive earlier, so they're worth more. -However, Company B will almost certainly have a much higher Terminal Value because it has a much higher FCF in Year 10. -So, if you count the PV of Terminal Value in the analysis, it's a good bet that Company B will have the higher Implied Value.

Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?

-This is tricky - the one without debt will have a higher WACC up to a certain point, because debt is "less expensive" than equity. Why? • Interest on debt is tax-deductible (hence the (1 - Tax Rate) multiplication in the WACC formula). • Debt is senior to equity in a company's capital structure - debt holders would be paid first in a liquidation or bankruptcy. • Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will. -However, the above is true only to a certain point. Once a company's debt goes up high enough, the interest rate will rise dramatically to reflect the additional risk and so the Cost of Debt would start to increase - if it gets high enough, it might become higher than Cost of Equity and additional debt would increase WACC. -It's a "U-shape" curve where debt decreases WACC to a point, then starts increasing it.

How would you estimate the Cost of Equity for a U.S.-based technology company?

-This question tests your ability to make a guesstimate based on common sense and your knowledge of current market rates. -You might say, "The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So, if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%." -The numbers will change based on market conditions, but that's the idea.

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?

-Trick question. You don't account for this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement - but we only go down to Cash Flow from Operations and then subtract Capital Expenditures to get to Free Cash Flow. -If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off - but we still wouldn't count the principal repayments themselves anywhere.

Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?

-Unlevered FCF must capture the company's core, recurring line items that are available to ALL investor groups. -That's because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company's core business available to all investor groups. -So, if an item is NOT recurring, NOT related to the company's core business, or NOT available to all investor groups, you leave it out. -This rule explains why you exclude all of the following items: • Net Interest Expense - Only available to Debt investors. • Other Income / (Expense) - Corresponds to non-core-business Assets. • Most non-cash adjustments besides D&A - They're non-recurring. • All Items in Cash Flow from Financing - They're only available to certain investors. • Most of Cash Flow from Investing - Only CapEx is a recurring, core-business item.

What does WACC mean intuitively?

-WACC is similar to Cost of Equity, but it's the expected annual return if you invest proportionately in all parts of the company's capital structure - Debt, Equity, Preferred Stock, and anything else it has. -To a company, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time. -Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

What is WACC and how do you calculate it?

-WACC is the weighted average cost of capital, and it is the discount rate used in the DCF calculations. It takes into consideration the capital structure of the business, and is the expected return on the business. -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.

How does the terminal value calculation change when we use the mid-year convention?

-When you're discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or Gordon Growth Method: • Multiples Method: -You add 0.5 to the final year discount number to reflect the fact that you're assuming the company gets sold at the end of the year. • Gordon Growth Method: You use the final year discount number as is, because you're assuming the cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end.

Does a DCF ever make sense for a company with negative cash flows?

-Yes, it may. 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 it starts generating positive cash flows in the future. -If the company has no path to positive cash flows, or you can't reasonably forecast its cash flows, then the analysis doesn't make sense.

Could Beta ever be negative?

-Yes, it's possible. The company's stock price must move in the opposite direction of the entire market for Beta to be negative. -Gold is commonly cited as an Asset that has a negative Beta because it often performs better when the stock market declines, and it acts as a "hedge" against disastrous macroeconomic events. -However, negative Betas for companies are quite rare and usually revert to positive figures, even if they're negative for short periods.

Should you ever use *different* Discount Rates for different years in a DCF?

-Yes, sometimes it makes sense to use different Discount Rates. -For example, if a company is growing quickly right now, but is expected to grow more slowly in the future, you might decrease the Discount Rate each year until the company reaches maturity. -So, if the company's current WACC is between 11% and 13%, and WACC for mature companies in the industry is between 8% and 9%, you might start it at 12% and then reduce it by 0.4% in each year of the explicit forecast period until it reaches 8.4% by the end. -It makes less sense to do this if the company is already mature and is not expected to change much over time.

In those formulas, you're not factoring in the interest rate on Debt. Isn't that wrong? More expensive Debt should be riskier.

-Yes, this is one drawback. However: 1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with high Debt / Equity ratios tend to pay higher interest rates as well. 2. The risk isn't directly proportional to interest rates. Higher interest on Debt will result in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it's not as simple as saying, "Interest is now 4% rather than 1% - risk is 4x higher." -An interest rate that's 4x higher might barely change a large company's financial profile, but it might make a much bigger difference for a small company

Why do you need to adjust the Terminal Value when you use the mid-year convention? Can't you just discount it to Present Value using a different discount period?

-Yes, you could discount the Terminal Value to its Present Value by using a different discount period instead. -However, the Terminal Values calculated via both methods should be directly comparable. -In other words, BOTH Terminal Values should be as of the end of Year 10 in a 10-year analysis. -If you do not adjust the Terminal Value produced by the Gordon Growth Method, and you're using the mid-year convention, you cannot compare it to the Terminal Value produced by the Multiples Method because one TV is as of Year 10.0, and the other is as of Year 10.5.

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, you might assume that the company's cash flows eventually decline to $0. -A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually. -It doesn't make the company "worthless"; it just means that the company will be worth less.

Do you still un-lever and re-lever Beta even when you're using Unlevered FCF?

-Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF. -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.

Why do you build a DCF analysis to value a company?

-You build a DCF analysis because a company is worth the Present Value of its expected future cash flows: -Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate -But you can't just use that single formula because a company's Cash Flow Growth Rate and Discount Rate change over time. -So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period). -You then project the company's cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s). -Then, you compare this sum - the company's Implied Value - to the company's Current Value or "Asking Price" to see if it's valued appropriately.

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). -If you use the Multiples Method, it's easy to pick a multiple that makes no logical sense because it implies a growth rate that's too high. -However, many bankers still use and prefer the Multiples Method because it's "easier" or because they don't understand the need to cross-check the output.

What should you do if you don't believe management's projections for a DCF model?

-You can take a few different approaches: • You can create your own projections. • You can modify management's projections downward to make them more conservative. • You can show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of numbers. -In reality, you'd probably do all of these if you had unrealistic projections.

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 Net Operating Losses (NOLs) factor into Free Cash Flow?

-You could set up an NOL schedule and apply the NOLs to reduce the company's cash taxes, also factoring in NOL accruals if the company earns negative Pre-Tax Income. -If you do this, then you don't need to count the NOLs in the Implied Enterprise Value -> Implied Equity Value calculation at the end. -However, it's far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end. -Beyond the extra work, one problem with the first approach is that the company may not use all of its NOLs by the end of the explicit forecast period!

Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?

-You don't "have to" un-lever and re-lever Beta: You could just use the company's historical Beta, i.e., its own Levered Beta, and skip this step. -But in a valuation, you're estimating the company's Implied Value - what it should be worth. -The historical Beta corresponds more closely to the company's Current Value - what the market says it's worth today. -By un-levering Beta for each comparable company, you isolate each company's inherent business risk. -Each company might have a different capital structure, so it's important to remove the risk from leverage and isolate just the inherent business risk. -You then take the median Unlevered Beta from these companies and re-lever it based on the capital structure (targeted or actual) of the company you're valuing. -You do this because there will always be business risk and risk from leverage, so you need to reflect both for the company you're valuing. -You can think of the result - Re-Levered Beta - as: "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."

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)))

Why might you create a "Normalized Terminal Year" in a DCF?

-You might create a Normalized Terminal Year if something about the company's revenue growth, margins, Working Capital, or CapEx is expected to change in a major way in the Terminal Period. -As a result of this change, multiplying Final Year FCF by (1 + Terminal FCF Growth Rate) won't produce accurate results in the Terminal Value formula. -For example, a key drug patent might expire in Year 9 or 10, or the company might have a huge Intangibles balance that gets completely amortized in Year 10. -The first scenario would make a huge impact on the company's revenue, growth rates, and margins, and the second would affect the company's margins and non-cash add-backs. -You use the FCF in this Normalized Year for the numerator in the Terminal Value calculation rather than multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).

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 exclude these previously reported results and adjust the discount periods as well. -For example, maybe it's September 30th , and the company's fiscal year ends on December 31st . -The company's future cash flow for this year will be generated between September 30th and December 31st . -Therefore, you should exclude the cash flow from January 1st to September 30th in your projections since that part of the year has already passed. -So, for the first year in the analysis, you would include only the projected FCF from September 30th to December 31st. To discount the FCF in that 3-month period, you would use 0.25 for the discount period because 3 months is 25% of the year. -You would then use 1.25 for the discount period of the next year, 2.25 for the year after that, and so on.

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

-You might take the percentage revenue earned in each country, multiply it by the ERP in that market, and then add up everything to get the weighted average ERP. -To calculate the ERP in each market, you might use one of the methods described in the previous question. The "Historical U.S. stock market returns + default spread" approach is common here.

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

-You should use the rate on the government bonds denominated in the currency of the company's cash flows. -So, if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if it reports them in EUR or GBP, you might use the rate on 10-year bonds issued by the European Central Bank or the Bank of England.

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 a better approximation of real life.

Explain why we would use the mid-year convention in a DCF.

-You use it to represent the fact that a company's cash flow does not come 100% at the end of each year - instead, it comes in evenly throughout each year. -In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on. -With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.

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 Unlevered FCF, but you will still reflect it in the analysis with the Discount Rate - WACC will change as the company's Debt and Equity levels change.

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.

How would you calculate the discount rate for an all equity firm?

Capital Assets Pricing Model (CAPM), as it is 100% equity.

What types of sensitivity analyses would we look at in a DCF?

Example sensitivities: • Revenue Growth vs. Terminal Multiple • EBITDA Margin vs. Terminal Multiple • Terminal Multiple vs. Discount Rate • Long-Term Growth Rate vs. Discount Rate And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).

How do you calculate FCF?

FCF = EBIT(1-T) + Depreciation - Capex - Change in Net Working Capital

What about a 1% change in revenue vs. a 1% change in the discount rate?

In this case the discount rate is likely to have a bigger impact on the valuation, though the correct answer should start with, "It could go either way, but most of the time..."

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.

Which method of calculating Terminal Value will give you a higher valuation?

It's hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

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.

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.

What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Take Cash Flow From Operations and subtract CapEx - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

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.

What is the capital assets pricing model?

The Capital Assets Pricing Model, referred to as CAPM, is used to calculate the required return on equity or the cost of equity. The return on equity is equal to the risk free rate (usually the yield on a 10-year U.S. government bond) plus the company's beta (a measure of the stock's volatility in relation to the stock market) times the market risk premium. Ke = Rf + B (Rm - Rf).

. 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?

The Discount Rate increase will make a bigger impact. Increasing revenue growth from 9% to 10% will barely impact FCF and Terminal Value, but the Discount Rate will affect the Present Value of everything, and 9% vs. 10% is a significant difference.

Why do you project out free cash flows for the DCF model?

The free cash flow is the money that can hypothetically be paid out to lenders and investors from the earnings of the company. It's basically the actual cash left over for shareholders.

How do you calculate a firm's terminal value?

There are two ways to calculate terminal value. The first is the terminal multiple method. To use this method, you choose an operation metric (most commonly EBITDA) and apply a comparable company's multiple to that number from the final year of projections. The second method is the perpetuity growth method where you choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You then multiply the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate.

What happens to FCF if NWC increases?

There will be a decrease in FCF. For example accounts receivable could increase from one period to the other (if all else equal, the NWC increases), which is actually a decrease in cash flow.

How do you calculate WACC for a private company?

This is problematic because private companies don't have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

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?

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.

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?

Trick question. If the convertible debt is in-the-money then you do not count it as debt but instead assume that it contributes to dilution, so the company's Equity Value is higher. If it's out-of-the-money then you count it as debt and use the interest rate on the convertible for Cost of Debt.

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.

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with Debt or Preferred Stock in this case - we're calculating Equity Value, not Enterprise Value.