Discounted Cash Flow Valuation/Modeling
Current Liabilities
-Accounts payable -Other short term liabilities.
What is the difference between accounts receivable and deferred revenue?
-Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. -Deferred revenue is the opposite, money that has not yet been recorded as revenue because it was collected for goods or services not yet delivered.
How do you determine which valuation methodology to use?
-Because each method has unique ability to provide useful information, you don't choose just one. The best way to determine the value of a company is to use a combination of valuation techniques. -Also depends on available information
Pros of DCF
-Closest intrinsic stock value -Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors.
Why might two companies with similar growth and profitability have different valuations?
-Competitive advantage that isn't represented in the financial statements. -Market leader in a key region -Owns uniquely valuable intellectual property
Cons of DCF
-For starters, the DCF model is only as good as its input assumptions. -DCF focuses on long-term value.
All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 billion of market cap?
-If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. -However, if the larger company has a lot of high-interest debt, it could have a higher WACC.
When would you not want to use a DCF?
-If you have a company that has very unpredictable cash flows -In this situation, you will most likely want to use a multiples or precedent transactions analysis.
Current Assets
-Inventory -Accounts receivable -Other short-term assets.
Cost of Debt
As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).
How would you value a company with cash flows of 1 million to perpetuity?
Assuming its an after tax cash flow, divide $1,000,000 by the firms WACC.
Fair Value of Equity
Enterprise Value - Debt
Reverse engineering DCF
start instead with what you do know with certainty about the stock: its current market valuation. By working backward, or reverse-engineering the DCF from its stock price, we can work out the amount of cash that the company will have to produce to justify that price.
What is Net Working Capital?
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 -An increase in net working capital is a use of cash. -A decrease in net working capital is a source of cash.
What is WACC and how do you calculate it?
WACC is the acronym for Weighted Average Cost of Capital. It is used as the discount rate in a discounted cash flow analysis to calculate the present value of a company's cash flows and terminal value. It reflects the overall cost of a company's raising new capital, which is also a representation of the riskiness of investing in the company. Mathematically, WACC is the percentage of equity in the capital structure times the cost of equity (calculated by the Capital Assets Pricing Model) plus percentage of debt in the capital structure times one minus the corporate tax rate times the cost of debt—current yield on outstanding debt—plus percentage of preferred stock in the capital structure times the cost of preferred stock if there is any preferred stock outstanding. Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred).
Operating cost
costs involved in operating a business, such as rent, utilities, insurance, and salaries
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 use formula -This is unlevered Free Cash Flow
How do you calculate a firm's terminal value?
-Terminal multiple method. Usually the Ebitda cash flow times the ebitda multiple. -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 (WACC) minus the assumed growth rate.
What is the Capital Assets Pricing Model?
-Used to calculate the cost of equity of a company -The return on equity = risk free rate + company's beta x market risk premium.
When would a company collect cash from a customer and not show it as revenue? If it isn't revenue, what is it?
-When a customer pays for a good or service to be delivered in the future. -Some examples would be annual magazine subscriptions, annual contracts on cell phone service -The revenue is not recognized until the good or service is delivered to the customer. -Until it is delivered, it is recorded as deferred revenue (liability) on the Balance Sheet.
What happens to Free Cash Flow if Net Working Capital increases?
-You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa.
Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?
All else being equal, the one without debt will have a higher WACC, because debt is "less expensive" than equity.
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 might there be multiple valuations of a single company?
Each method of valuation will generate a different value because it is based on different assumptions, different multiples, or different comparable companies and/or transactions.
Walk me through a Discounted Cash Flow model.
First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, -Project free cash flows for five to ten years. - Predict cash flow for over 5 years using perpetuity method -Once future cash flows have been projected, calculate the present value of those cash flows. -To find the present values of the cash flows (which is equal to the company's Enterprise Value), we discount them with the WACC, as follows. CF1/ (1+WAAC)^1 -The final cash flow (CFn) in the analysis will be the sum of the terminal value calculation and the 5 years present cash flow
Cost of equity
From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. (CAPM), where: Cost of Equity (Re) = Risk free rate + Beta (equity market risk premium).
How do you know if your DCF is too dependent on future assumptions?
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" but usually when the Terminal Value contributes over a certain % of the company's Enterprise Value is when you know you're too high.
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).
cost of capital
The cost of funds used for financing a business. Cost of capital depends on the mode of financing used - it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt.
Why do you project out free cash flows for the DCF model?
The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.
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.
Net Investments
To underpin growth, companies need to keep investing in capital items such as property, plants and equipment. You can calculate net investment by taking capital expenditure, disclosed in a company's statement of cash flows, and subtracting non-cash depreciation charges, found on the income statement.
All else equal, should the cost of equity be higher for a company with $100 million of market cap or a company with $100 billion of market cap?
Typically a smaller company is more risky therefore would have a higher cost of equity
Working Capital
Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, short-term financing to maintain current assets such as inventory. The faster a business expands, the more cash it will need for working capital and investment. Working capital is calculated as current assets minus current liabilities the increase in working capital is treated as a cost against free cash flow.
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 in this case - we're calculating Equity Value, not Enterprise Value.
How do you calculate Free Cash Flow?
𝐸𝐵𝐼𝑇(1 − 𝑇) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 − ∆𝑁𝑊𝐶 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 Free cash flow is the cash that flows through a company in the course year once all cash expenses have been expensed
