Discounted Cash Flow Model Exam
A DCF values a company based on: - ANSWER The present value of its cash flows
and the present value of its terminal value.
Walk me through a DCF - ANSWER First, you project out the company's financials
using assumptions for revenue growth, expenses and working capital. Then you get
FCF for each year which you sum up and discount to a NPV based on your discount
rate, usually the WACC. Then you determine the company's terminal value using
either the multiples method or the Gordon Growth Method and dicount that back to
NPV using WACC. Add the two together to get the estimated EV.
How do you get from revenue to FCF? - ANSWER Revenue-COGS-Operating
Expenses to get to EBIT. Then multiply by (1-Tax Rate), add back Depreciation and
other non-cash charges and subtract CAPEX and the change in Working Capital.
(This is unlevered FCF since we went off of EBIT rather than EBT).
What is an alternate way to calculate FCF aside from taking NI, adding DEP and
subtracting CAPEX? - ANSWER Take CF from operations and subtract CAPEX to
get levered CF. To get unlevered you need to add back the tax adjusted interest
expense and subtract tax adjusted interest income.
Why do you use 5 or 10 years for a DCF? - ANSWER Anything beyond 10 years is
too difficult to predict for most companies.
What do you usually use for the discount rate? - ANSWER WACC, although you
could use Cost of Equity.
How do you calculate WACC? - ANSWER Cost of Equity *% of capital structure
composed of equity+ cost of debt* % of capital structure composed of debt*(1-tax
rate) + cost of preferred*% of capital structure composed of preferred
How do you calculate cost of equity - ANSWER Use the Capital Asset Pricing
Model = Risk free rate +beta *Equity risk premium
What is the Risk free rate - ANSWER Typically the yield on 10 or 20 year T-bond
What is risk premiuim - ANSWER The % by which stocks are expected to out-
perform risk-less assets
How do you get Beta in the Cost of Equity calculation? - ANSWER Unlevered beta=
levered beta/(1+(1-tax rate)*(total debt/total equity)
Levered Beta= unlevered beta*(1+(1-Tax rate)*(total debt/total equity)
Why do you have to un-lever and re-lever beta? - ANSWER Levered beta reflects
the debt already assumed by each company but since each company's capital
structure is different and if we want to see how risky the company is regardless of
, debt structure then we must un-lever the beta. In the end beta will be re-levered
because we want the cost of equity to reflect the true risk
Which would you expect to have a higher beta a tech company or a manufacturing
company? - ANSWER A technology company because the technology industry is
seen as riskier then the manufacturing industry
What is the effect of using levered cash flow vs unlevered cash flow in your DCF? -
ANSWER Levered 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 interest payments)
If you use levered FCF what should you use as the discount rate? - ANSWER You
would use the cost of equity rather than the WACC since we are not concerned with
the debt or preferred stock in this case
How do you calculate terminal value? - ANSWER You can either use the multiples
method in which you apply an exit multiple to the company's year 5 EBITDA, EBIT or
FCF or you can use the Gordon Growth method to estimate its value based on its
growth rate into perpetuity
Gordon Growth Method equation: - ANSWER Terminal value= year 5
FCF*(1+growth rate)/(discount rate- growth rate)
Why would you use the Gordon Method over the multiples method - ANSWER In
banking, you almost always use the multiples method as it is much easier to get data
on exit multiples since they are based on comparable companies.Picking a long term
growth rate is always a shot in the dark. You might use the GGM if you have no good
comparables.
What is an appropriate growth rate to use for terminal value - ANSWER Typically
the nation's long term GDP growth rate, rate of inflation or something similar that is
conservative. Anything over 5% would be seen as very aggressive.
How do you select appropriate exit multiples when calculating Terminal Value? -
ANSWER Normally you look at comparable companies and pick the median of the
set. You would want to select a range of exit multiples and show what the TV looks
like over that range. For example if the median EBITDA multiple is 8x you would
want to show all TV from 6x to 10x
Which method of calculating terminal value will give you a higher valuation? -
ANSWER Both are highly dependent on the assumptions you make, but typically
the multiples method because exit multiples span a larger range than long-term
growth rates
What is the flaw in basing terminal multiples on what public comparables are trading
at? - ANSWER The median multiples could change greatly in the next 5-10 years
so it may no longer be accurate to assume those multiples.
A DCF values a company based on: - ANSWER The present value of its cash flows
and the present value of its terminal value.
Walk me through a DCF - ANSWER First, you project out the company's financials
using assumptions for revenue growth, expenses and working capital. Then you get
FCF for each year which you sum up and discount to a NPV based on your discount
rate, usually the WACC. Then you determine the company's terminal value using
either the multiples method or the Gordon Growth Method and dicount that back to
NPV using WACC. Add the two together to get the estimated EV.
How do you get from revenue to FCF? - ANSWER Revenue-COGS-Operating
Expenses to get to EBIT. Then multiply by (1-Tax Rate), add back Depreciation and
other non-cash charges and subtract CAPEX and the change in Working Capital.
(This is unlevered FCF since we went off of EBIT rather than EBT).
What is an alternate way to calculate FCF aside from taking NI, adding DEP and
subtracting CAPEX? - ANSWER Take CF from operations and subtract CAPEX to
get levered CF. To get unlevered you need to add back the tax adjusted interest
expense and subtract tax adjusted interest income.
Why do you use 5 or 10 years for a DCF? - ANSWER Anything beyond 10 years is
too difficult to predict for most companies.
What do you usually use for the discount rate? - ANSWER WACC, although you
could use Cost of Equity.
How do you calculate WACC? - ANSWER Cost of Equity *% of capital structure
composed of equity+ cost of debt* % of capital structure composed of debt*(1-tax
rate) + cost of preferred*% of capital structure composed of preferred
How do you calculate cost of equity - ANSWER Use the Capital Asset Pricing
Model = Risk free rate +beta *Equity risk premium
What is the Risk free rate - ANSWER Typically the yield on 10 or 20 year T-bond
What is risk premiuim - ANSWER The % by which stocks are expected to out-
perform risk-less assets
How do you get Beta in the Cost of Equity calculation? - ANSWER Unlevered beta=
levered beta/(1+(1-tax rate)*(total debt/total equity)
Levered Beta= unlevered beta*(1+(1-Tax rate)*(total debt/total equity)
Why do you have to un-lever and re-lever beta? - ANSWER Levered beta reflects
the debt already assumed by each company but since each company's capital
structure is different and if we want to see how risky the company is regardless of
, debt structure then we must un-lever the beta. In the end beta will be re-levered
because we want the cost of equity to reflect the true risk
Which would you expect to have a higher beta a tech company or a manufacturing
company? - ANSWER A technology company because the technology industry is
seen as riskier then the manufacturing industry
What is the effect of using levered cash flow vs unlevered cash flow in your DCF? -
ANSWER Levered 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 interest payments)
If you use levered FCF what should you use as the discount rate? - ANSWER You
would use the cost of equity rather than the WACC since we are not concerned with
the debt or preferred stock in this case
How do you calculate terminal value? - ANSWER You can either use the multiples
method in which you apply an exit multiple to the company's year 5 EBITDA, EBIT or
FCF or you can use the Gordon Growth method to estimate its value based on its
growth rate into perpetuity
Gordon Growth Method equation: - ANSWER Terminal value= year 5
FCF*(1+growth rate)/(discount rate- growth rate)
Why would you use the Gordon Method over the multiples method - ANSWER In
banking, you almost always use the multiples method as it is much easier to get data
on exit multiples since they are based on comparable companies.Picking a long term
growth rate is always a shot in the dark. You might use the GGM if you have no good
comparables.
What is an appropriate growth rate to use for terminal value - ANSWER Typically
the nation's long term GDP growth rate, rate of inflation or something similar that is
conservative. Anything over 5% would be seen as very aggressive.
How do you select appropriate exit multiples when calculating Terminal Value? -
ANSWER Normally you look at comparable companies and pick the median of the
set. You would want to select a range of exit multiples and show what the TV looks
like over that range. For example if the median EBITDA multiple is 8x you would
want to show all TV from 6x to 10x
Which method of calculating terminal value will give you a higher valuation? -
ANSWER Both are highly dependent on the assumptions you make, but typically
the multiples method because exit multiples span a larger range than long-term
growth rates
What is the flaw in basing terminal multiples on what public comparables are trading
at? - ANSWER The median multiples could change greatly in the next 5-10 years
so it may no longer be accurate to assume those multiples.
