DISCOUNTED CASH FLOW
A company has a high Debt balance and is paying off a significant portion of its
Debt principal each year. How does that impact a DCF? - answer-Trick question. You
don't account for this at all in an Unlevered DCF because you ignore interest
expense and debt principal repayments.
In a Levered DCF, you factor it in by reducing the interest expense each year as the
Debt goes down and also by reducing Free Cash Flow by the mandatory repayments
each year.
The exact impact - i.e. whether the implied Equity Value goes up or down - depends
on the interest rate and the principal repayment percentage each year; however, in
most cases the principal repayments far exceed the net interest expense, so the
Equity Value will most likely decrease because Levered FCF will be lower each year.
An alternative to the DCF is the Dividend Discount Model (DDM). How is it different
in the general case (i.e. for a normal company, not a commercial bank or insurance
firm?) - answer-The setup is similar: you still project revenue and expenses over a 5-
10 year period, and you still calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - instead, you stop at Net
Income and assume that Dividends Issued are a percentage of Net Income, and
then you discount those Dividends back to their present value using the Cost of
Equity.
Then, you add those up and add them to the present value of the Terminal Value,
which you might base on a P / E multiple instead.
Finally, a Dividend Discount Model gets you the company's Equity Value rather than
its Enterprise Value since you're using metrics that include interest income and
expense.
As an approximation, do you think it's OK to use EBITDA - Changes in Operating
Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow? - answer-
This is inaccurate because it excludes taxes completely. It would be better to use
EBITDA - Taxes - Changes in Operating Assets and Liabilities - CapEx.
If you need a very quick approximation, yes, this formula can work and it will get
you closer than EBITDA by itself. But taxes are significant and should not be
overlooked.
Can Beta ever be negative? What would that mean? - answer-Theoretically, yes,
Beta could be negative for certain assets. If Beta is -1, for example, that would
mean that the asset moves in the opposite direction from the market as a whole. If
the market goes up by 10%, this asset would go down by 10%.
,In practice, you rarely, if ever, see negative Betas with real companies. Even
something labeled as "counter-cyclical" still follows the market as a whole; a
"counter-cyclical" company might have a Beta of 0.5 or 0.7, but not -1.
ie. Gold
Can you explain how to create a multi-stage DCF, and why it might be useful? -
answer-You use a multi-stage DCF if the company grows at much different rates,
has much different profit margins, or has a different capital structure in different
periods.
For example, maybe the company grows revenue at 15% in the first two years, then
10% in years 2-4, and then 5% in year 5, with decreasing growth each year after
that.
So you might separate that into 3 stages and then make different assumptions for
Free Cash Flow and the Discount Rate in each one.
Note that a standard DCF, by itself, is actually a two-stage DCF because you divide
it into the "near future" and "far future."
You can divide it into more periods if you want, and it would just be an extension of
this concept.
Can you explain the Gordon Growth formula in more detail? I don't need a full
derivation, but what's the intuition behind it? - answer-We actually do have a full
derivation if you look in the Key Rules section above. Here's the formula:
Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate -
Growth Rate).
And here's the intuition behind it:
Let's say that we know for certain that we'll receive $100 every year indefinitely,
and we have a required return of 10%.
That means that we can "afford" to pay $1,000 now ($%) to receive $100 in
year 1 and $100 in every year after that forever.
But now let's say that that stream of $100 were actually growing each year - if
that's the case, then we could afford to invest more than the initial $1,000.
Let's say that we expect the $100 to grow by 5% every year - how much can we
afford to pay now to capture all those future payments, if our required return is
10%?
Well, that growth increases our effective return... so now we can pay more and still
get that same 10% return.
, We can estimate that by dividing the $100 by (10% - 5%). 10% is our required
return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2,000.
This corresponds to the formula above: $100 represents Final Year Free Cash Flow *
(1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate.
The higher the expected growth, the more we can afford to pay upfront. And if the
expected growth is the same as the required return, theoretically we can pay an
infinite amount (you get a divide by zero error in the equation) to achieve that
return.
You can test this yourself by plugging the values into a spreadsheet: enter $100,
make it grow by 5% each year, and then use NPV(10%, Area With All The Numbers)
and you'll see how it approaches $2,000 as you add more to it-
Cost of Equity tells us the return that an equity investor might expect for investing
in a given company - but what about dividends? Shouldn't we factor dividend yield
into the formula? - answer-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.
Do you think a DCF would work well for an oil & gas company? - answer-If it's an
exploration & production (E&P)-focused company, generally a DCF will not work well
because:
• CapEx needs are enormous and will push FCF down to very low levels.
• Commodity prices are cyclical and both revenue and FCF are difficult to
project.
For other types of energy companies - services-based companies or downstream
companies that just refine and market oil and gas - a DCF might be more
appropriate.
For more on this topic and the alternative to a DCF that you use for oil & gas
companies (called a NAV, or Net Asset Value, analysis), see the industry-specific
guides.
Explain why we use the mid-year convention in a DCF. - answer-You use it to
represent the fact that a company's cash flow does not arrive 100% at the end of
each year - instead, it comes in evenly throughout each year.
In a DCF without the 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 the 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.
The end result is that the mid-year convention produces higher values since the
discount periods are all lower.
A company has a high Debt balance and is paying off a significant portion of its
Debt principal each year. How does that impact a DCF? - answer-Trick question. You
don't account for this at all in an Unlevered DCF because you ignore interest
expense and debt principal repayments.
In a Levered DCF, you factor it in by reducing the interest expense each year as the
Debt goes down and also by reducing Free Cash Flow by the mandatory repayments
each year.
The exact impact - i.e. whether the implied Equity Value goes up or down - depends
on the interest rate and the principal repayment percentage each year; however, in
most cases the principal repayments far exceed the net interest expense, so the
Equity Value will most likely decrease because Levered FCF will be lower each year.
An alternative to the DCF is the Dividend Discount Model (DDM). How is it different
in the general case (i.e. for a normal company, not a commercial bank or insurance
firm?) - answer-The setup is similar: you still project revenue and expenses over a 5-
10 year period, and you still calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - instead, you stop at Net
Income and assume that Dividends Issued are a percentage of Net Income, and
then you discount those Dividends back to their present value using the Cost of
Equity.
Then, you add those up and add them to the present value of the Terminal Value,
which you might base on a P / E multiple instead.
Finally, a Dividend Discount Model gets you the company's Equity Value rather than
its Enterprise Value since you're using metrics that include interest income and
expense.
As an approximation, do you think it's OK to use EBITDA - Changes in Operating
Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow? - answer-
This is inaccurate because it excludes taxes completely. It would be better to use
EBITDA - Taxes - Changes in Operating Assets and Liabilities - CapEx.
If you need a very quick approximation, yes, this formula can work and it will get
you closer than EBITDA by itself. But taxes are significant and should not be
overlooked.
Can Beta ever be negative? What would that mean? - answer-Theoretically, yes,
Beta could be negative for certain assets. If Beta is -1, for example, that would
mean that the asset moves in the opposite direction from the market as a whole. If
the market goes up by 10%, this asset would go down by 10%.
,In practice, you rarely, if ever, see negative Betas with real companies. Even
something labeled as "counter-cyclical" still follows the market as a whole; a
"counter-cyclical" company might have a Beta of 0.5 or 0.7, but not -1.
ie. Gold
Can you explain how to create a multi-stage DCF, and why it might be useful? -
answer-You use a multi-stage DCF if the company grows at much different rates,
has much different profit margins, or has a different capital structure in different
periods.
For example, maybe the company grows revenue at 15% in the first two years, then
10% in years 2-4, and then 5% in year 5, with decreasing growth each year after
that.
So you might separate that into 3 stages and then make different assumptions for
Free Cash Flow and the Discount Rate in each one.
Note that a standard DCF, by itself, is actually a two-stage DCF because you divide
it into the "near future" and "far future."
You can divide it into more periods if you want, and it would just be an extension of
this concept.
Can you explain the Gordon Growth formula in more detail? I don't need a full
derivation, but what's the intuition behind it? - answer-We actually do have a full
derivation if you look in the Key Rules section above. Here's the formula:
Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate -
Growth Rate).
And here's the intuition behind it:
Let's say that we know for certain that we'll receive $100 every year indefinitely,
and we have a required return of 10%.
That means that we can "afford" to pay $1,000 now ($%) to receive $100 in
year 1 and $100 in every year after that forever.
But now let's say that that stream of $100 were actually growing each year - if
that's the case, then we could afford to invest more than the initial $1,000.
Let's say that we expect the $100 to grow by 5% every year - how much can we
afford to pay now to capture all those future payments, if our required return is
10%?
Well, that growth increases our effective return... so now we can pay more and still
get that same 10% return.
, We can estimate that by dividing the $100 by (10% - 5%). 10% is our required
return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2,000.
This corresponds to the formula above: $100 represents Final Year Free Cash Flow *
(1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate.
The higher the expected growth, the more we can afford to pay upfront. And if the
expected growth is the same as the required return, theoretically we can pay an
infinite amount (you get a divide by zero error in the equation) to achieve that
return.
You can test this yourself by plugging the values into a spreadsheet: enter $100,
make it grow by 5% each year, and then use NPV(10%, Area With All The Numbers)
and you'll see how it approaches $2,000 as you add more to it-
Cost of Equity tells us the return that an equity investor might expect for investing
in a given company - but what about dividends? Shouldn't we factor dividend yield
into the formula? - answer-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.
Do you think a DCF would work well for an oil & gas company? - answer-If it's an
exploration & production (E&P)-focused company, generally a DCF will not work well
because:
• CapEx needs are enormous and will push FCF down to very low levels.
• Commodity prices are cyclical and both revenue and FCF are difficult to
project.
For other types of energy companies - services-based companies or downstream
companies that just refine and market oil and gas - a DCF might be more
appropriate.
For more on this topic and the alternative to a DCF that you use for oil & gas
companies (called a NAV, or Net Asset Value, analysis), see the industry-specific
guides.
Explain why we use the mid-year convention in a DCF. - answer-You use it to
represent the fact that a company's cash flow does not arrive 100% at the end of
each year - instead, it comes in evenly throughout each year.
In a DCF without the 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 the 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.
The end result is that the mid-year convention produces higher values since the
discount periods are all lower.
