Valuation Methods: DCF

3 factor to keep in mind when looking for "perfect bond" - answer-date of issuance: look for bonds issued over last 1-2 years maturity date: bonds expected to mature in the next 10-20 yrs size: look for bonds with substantial size compared to overall debt issues 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? - answer-Trick question. You don't account for this at all in an Unlevered DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement - but we only take into account EBIT * (1 - Tax Rate), and then a few items from Cash Flow from Operations, and then subtract Capital Expenditures to get to Unlevered 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 - the mandatory debt repayments would also reduce Levered Free Cash Flow (note: some people define Levered FCF differently, but if you think about it, repaying debt really does reduce the cash flow that can go to equity investors so it should be subtracted out here). asset beta = - answer-un-levered beta Beta - for a private company - answer-for a non public use comparable companies 1. look up the beta for pulically traded comps 2. un-lever each beta 3. take the median or avg of set -lever that beta based on companies target cap. struct. why un-lever and relever: comparable companies will have different capital structures, and therefor dif. levels of risk Beta - for a public company - answer-a measure of the systematic risk that investors should be compensated for for a publicly traded company, find beta by running a beta regression of the companies stock returns against the returns of the market (usually sp 500) - find how volatile the company is relative to the market Can you have a negative beta? - answer-of course but be ready to explain what a negative beta implies CAPM model - answer-defines the expected return on a security (cost of equity) as the rate of return on a risk-free security + a risk premium -formula can be extended to include a size premiu. cost of capital - answer-the quantification of a company's risk profile can be seen in their cost of capital higher cost of reflects more risk (investors demand a higher return for increased risk) commonly referred to as the WACC weighted across debt, equity, and preferred stock debt it cheaper than equity due to its seniority in the capital structure (debt holders will get paid first, and therefore require a lower cost) and availability to provide tax shield 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? - 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. Discounted Cash Flow analysis - answer-intrinsic method of valuation based on the present value of the company's future cash flows concept is based on the going concern principle in accounting that firms are expected to operate into perpetuity firm total enterprise value = PV of FCFS + PV of terminal value, both discounted using WACC PV of FCFs, discounted using WACC + PV of Terminal Value, discounted using WACC = Implied Total Enterprise Value today Does a DCF give an enterprise value or equity value? - answer- equity beta = - answer-levered beta exit multiple method - answer-basic calculation to approximate company value at the end of the projection period FCFT - answer-Final projected FCF Forecasting Free Cash Flows - answer-project out cash flows 5-10 years -- long enough to be useful but short enough to be able to predict cash flows with some accuracy and confidence project out until cash flows become steady 3-5 years for large companies with stable predictable cash flows ex: amazon and Microsoft 8-10 years for start ups, riskier companies, or companies with unpredittable cash flows EBIT*(1-tax rate) +depreciation -capital expenditures +/- changes in NWC = Unlevered Free Cash Flow Forecasting Free Cash Flows (cont.) - answer-the cash flows are considered unlevered because they ignore the effects of debt in the firms capital structure by excluding interest expense the cash flows are available to pay all investors- both debt and equity to obtain levered free cash flows subtract after-tax interest expense (interest expense * (1-tax rate)) when discounting levered free cash flows- use the cost of equity instead of WACC FOUR major steps in performing a DCF analysis: - answer-1. Forecast free cash flows 5-10 years 2