Discounted Cash Flow Questions and 100% Correct Answers
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Discounted Cash Flow
Institution
Discounted Cash Flow
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.
In a DCF, you divide the valuation into two periods. During the forecast period, assumptions change while in the terminal period assumptions ...
Discounted Cash Flow Questions and
100% Correct Answers
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.
In a DCF, you divide the valuation into two periods. During the forecast period,
assumptions change while in the terminal period assumptions stay the same.
You then project the cash flows and bring both the FCF and terminal value back to
present value by discounting them, usually by the WACC.
Walk me though a Discounted Cash Flow Analysis ✅A DCF values a company based
on the present value of its cash flows in the forecast period and the present value of its
terminal value.
1. Make assumptions for items such as revenue growth, expenses, working capital and
CapEx.
2. Project the company's FCF over the next 5-10 years using these assumptions
3. Then you discount the Cash Flows using the discount rate, usually the weighted cost
of capital and sum up the Present values of the FCF
4. Calculate the company's Terminal Value using the Terminal Multiple Method or the
Gordon Growth Method. This reflect the company's far future value after the forecast
period.
5.You then discount the Terminal Value to Present Value using the discount rate and
add it the the PV of FCF
6. You current have the enterprise value, to calculate implied share price, you would
have to transition from enterprise value to equity value and divide it by diluted shares
outstanding to get the implied price per share
How do you move from Revenue to Free Cash Flow in a DCF? ✅First confirm that the
interviewer is asking for Unlevered Free Cash Flow (FCF to the firm)
,NOPAT= EBIT*(1-TAX RATE)
+Depreciation & Amortization
+/- Changes in Working Capital
- CapEx
___________________________
Unlevered Free Cash Flow
How to Calculate Unlevered Free Cash Flow? ✅Revenue
- COGS
- Operating Expenses
------------------
EBIT (Operating Income)
NOPAT= EBIT*(1-TAX RATE)
+Depreciation & Amortization
+/- Changes in Working Capital
- CapEx
___________________________
Unlevered Free Cash Flow
How to Calculate Levered Free Cash Flow? ✅Revenue
- COGS
- Operating Expenses
- Net Interest Expense
------------------
EBIT (Operating Income)
NOPAT= EBIT*(1-TAX RATE)
+Depreciation & Amortization
+/- Changes in Working Capital
- Mandatory Debt Payments
- CapEx
___________________________
Unlevered Free Cash Flow
What does the Discount Rate mean? ✅The Discount Rate represents the opportunity
cost for the investors
A higher Discount Rate means the risk and potential returns are both higher, however, it
makes a company less valuable because it means the investors have better options
elsewhere
, A lower Discount Rate means lower risk and lower potential returns, but a lower
Discount Rate makes a company more valuable.
How do you calculate Terminal Value in a DCF? ✅You can use the Terminal Multiples
Method or the Gordon Growth Method
How do you calculate the Terminal Value using the Multiples Method? ✅You apply a
Terminal Multiple to the company's FCF
in the final year of the forecast period.
For example, if you apply a 10x EV/EBITDA multiple to the company's Year 10 EBITDA
of $500, its Terminal Value is $5,000.
How do you calculate the Terminal Value using the Gordon Growth Method? ✅With
the Gordon Growth Method, you assign a "Terminal Growth Rate" to the company's
Free
Cash Flows in the Terminal Period and assume they'll grow at that rate forever.
What is the Gordon Growth Rate formula? ✅Terminal Value = Final Year Free Cash
Flow * (1 + Terminal Growth Rate) / (Discount Rate -
Terminal Growth Rate)
Which Terminal Value Method is Better? ✅The Gordon Growth Method is better
because growth always slows down over time
All companies' cash flows eventually grow more slowly than GDP.
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.
What are some signs that you might be using the incorrect assumptions in a DCF? ✅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
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