IBA: Valuation & DCF Analysis

What's the point of valuation? WHY do you value a company?

You value a company to determine its Implied Value according to your views of it.

If this Implied Value is very different from the company's Current Value, you might be able to

invest in the company and make money if its value changes.

If you are advising a client company, you might value it so you can tell the management team the price that it might receive if the company wants to sell.

But public companies already have Market Caps and share prices. Why bother valuing them?

Because a company's Market Cap and Share Price reflect its Current Value according to "the market" - but the market might be wrong!

You value companies to see if the market's views are correct or incorrect.

Pros and Cons of Valuation Methods

Public Comps are useful because they're based on real market data, quick to calculate, and are less subject to far-in-the-future assumptions.

However, there may not be true comparable companies, the analysis will be less accurate for

volatile or thinly traded companies, and it may undervalue companies' long-term potential.

Precedent Transactions are useful because they're based on the real prices that companies have paid for other companies, and they may reflect industry trends more than Public Comps.

However, the data is often spotty and misleading, there may not be comparable transactions, and specific deal terms and market conditions might distort the multiples.

DCF Analysis is less subject to market fluctuations, and it better reflects company-specific factors and long-term trends.

However, it's also very dependent on far-in-the-future assumptions, and there's disagreement over the proper calculation methods for key figures like Cost of Equity and WACC.

Which of the 3 main methodologies will produce the highest Implied Values?

DCF tends to produce the most variable output, depending on your assumptions, and Precedent Transactions tend to produce higher values than Public Comps because of the control premium.

When is a DCF more useful than Public Comps or Precedent Transactions?

It's especially useful when the company you're valuing is mature and has stable, predictable cash flows, or when you lack good Public Comps and Precedent Transactions.

When are Public Comps or Precedent Transactions more useful than the DCF?

If the company you're valuing is early-stage, and it is impossible to estimate its future cash flows or the company has no path to cash flow at all

Also when you run into problems in the DCF,

such as the inability to estimate the Discount Rate, or when cash flows fluctuate wildly.

Which should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?

(Assume the growth rates, margins, and all other financial stats are the same)

In all likelihood, the healthcare company will be worth more because healthcare is a less asset-intensive industry. That means the company's CapEx and Working Capital requirements will be lower, and Free Cash Flow will be higher as a result.

How do you value an apple tree?

The same way you value a company: Comparables and a DCF.

The Discount Rate would be based on your opportunity cost - what you might be able to earn each year by investing in other, similar apple trees.

People say the DCF is an intrinsic valuation methodology, whereas Public Comps and Precedent Transactions are relative.

But is that correct?

No, not exactly. The DCF is based on the company's expected future cash flows, more so than the others, so in that sense, it is "intrinsic valuation."

But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, that multiple is also linked to peer companies.

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.

Walk me through a DCF analysis.

Project FCF for explicit period (5-10 years)

Determine Terminal Value (via EMM or GGM)

Discount FCF's and Terminal Value

Sum values together to get implied enterprise value

How do you move from Revenue to Free Cash Flow in a DCF?

Unlevered:

Revenue - COGS - Operating Expenses = EBIT

EBIT*(1-tax rate) + Non-cash charges & change in WC - CapEx

Levered:

Revenue - COGS - Operating Expenses = EBIT

(EBIT - net interest expense)*(1-tax rate) +Non-cash charges & change in WC - CapEx - Mandatory Debt Repayments

What does the Discount Rate mean?

The Discount Rate represents the opportunity cost for the investors - what they could earn by investing in other, similar companies in this industry.

A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate implies lower risk and lower potential returns.

A higher Discount Rate makes a company less valuable because it means investors have better opportunities elsewhere; a lower Discount Rate makes a company more valuable.

How do you calculate Terminal Value in a DCF, and which method is better?

You can use the Multiples Method or the Gordon Growth Method

Ultimately, the Gordon Growth Method is better because growth always slows down over time; all companies' cash flows eventually start growing 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.

Terminal Value Equation

Terminal Value = (Final Year FCF * (1 + Terminal Growth Rate)) / (Discount Rate - Terminal Growth Rate)

What are some signs that you might be using the incorrect assumptions in a DCF?

Too Much Value from the PV of Terminal Value

Implied Terminal Growth Rates or Terminal Multiples That Don't Make Sense

You're Double-Counting Items

Mismatched Final Year FCF Growth and Terminal Growth Rate

If your DCF seems off, what are the easiest ways to fix it?

The simplest method is to extend the explicit forecast period so that the company's Free Cash Flow contributes more value, and so that there's more time for FCF growth to slow down and approach the Terminal Growth Rate.

How do you interpret the results of a DCF?

You compare the company's Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.

You do this over a range of assumptions because investing is probabilistic.

Does a DCF ever make sense for a company with negative cash flows?

Yes, it may. A DCF is based on a company's expected future cash flows, so even if the company is cash flow-negative right now, the analysis could work if it starts generating positive cash flow in the future.

If the company has no plausible path to positive cash flow or you can't reasonably forecast cash flow, then the analysis doesn't make sense.

How do Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from an Unlevered DCF?

In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E.

An APV Analysis is similar to a traditional Unlevered DCF, but you value the company's Interest Tax Shield separately and add its Present Value at the end.

You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Unlevered Beta).

You then project the Interest Tax Shield each year, discount it at that same Discount Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.

Will you get the same results from an Unlevered DCF and a Levered DCF?

No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on the company's Debt, whereas the Levered DCF does.

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results than the other methods.

The Levered DCF sometimes produces odd results because Debt principal repayments can spike the Levered FCF up or down suddenly.

The APV Analysis is flawed because it doesn't factor in the main downside of Debt: Increased chances of bankruptcy.

The Unlevered DCF solves this issue because WACC decreases with more Debt, at first, but then starts increasing past a certain level, which reflects that added risk of bankruptcy.

WHY do you calculate Unlevered Free Cash Flow by excluding and including various items on the financial statements?

Unlevered FCF must capture the company's core, recurring items that are available to ALL investor groups. (Unlevered FCF : Enterprise Value)

So if an item is NOT recurring, NOT related to the company's core business, or NOT available to all investor groups, you leave it out.

Why Exclude the Following Items when calculating Unlevered FCF?

Net Interest Expense

Other Income/Expense

Most non-cash adjustments besides D&A

CFF

Most of CFI

Net Interest Expense: Only available to Debt investors.

Other Income / (Expense): Corresponds to non-core-business Assets.

Most non-cash adjustments besides D&A: They're non-recurring.

The Cash Flow from Financing section: They're available only to certain investors.

Most of Cash Flow from Investing: Only CapEx is a recurring, core-business item.

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company's business model?

The Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth.

It's related to whether a company records items before or after paying or collecting them in cash.

The Change in WC could reduce or increase the company's Free Cash Flow, but it's rarely a major value driver because it tends to be fairly small for most companies.

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It's a non-cash add-back on the Cash Flow Statement.

No! SBC is not a real non-cash expense in the context of valuation because it creates additional shares and dilutes the existing investors.

It's true that Stock-Based Compensation is a non-cash expense on the Cash Flow Statement, but the context is different: Accounting rather than valuation.

What's the proper tax rate to use when calculating FCF - the effective tax rate, the statutory tax rate, or the cash tax rate?

The company's Free Cash Flows should reflect the cash taxes it pays.

So it doesn't matter which rate you use as long as the cash taxes are correct.

It's most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.

How should CapEx and Depreciation change over the explicit forecast period?

Just like the company's Free Cash Flow growth rate should decline over the explicit forecast period, the company's CapEx and Depreciation should also decline.

High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from "growth" to "maintenance."

If the company's FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end.

If the company's FCF is growing, CapEx should never EQUAL Depreciation.

Should you reflect inflation in the FCF projections?

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures.

If the company's capital structure is expected to change, how do you reflect it in FCF?

You'll reflect it directly in a Levered DCF because the company's Net Interest Expense and Debt Repayments will change over time.

It won't show up explicitly in Unlevered FCF, but you will still reflect it in the analysis by changing the Discount Rate over time.

And in a Levered FCF, Cost of Equity will change because additional Debt increases the Cost of Equity and less Debt reduces it.

What's the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

If you include an income or expense in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa)

How do Net Operating Losses (NOLs) factor into Free Cash Flow?

You could set up an NOL schedule and use them to reduce the company's cash taxes, also factoring in accruals if the company ever records negative Pre-Tax Income.

If you do this, then you don't need to count them in the Implied Enterprise Value --> Implied Equity Value calculation at the end.

However, it's far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end.

How does the Pension Expense factor into Free Cash Flow?

There are several different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments.

Most of those count as operating expenses and should be reflected in the company's Free Cash Flow.

In an Unlevered DCF, you should exclude the Interest Expense and Expected Return on Plan Assets within the Pension Expense and then subtract the Unfunded portion of the Pension Obligation when moving from Implied Enterprise Value to Implied Equity Value.

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

For the most part, no. You certainly shouldn't make speculative projections for these items - they are all non-recurring, so it's not correct to forecast them as if they were recurring, predictable items.

What does the Cost of Equity mean intuitively?

It tells you the percentage a company's stock "should" return each year, over the very long term, also factoring in dividends and stock repurchases.

In a valuation, it represents the percentage an Equity investor might earn each year.

To a company, Cost of Equity represents the cost of funding its operations by issuing shares to new investors.

How does a company "pay" for equity?

via potential Dividends (a real cash expense) and also by diluting existing investors (and thereby giving more stock appreciation potential to others).

What does WACC mean intuitively?

WACC is similar to Cost of Equity, but it's the expected annual return percentage if you invest proportionately in all parts of the company's capital structure.

To a company, WACC represents the cost of funding its operations by using all its sources of capital.

Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

How do you calculate Cost of Equity?

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

You should use the rate on the government bonds that match the currency of the company's cash flows.

What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?

One option is to take the Risk-Free Rate in a country that is assumed to be "risk-free," like the U.S. or U.K., and then add a default spread based on your country's credit rating.

How do you calculate the Equity Risk Premium?

Many firms use a publication called "Ibbotson's" that publishes Equity Risk Premium data for companies of different sizes in different industries each year.

You could also take the historical data for the U.S. stock market and add a premium based on the default spread of your country/market.

Finally, some groups just use a "standard" number for each market, such as 6-7%.

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

You might take the percentage revenue from each country, multiply it by the ERP in that market, and then add everything up to get a weighted average.

What does Beta mean intuitively?

Levered Beta tells you how volatile a company's stock price is relative to the stock market as a whole, factoring in both the intrinsic business risk and the risk from leverage (i.e., Debt).

Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it's always less than or equal to Levered Beta.

Could Beta ever be negative?

Yes, it's possible. The company's stock price has to move in the opposite direction of the market as a whole for Beta to be negative.

Why do you have to un-lever and re-lever Beta when calculating Cost of Equity?

By un-levering Beta for each comparable company, you isolate each company's inherent business risk. (Not factoring in capital structure)

You then take the median Unlevered Beta from these companies and re-lever it based on the targeted capital structure of the company you're valuing.

You do this because, in reality, there will always be business risk and risk from leverage, and so you need to reflect both for the company you're valuing.

Unlevered Beta Formula

Levered Beta / (1 + (1 - tax rate)) * total Debt/Equity

Levered Beta Formula

Unlevered Beta * (1 + (1 - tax rate)) * total Debt/Equity

In those formulas, you're not factoring in the interest rate on Debt. Isn't that wrong?

More expensive Debt should be riskier.

Yes, this is one drawback of this approach. However:

The Debt / Equity ratio is a proxy for interest rates on Debt (companies with high Debt / Equity ratios tend to have higher interest rates as well.)

The risk isn't directly proportional to interest rates. Higher interest on Debt will result in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it's not as simple as saying, "Interest is now 4% rather than 1% - risk is 4x higher."

Do you still un-lever and re-lever Beta even when you're using Unlevered FCF?

Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF.

What are some different ways to calculate Beta in the Cost of Equity calculation?

Some people argue that you should use Predicted Beta instead of Historical Beta because Cost of Equity relates to expected future returns.

If you do use historical data, you could use the company's own Historical Beta or the re-levered

Beta based on the historical performance of comparable companies.

And if you re-lever Beta, you could do it based on the company's current capital structure or its targeted or "optimal" capital structure.

How would you estimate the Cost of Equity for a U.S.-based technology company?

You might say, "The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company is more volatile than the market as a whole, with a Beta of around 1.5. So if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%."

How do you calculate WACC?

WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred

Stock * % Preferred Stock

WACC reflects the company's capital structure, so why do you pair it with Unlevered FCF? It's not capital structure-neutral!

Unlevered FCF is available to ALL investors, and WACC represents ALL investors.

Should you use the company's current capital structure or optimal capital structure to calculate WACC?

Optimal capital structure is impossible to calculate.

You'll often use the median capital structure percentages from the comparable public companies as a proxy for the "optimal" capital structure.

The logic is the same as the logic for un-levering and re-levering Beta: You want to capture what this company's capital structure should be, not what it is right now.

It's better to use this expected capital structure because the company's Implied Value in a DCF

is based on its expected, future cash flows.

Why is Equity more expensive than Debt?

Because it offers higher risk and higher potential returns.

How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity.

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC calculation, and what do they mean?

One simple method is to calculate the weighted average coupon rate on the company's existing Debt or Preferred Stock or to calculate the median coupon rate on outstanding issuances of comparable companies.

How do convertible bonds factor into the WACC calculation?

If the company's current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula.

If not, you count them as Debt and use the coupon rate (or YTM) to calculate their Cost.

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors.

As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt.

However, the exact impact depends on where you are on that curve.

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses less Debt?

The Cost of Equity and Cost of Debt decrease because less debt means a lower risk of bankruptcy & therefore, less risk for all investors.

WACC could go either way depending on where you are on the curve.

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect WACC?

If you're using the company's current capital structure, WACC will most likely increase because 20% Debt is a fairly low level.

But if you're using the targeted, optimal, or median capital structure from the comparable companies, this change won't affect WACC because you're not using the company's current capital structure at all.

Should you ever use *different* Discount Rates for different years in a DCF?

Yes, sometimes it makes sense to use different Discount Rates.

If a company is growing quickly right now, but it's expected to mature and grow more slowly in the future, you might use decreasing Discount Rates.

It makes less sense to do this if the company is already stable and mature and it's not expected to change much over time.

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

The company's FCF growth rate, and possibly its Discount Rate, change over time in the explicit forecast period b/c you forecast cash flow in each year.

In the Terminal Period, you assume a "steady state": Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

What's the intuition behind the Gordon Growth formula for Terminal Value?

The intuition is that a company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher.

That's because the company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere.

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from Public Comps or Precedent Transactions?

Neither one - you just use them as starting points in the analysis, and then you adjust once you see the Terminal FCF Growth Rates that the selected multiples imply.

It's better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don't want to reflect the control premium inherent in Precedent Transactions.

Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, you adjust it up or down as necessary.

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?

This growth rate should be below the country's long-term GDP growth rate and in-line with other macroeconomic variables like the rate of inflation.

Why do you need to discount the Terminal Value back to its Present Value?

Because the Terminal Value represents the Present Value of the company's cash flows from the very end of the explicit forecast period into perpetuity.

Valuation tells you what a company is worth TODAY, so any "future value" must always be discounted back to its Present Value.

What do you do after summing the PV of Terminal Value and PV of Free Cash Flows?

Levered DCF: divide the company's Implied Equity

Value by its diluted share count to get its Implied Share Price

Unlevered DCF: you have to "back into" the company's Implied Equity Value and then calculate its Implied Share Price.

You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting Liability and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling Interests, etc.). Then, you divide by the company's diluted share count to get its Implied Share Price.

The diluted share count factors in the company's in-the-money options.

But what about its out-of-the-money options? Shouldn't you account for them in a DCF?

In theory, yes you should subtract the value of those options to determine its true Implied Equity Value.

In practice, not really because these options tend to make a very small impact and the fact that the valuation of options gets tricky and requires inputs that you may or may not have.

How can you check whether or not your Terminal Value estimate is reasonable?

It's an iterative process: You start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by seeing what Growth Rates or Multiples they imply.

If it seems wrong, then you adjust the range of Terminal Multiples or Terminal FCF Growth Rates up or down until you get more reasonable results.

What's one problem with using EV / EBITDA multiples to calculate Terminal Value?

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures.

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Yes. For example, if you're valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, you might assume that the company's cash flows eventually decline to 0.

A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually.

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

The same variables are important in any DCF: The Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the revenue growth and margin assumptions.

Why do you use the mid-year convention in a DCF analysis?

You use it because a company's cash flow does not arrive 100% at the end of each year - it's generated throughout each year.

What impact does the mid-year convention make?

A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower. As a result, a formula like this:

Present Value = $100 / ((1 + 10%) ^ Year#)

Will produce higher values because the Year # of the first period would be 1 without the mid-year convention, but 0.5 with the mid-year convention.

Why might you include a "stub period" in a DCF, and what does it mean?

You include a "stub period" if you're valuing a company midway through the year, and it has already reported some of its financial results.

A DCF is based on expected future cash flow, so you should exclude these previously reported results and adjust the discount periods as well.

For example, maybe it's September 30th and the company's fiscal year ends on December 31st. To discount the FCF in that 3-month period, you use 0.25 for the discount period since 3 months is 25% of the year. You then use 1.25 for the discount period of the next year, 2.25 of the year after that, and so on.

You're valuing a company on April 30th, and you want to include both the stub period and the mid-year convention in your analysis.

How would you change the company's Free Cash Flow, and which discount periods would you use?

If you include both the stub period and the mid-year convention, you divide the stub period of the first year by 2. And then in each year after that, you subtract 0.5 from the "normal" discount period.

In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the "normal" stub discount period is 0.67.

Since you're using the mid-year convention, you divide that by 2 to get 0.34. You then use that period to discount the company's FCF from April 30th to December 31st.

The "normal" discount period of the next year would be 0.67 + 1.00, or 1.67. So you take the 1.67 and subtract 0.50 to get 1.17.

For the next year after that, the "normal" discount period is 0.67 + 2.00, or 2.67, so you subtract 0.50 and get 2.17. You continue that for the rest of the years.

Continuing with the same example, how do the Terminal Value and PV of Terminal Value calculations change with this April 30th valuation?

With the Multiples Method, the Terminal Value calculation stays the same since it's based on the company's EBITDA (or other metric) in the final projection year times an appropriate multiple.

When you discount the Terminal Value, the stub period affects the discount period, but the mid-year convention does not because the Terminal Value is as of the END of the last projection year.

So if the valuation date is April 30th, and there are 10 years in the projection period, you use 9.67 for the discount period to calculate the PV of the Terminal Value.

With the Gordon Growth method, if you're using the mid-year convention, you must adjust the Terminal Value by multiplying it by (1 + Discount Rate)^0.5.

You have to do this because the normal formula, FCF in Year 1 of Terminal Period / (Discount Rate - Terminal Growth Rate), gives you the Present Value at Year 10.5 if you're using the mid-year convention.

When you multiply by (1 + Discount Rate)^0.5, you "move the Terminal Value back" to the end of Year 10.

Discounting the Terminal Value works the same way as it does with the Multiples Method: Only the stub period affects it. So you use also 9.67 for the discount period.

Why do you need to adjust the Terminal Value when you use the mid-year convention?

Can't you just discount it to Present Value using a different discount period?

Yes, you could discount the Terminal Value to its Present Value by using a different discount period instead.

However, the Terminal Values calculated via both methods should be directly comparable.

Why might you need to create a "Normalized Terminal Year" in a DCF?

You might create a Normalized Terminal Year if something about the company's revenue growth, margins, or CapEx is expected to change in a major way in the Terminal Period.

As a result of this change, multiplying FCF in the final projection year by (1 + Terminal FCF Growth Rate) won't produce accurate results in the Terminal Value formula.

For example, a key patent might expire in Year 9 or 10, or the company might have a huge Intangibles balance that gets completely amortized in Year 10.

You use the FCF in this Normalized Year for the Terminal Value calculation rather than multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).

What impact does the Normalized Terminal Year make?

Technically, it could go either way, but in most cases, the Normalized Terminal Year will reduce a company's Implied Value because you often adjust down the company's growth rates and margins in this year.

Which assumptions make the biggest impact on a DCF?

The Discount Rate and Terminal Value make the biggest impact on the DCF output.

That's because the Discount Rate affects the PV of everything and because the PV of the Terminal Value often represents 50%+ of the company's Implied Value.

Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?

Assuming that both companies have the same capital structure percentages, Cost of Equity and WACC should both be higher for the $500 million company.

All else being equal, smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains why Cost of Equity will be higher.

Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt (and Preferred) also tends to be higher.

And since all the Costs tend to be higher for smaller companies, WACC must be higher, assuming the same capital structure percentages.

Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?

The Discount Rate increase will make a bigger impact.

Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase the Discount Rate from 9% to 10%?

It's harder to tell here. More than doubling a company's revenue growth could make a bigger impact than changing the Discount Rate by 1%, but when the changes are this different, you'd have to run the numbers to tell for sure.

Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in each year.

Which company will have the higher Implied Value?

If it's just this series of cash flows, Company A will have the higher Implied Value b/c the time value of money.

However, Company B will almost certainly have a much higher Terminal Value because it has higher FCF in Year 10. So if the Terminal Value comprises a big portion of the Implied Value, and you count it in the analysis, it's a good bet that Company B will have the higher Implied Value.

How do higher vs. lower tax rates affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt.

Assuming there's some Debt, a higher tax rate will reduce Cost of Equity, Cost of Debt, and WACC.

It's easy to see why it reduces the Cost of Debt: Since you multiply by (1 - Tax Rate), a higher rate always reduces the after-tax cost.

But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower.

However, the Implied Value from a DCF will be lower because the higher tax rate reduces FCF and, therefore, the company's Terminal Value. Those changes tend to outweigh a lower WACC.

Can you walk me through how you use Public Comps and Precedent Transactions?

First, you select the companies and transactions based on criteria such as industry, size, and

geography.

Then, you determine the appropriate metrics and multiples for each set - for example,

revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples - and

you calculate them for all the companies and transactions.

Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for

each valuation multiple in the set.

Finally, you apply those numbers to the financial metrics of the company you're analyzing to

estimate its Implied Value.

Why is it important to select Public Comps and Precedent Transactions that are similar?

Because the comparable companies and transactions should have similar Discount Rates.

Remember that a company's valuation multiples depend on its Free Cash Flow, Discount Rate,

and Expected FCF Growth Rate.

If the companies in your set all have similar Discount Rates, it's easier to conclude that one

company has a higher multiple because its expected growth rate is higher.

If they don't have similar Discount Rates, it's harder to draw meaningful conclusions.

How do you select Comparable Companies and Precedent Transactions?

You screen based on geography, industry, and size, and also time for Precedent Transactions.

Are there any screens you should AVOID when selecting Comparable Companies and Precedent Transactions?

You should avoid screening by both financial metrics and Equity Value or Enterprise Value.

If you do that, you're artificially constraining the multiples because EV / Revenue must be

above 2x for every company in the set.

Both Public Comps and Precedent Transactions seem similar. What are the main differences?

Screening Criteria: In addition to industry, size, and geography, you also use time

because you only want transactions from the past few years. You might also use

Transaction Size, and you might use broader screening criteria in general.

Metrics and Multiples: You focus more on historical metrics and multiples, especially

LTM revenue and EBITDA as of the announcement date.

Calculations: All the multiples are based on the purchase price as of the announcement

date of the deal.

Output: The multiples produced tend to be higher than the multiples from Public Comps

because of the control premium. But the multiples also tend to span wider ranges

because deals can be done for many different reasons.

Can you walk me through the process of finding market and financial information for the

Public Comps?

You start by finding each company's most recent annual and interim (quarterly or half-year)

filing. You calculate its diluted share count and Current Equity Value and Current Enterprise

Value based on the information there and its most recent Balance Sheet.

Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent

annual results, adding the results from the most recent partial period, and subtracting the

results from the same partial period the last year.

For the projected figures, you look in equity research or find consensus figures on Bloomberg.

And then you calculate all the multiples by dividing Current Equity Value or Current Enterprise

Value by the appropriate metric.

Can you walk me through the process of finding market and financial information for the

Precedent Transactions?

You find the acquired company's filings from just before the deal was announced, and you

calculate the LTM financial metrics in the same way using those.

To calculate the company's Equity Value and Enterprise Value, you use the purchase price the

acquirer paid, and you move from Equity Value to Enterprise Value in the same way you usually

do, using the company's most recent Balance Sheet as of the announcement date.

You calculate all valuation multiples in the same way, using Transaction Equity Value or

Transaction Enterprise Value as appropriate.

How do you decide which metrics and multiples to use in these methodologies?

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability-

based metrics and multiples. For example, you might use Revenue, EBITDA, and Net Income,

and the corresponding multiples: EV / Revenue, EV / EBITDA, and P / E.

You do this because you want to value a company in relation to how much it sells and to how

much it keeps of those sales.

Why do you look at BOTH historical and projected metrics and multiples in these

methodologies?

Historical metrics are useful because they're based on what actually happened, but they can

also be deceptive if there were non-recurring items or if the company made acquisitions or

divestitures.

Projected metrics are useful because they assume the company will operate in a "steady state,"

without acquisitions, divestitures, or non-recurring items, but they're also less reliable because

they're based on predictions of the future.

When you calculate forward multiples for the comparable companies, should you use

each company's Current Equity Value or Current Enterprise Value, or should you project them

to get the Year 1 or Year 2 values?

No, you always use the Current Equity Value or Current Enterprise Value. NEVER "project"

either one.

A company's share price, and, therefore, both of these metrics, is based on past performance

and future expectations.

So to "project" these metrics, you'd have to jump into the future and see what future

expectations are at that point, which doesn't make sense.

What should you do if some companies in your set of Public Comps have fiscal years that

end on June 30th and others have fiscal years that end on December 31st?

You have to "calendarize" by adjusting the companies' fiscal years so that they match up.

For example, to make everything match a December 31st year-end date, you take each

company with a June 30th fiscal-year end and do the following:

• Start with the company's full June 30th fiscal-year results.

• Add the June 30th - December 31st results from this year.

• Subtract the June 30th - December 31st results from the previous year.

How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you're valuing?

The interpretation depends on how the growth rates and margins of your company compare to those of the comparable companies.

Public Comps are most meaningful when the growth rates and margins are similar, but the

multiples are different. This could mean that the company you're valuing is mispriced and that

there's an opportunity to invest and make money.

For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15-

20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these

ranges.

However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable

companies all trade at multiples of 10x to 12x.

That could indicate that your company is undervalued since its multiples are lower, but its

growth rates, margins, industry, and size are all comparable.

If the growth rates and margins are very different, it's harder to draw conclusions since

companies growing at different rates are expected to trade at different multiples.

Is it valid to include both announced and closed deals in your set of Precedent

Transactions?

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn't closed

yet, the simple announcement of the deal reflects what one company believes another is worth.

Note that you base all the metrics and multiples on the financial information as of the

announcement dates.