fina exam 2

What does DCF valuation estimate?

A company’s value today based on the present value of its expected future cash flows.

What does FCFF stand for?

Free cash flow to the firm: cash available to debt and equity investors after operating needs and reinvestment.

What does WACC stand for?

Weighted average cost of capital: the required return for the company’s debt and equity capital combined.

What discount rate do we use for FCFF?

WACC.

What is the projection period?

The years when each cash flow is forecast separately, usually 3–5 years and sometimes up to 10.

What is the stable growth rate, g?

The constant long-term rate at which cash flows are assumed to grow forever.

Why should stable growth be reasonable compared with economic growth?

A company cannot realistically grow faster than the entire economy forever.

What is the terminal phase?

The period after the detailed forecast when cash flows follow a stable long-term growth assumption.

What is terminal value, TV?

The value, at the end of the projection period, of all cash flows after that period.

What does T represent in terminal value formulas?

The final year of the detailed forecast. Terminal value is measured at that time.

What is the perpetuity growth terminal value formula?

TV_T = FCFF_(T+1) / (WACC − g).

How do you find next year’s FCFF using stable growth?

FCFF_(T+1) = FCFF_T × (1 + g).

What is the terminal value formula using the final projected cash flow?

TV_T = [FCFF_T × (1 + g)] / (WACC − g).

What condition must hold for the growing perpetuity formula?

WACC must be greater than g.

Cash flows grow at 2.5% forever after Year 5. Which cash flow goes in the terminal value numerator?

Year 6 cash flow: FCFF_6 = FCFF_5 × 1.025.

If stable growth starts after Year 5, at what date is terminal value calculated?

Year 5: TV_5 = FCFF_6 / (WACC − g).

Does TV_5 include Year 5 cash flow?

No. It includes Year 6 onward. Add Year 5 cash flow separately.

How do you discount a Year t cash flow to today?

PV = CF_t / (1 + WACC)^t.

How do you discount terminal value to today?

PV(TV_T) = TV_T / (1 + WACC)^T.

What is the full FCFF DCF formula for enterprise value?

EV = FCFF_1/(1+WACC) + … + FCFF_T/(1+WACC)^T + TV_T/(1+WACC)^T.

Why do the final projected cash flow and terminal value use the same discount exponent?

They are both valued at Year T.

Do you add the most recently reported FCFF_0 as a future cash flow?

No. It already happened. Use it to forecast future cash flows.

What are the three main FCFF DCF steps?

Forecast cash flows, calculate terminal value, and discount everything to today.

What information is needed for perpetuity growth DCF stock valuation?

Projected FCFF, WACC, stable growth rate, final forecast year, debt, cash, and shares outstanding.

What happens to value when expected future cash flows increase?

Value increases, holding everything else constant.

What happens to value when the discount rate increases?

Value decreases, holding cash flows constant.

What happens to terminal value when g increases?

It increases, holding final-year FCFF and WACC constant, as long as g stays below WACC.

Why can DCF estimates be uncertain?

Cash flows are difficult to forecast, and value is sensitive to the discount rate and terminal assumptions.

What are the two main DCF reasons fundamental stock values change?

Changes in expected future cash flows and changes in discount rates.

What does “stock prices are forward-looking” mean?

Prices reflect future expectations. Past results matter when they change those expectations.

What value results from discounting FCFF at WACC?

Enterprise value: the value of the company’s operations.

What is equity value?

The total value belonging to shareholders.

What is market capitalization?

Current share price × Shares outstanding.

What is the simplified enterprise value formula?

EV = Equity value + Debt − Cash.

What is net debt?

Net debt = Debt − Cash.

Why is cash subtracted when calculating enterprise value?

Cash offsets part of the cost of taking on the company’s debt.

How do you move from enterprise value to equity value?

Equity value = EV − Debt + Cash.

How do you find estimated value per share?

Share value = Equity value / Shares outstanding.

When is enterprise value greater than equity value?

When debt is greater than cash, using the simplified formula.

When can equity value exceed enterprise value?

When cash is greater than debt.

What does “walk the bridge to equity” mean?

Start with EV, subtract debt, and add cash.

What is the simplified FCFF formula using a reinvestment rate?

FCFF = Revenue × Operating margin × (1 − Tax rate) × (1 − Reinvestment rate).

What is operating margin?

Operating margin = EBIT / Revenue.

What is after-tax operating income, or NOPAT?

NOPAT = EBIT × (1 − Tax rate).

What does a 70% reinvestment rate mean in the simplified FCFF formula?

The company reinvests 70% of after-tax operating income, leaving 30% as FCFF.

What is relative valuation?

Estimating a company’s value using valuation multiples of similar companies.

What are comps?

Comparable companies with similar business characteristics, growth, and risk.

Why can’t you compare companies using share price alone?

Their sizes and share counts differ. A lower share price does not automatically mean a cheaper company.

What is the paper towel lesson for valuation?

Compare price per unit to make a fair comparison.

Which is cheaper: 12 rolls for $12 or 24 rolls for $18?

The 24-pack: $0.75 per roll versus $1 per roll.

At $0.75 per roll, what should 48 rolls cost?

48 × $0.75 = $36.

What is the basic idea behind valuation multiples?

Similar companies should have similar values per dollar of a relevant performance measure.

What is a valuation multiple?

Company value divided by a measure that helps explain that value.

What can be the numerator of a valuation multiple?

Equity value or enterprise value.

What are common denominators of valuation multiples?

Earnings, sales, EBIT, EBITDA, or FCFF.

What are examples of nonfinancial valuation measures?

Monthly active users, patents, or number of customers.

Why use nonfinancial valuation measures for young companies?

Their earnings and cash flows may be low, negative, or highly uncertain.

If two companies have identical future cash flows and risk, how should their values compare?

They should have the same value.

If A has twice B’s future cash flows with the same timing and risk, how should their values compare?

A should be worth twice as much as B.

What is the P/E formula?

P/E = Share price / EPS = Market capitalization / Net income.

What is earnings per share, EPS?

Earnings available to common shareholders / Common shares outstanding.

What does a P/E of 20 mean?

Investors pay $20 for each $1 of annual earnings.

What is trailing P/E?

Current share price / EPS from the trailing 12 months.

What is forward P/E?

Current share price / Expected future EPS, usually next year’s.

When is forward P/E especially useful?

When forecasts are reliable and better represent future earning power.

Why is P/E a consistent ratio?

Both equity value and net income relate to shareholders.

What is a major weakness of P/E?

Negative earnings make it difficult to interpret, and tiny positive earnings can create extremely high ratios.

How do you estimate share value using a comparable P/E?

Estimated share value = Comparable P/E × Company’s EPS.

What does EBIT stand for?

Earnings before interest and taxes; operating income.

What does EBITDA stand for?

Earnings before interest, taxes, depreciation, and amortization.

What is the EBITDA formula?

EBITDA = EBIT + Depreciation + Amortization.

Are EBITA and EBITDA the same?

No. EBITA adds back amortization to EBIT; EBITDA adds back depreciation and amortization.

Why add back depreciation and amortization?

They reduce accounting profit but are not current-period cash payments.

Is EBITDA the same as FCFF?

No. EBITDA does not deduct taxes, capital spending, or changes in working capital.

Why pair EBIT, EBITDA, sales, and FCFF with enterprise value?

These measures relate to the business before payments to debt investors, so the numerator includes debt and equity claims.

What is EV/Sales?

EV / Annual revenue.

What is EV/EBIT?

EV / Annual EBIT.

What is EV/EBITDA?

EV / Annual EBITDA.

What is EV/FCFF?

EV / Annual FCFF.

Why is EV/EBITDA often more practical than EV/FCFF?

EBITDA is usually easier to obtain or estimate; FCFF requires additional calculations.

Why might EV/EBITDA work when P/E or EV/EBIT does not?

Adding back depreciation and amortization may make EBITDA positive even when net income or EBIT is negative.

Can EBITDA also be negative?

Yes. EV/EBITDA is also difficult to interpret when EBITDA is negative or close to zero.

How do you estimate EV using an EV/EBITDA multiple?

Estimated EV = Comparable EV/EBITDA × Company’s EBITDA.

Why can comparable companies have different multiples?

Differences in growth, risk, capital structure, accounting, or business characteristics.

Do different valuation multiples always produce the same value?

No. P/E, EV/EBITDA, and other ratios may give different estimates.

What if all comparable companies are overvalued?

Relative valuation may also overvalue the company being analyzed.

What if all comparable companies are undervalued?

Relative valuation may also undervalue the company being analyzed.

Does a low multiple prove a stock is underpriced?

No. It may reflect low growth, high risk, or weak business prospects.

What is the hybrid DCF and relative valuation approach?

Discount near-term cash flows and estimate terminal value using a comparable-company multiple.

What is an exit multiple?

A valuation multiple applied to projected performance at the end of the forecast period.

What is the course’s EV/EBITDA exit terminal value formula?

TV_T = Comparable EV/EBITDA × EBITDA_T.

What is the course’s EV/FCFF exit terminal value formula?

TV_T = Comparable EV/FCFF × FCFF_T.

Which FCFF does the course use in its exit multiple example?

Year T FCFF. The perpetuity growth formula uses Year T+1 FCFF.

Do you need g to calculate terminal value with an exit multiple?

No. You use the multiple and projected financial measure.

What happens after calculating exit terminal value?

Discount it and the projected cash flows to today, then add them to find EV.

Revenue is $800 million and operating margin is 25%. What is EBIT?

$800 million × 0.25 = $200 million.

EBIT is $200 million and the tax rate is 25%. What is NOPAT?

$200 million × 0.75 = $150 million.

NOPAT is $150 million and reinvestment is 70%. What is FCFF_0?

$150 million × 0.30 = $45 million.

FCFF_0 is $45 million and grows 10%. What is FCFF_1?

$45 million × 1.10 = $49.5 million.

FCFF_1 is $49.5 million and grows 10%. What is FCFF_2?

$49.5 million × 1.10 = $54.45 million.