Level 2 Valuation Questions : DCF and WACC Concepts
1. Walk me through a DCF analysis
The steps to walk through a DCF analysis are:
Project future Cash Flow until the business reaches maturity (usually 5-10 years).
Calculate Terminal Value.
Discount the Projected Cash Flows and Terminal Value using WACC.
Work from Enterprise Value to Equity Value by subtracting Debt and adding Cash.
Calculate Price per Share by dividing Equity Value by the Number of Shares.
Remember to keep it high-level!
2. All else equal, which comp method (trading or transaction) will result in a higher valuation? Why?
Precedent Transactions analysis typically results in a higher valuation because you have to pay a ‘Control Premium’ to acquire an entire business vs buying a smaller stake.
3. Why is the LBO valuation generally referred to as a “floor” valuation?
An LBO firm typically doesn’t own a competing asset to a target company it acquires and thus can’t generate Synergies. This typically results in the lowest purchase price (vs Corporate Acquirers).
To explain further, when a Corporate (or ‘Strategic’) buyer makes an acquisition, they can typically generate Synergies which raises profit and thus justifies a higher acquisition price. An LBO firm typically can’t generate synergies and can’t justify as high of a price.
4. Walk me through the Cost of Equity (i.e. CAPM) formula…in Plain English.
The formula starts with the Risk-Free Rate (usually the 10 Yr US Treasury).
This gives us a baseline for the Minimum Return we should expect if we’re taking zero risk.
We then add a reward for taking incremental Risk in the form of Beta (which characterizes the volatility/riskiness of an individual stock) and multiply Beta by the Equity Risk Premium (which reflects the historical Reward for investing in Stocks vs Bonds over time).
5. What is a reasonable terminal growth rate? Why?
You should assume long-term growth in line with GDP growth for your Terminal Value calculation. Otherwise, you will outgrow the economy.
6. What are the two most common methods for calculating Terminal Value?
The two most common approaches are the Perpetuity Growth Method and the Exit Multiple Method.
In the Free Cash Flow Formula, why do we start with EBIT * (1-T)…as opposed to EBITDA * (1-T)?
EBIT takes into account Depreciation and Amortization (‘D&A’) which is a non-cash expense that lowers our taxes owed.
In short, Depreciation ‘shields’ us from tax liability and so the D&A impact is referred to as the ‘Depreciation Tax Shield’.
7. What is the Depreciation tax shield in the Unlevered Free Cash Flow calculation?
When we calculate Taxes in our Unlevered Free Cash Flow, we calculate taxes based on EBIT, which incorporates Depreciation and Amortization (D&A) as a deduction.
This lowers our taxable income (even though D&A are non-cash charges), which in turn lowers our taxes owed.
We then add D&A back in the calculation because it’s non-cash. In short, D&A lowers (i.e. shields) our taxes owed.
8. Why don’t we include interest in the Unlevered Free Cash Flow calculation?
‘Unlevered’ means you do not include anything connected to leverage, such as interest expense.
In short, we look at the cash flow absent the impact of debt and discount it by the weighted average cost of capital which reflects the blended expected returns of all capital providers (Debt and Equity).
In the end, we arrive at the total value of the business (i.e. Enterprise Value) absent the impacts of Debt and Equity.
9. Why do we look at the cost of debt on an after-tax basis?
Interest is tax-deductible for a business and so the real cost of Debt is the after-tax interest cost.
10. All else equal, which should be higher: Cost of Equity or Cost of Debt?
Usually, the Cost of Equity is greater than the Cost of Debt.
This is because the lenders to a business take less risk because they are paid first in the event of a sale or bankruptcy.
In contrast, Investors aren’t paid until after all Lender claims have been satisfied and thus take more risk.
11. Why is WACC characterized as an ‘Opportunity Cost of Capital?’
WACC is characterized as an opportunity cost of capital because it represents the level of risk and foregone investments taken by investors
Do we use market or book value for our Debt/Equity weightings in the WACC formula?
We typically use book value for the Debt weighting and Market Value for the Equity weighting in the Weighted Average Cost of Capital Formula.
12. What is the formula to un-lever Beta?
The formula to un-lever Beta is: Levered Beta / (1 + [D/E])*(1-T))
13. What is the formula to re-lever Beta?
The formula to re-lever Beta is: Unlevered Beta * (1 + [D/E])*(1-T))
14. How do we find the Beta of a Private Company?
To find the Beta of a Private company, we find the Beta for several publicly traded peers. We then un-lever the peer Betas, take the average of the peer Betas, and re-lever the average with the target capital structure of the company we are valuing.
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