This is one of the classic questions in Investment Banking recruiting. You will 100% get this question. Knowing how to run a DCF is part of every Investment Banker’s core repertoire. You must know this question in and out. If you show up unprepared or are caught off guard, you will get rejected.
This is where an interview situation differs from your academic studies. In college, you will get lecture notes that would devote an entire chapter on this topic. In an interview situation, you must give a concise answer within 5 to 10 minutes. Yes, we are talking about roughly 5 minutes of an entire 60-minute-long interview. You have to deliver a short and condensed answer while not missing out on important details – all in a high-stakes situation. And you only get one shot to get it right.
How do you go about this? We are here to help you. In this post, you will find a concise structure and the underlying concepts of a DCF analysis. We will give you everything you need to tackle this question.
Here is how to structure your answer:
Create a 5-year forecast with reasonable assumptions
Derive the Unlevered Free Cash Flow
Calculate the Terminal Value
Determine the Discount Rate
Discount all Cash Flows and Terminal Value
1. Create a 5-year forecast with reasonable assumptions
If you want to know whether it’s worth investing in a company, you want to estimate how much money that target company can generate in the future. That’s where you need to create a 5-year forecast of that company.
Why 5 years, you might ask? Because it’s an industry convention. 2 to 3 years is too short, whereas 7 to 8 years is getting too long. 5 years is the sweet spot. The longer the projection period, the more uncertain the projections become. A shorter projection period increases accuracy of projected cash flows. However, this increases the share of the terminal value of the Enterprise Value.
It’s important to have reasonable growth assumptions for the DCF to be valid. If assumptions are too ambitious, the valuation will be too expensive and shy of potential investors that don’t believe in such overblown growth. If assumptions are too conservative, you might leave some money on the table when selling the company because more growth could have been realized.
The DCF analysis focuses mainly on the company’s business plan and cash flows instead of the market-centric multiple valuations. Therefore, it is considered a fundamental approach – meaning how the company performs in terms of revenues and EBITDA.
For interview purposes, you don’t have to go into the details of forecasting future incomes. This would be too detailed. Keep in mind that more conservative projections will yield more realistic valuation levels. Growth assumptions that are too aggressive and unlikely to materialize will result in an over-valuation. This defeats the initial purpose of accurately valuing the company.
2. Derive the Unlevered Free Cash Flow
After setting up the business plan and forecast, you need to derive the Unlevered Free Cash Flow. When bankers talk about “free cash flow”, they always refer to “Unlevered Free Cash Flow” or “free cash flow to the firm”. This is the cash flow available to both Debt and Equity investors. You always want to look at the cash flow the firm generates independent of its capital structure. This makes companies more comparable.
Here is one way to derive the Unlevered Free Cash Flow:
EBITDA
+/– Changes in Working Capital
– Taxes
– Capex
= Unlevered Free Cash Flow
This is the cash flow available to both Debt and Equity investors after taxes and investments (capex). Note that it also excludes Interest Expenses and any Debt Repayments. This is the cash flow that is widely used for a DCF analysis. Side note: There is also a levered cash flow. This is the cash flow after Interest Expenses and Debt Repayments. In other words, it’s the cash flow available to all Equity investors. This figure is more relevant for Equity investors as it better indicates their company’s actual profitability after debt service.
Keep in mind: You only project Unlevered Free Cash Flow once a company has reached a stable state, where growth and profitability have leveled into a steady state. You wouldn’t want to use a DCF to value a startup that may grow exponentially and where margins fluctuate.
3. Calculate the Terminal Value
Ok, now you have your 5-year forecast and your Unlevered Free Cash Flow. What’s next? We need to calculate the Terminal Value. The Terminal Value captures the value of the company beyond the projection period of the DCF. Depending on the case, the Terminal Value can go up to about 75% of the value of a 5-year DCF.
There are two methods to calculate the terminal value: (1) Exit multiple method and (2) perpetuity growth method (Gordon Growth).
(1) The exit multiple method assumes that the company will be sold at the end of the projection period and assigns an exit multiple to the EBITDA or EBIT of the final projection year. This method assumes that the company will be sold at the end of the projection period based on public markets valuations. The idea is that on “exit”, the company should have reached a “steady state” with no significant growth remaining and stable margins.
To derive the Terminal Value, multiply the EBITDA or EBIT of the last projected year by the respective EBITDA or EBIT multiple. It’s important to choose the appropriate valuation level of the multiple. Too high and you inflate your Enterprise Value; too low and you may leave money on the table for your client. It’s a (+) simple way of estimating the Terminal Value and (+) the multiple is determined based on public market data. However, (-) because it’s so simple, it’s somewhat imprecise and (-) the quality of the peer group can also be up for debate.
(2) The perpetuity growth method (Gordon Growth) assumes that the company will continue to generate cash flows in its steady-state forever:
Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate)
Roughly speaking, the growth rate = GPD growth rate. You are assuming that the company is steadily moving with the national economy forever. If you assume a perpetuity growth rate higher than the GPD growth rate %, you are saying that you expect the company’s growth to outpace the economy’s growth forever. The Terminal Value method is theoretically preferable because it (+) focuses on cash flows and (+) captures long-term growth views instead of assuming a sale of the company. However, (-) a perpetual growth is difficult to predict and (-) assuming a constant WACC forever is not realistic.
In a DCF valuation, you would always use both methods to cross-check your Terminal Value calculation. If your growth rate is in-line but your exit multiple valuation is completely out of line, you need to check the exit multiple assumptions and vice versa. Both methods need to somehow match up in the same ballpark.
4. Determine the Discount Rate
Weighted Cost of Capital (WACC)
Once you have your projected Unlevered Free Cash Flows and the Terminal Values, you need to discount them to the present. As discount rate, we use the Weighted Cost of Capital (WACC):
WACC = Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate)
Why do we have to “discount” our cash flows? Put simply, if you spend money all your money on buying one single company, that money cannot be used for anything else. You can’t use it to invest in the S&P 500, for example. That money is locked into one company. So, you have to factor in the lost opportunity cost – aka the cost of capital. The discount rate is a weighted average of expected returns by different capital providers, such as debt or equity. Equity is usually more expensive than Debt because it includes the risk of ownership.
The assumed capital structure should reflect the long-term targeted capital structure instead of the current capital structure of the target company. While different discount rates can be used for each projection period, a constant rate is more common.
Cost of Equity
To determine the Cost of Equity, we use the capital asset pricing model (CAPM):
Cost of Equity = Risk-Free Rate + ((Beta * (Market Return – Risk Free Return))
The Cost of Equity equals the risk-free rate plus the excess market return multiplied by beta. In other words, you take the risk-free base rate and add a company-specific risk factor on top of it. Beta is a measure of volatility. If beta is 1, there is a perfect correlation with the market. If beta is 2, this stock moves up two times stronger up AND down compared to the market. This means if the market goes up by 10%, this stock goes up by 20%. If beta is -1, this stock moves up when the market moves down.
You can find the betas on databases, such as Bloomberg or Capital IQ. This is where you would pick the beta based on a selection of comparable companies. Before applying the comparable beta to your target company, you need to un-lever all the betas you just picked out. All the betas in the data basis reflect their respective capital structure, which varies from company to company. The more debt a company has, the riskier it becomes. Once you have the unlevered betas of your comparable companies and have picked your appropriate unlevered beta for your target company, you need to re-lever that target beta to reflect the target capital structure of your target company:
Un-Levered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity)))
Levered Beta = Un-Levered Beta * (1+((1-Tax Rate)*(Total Debt/Equity)))
Now you have all the inputs to plug into your Cost of Equity formula.
Cost of Debt
Moving on to Cost of Debt. Cost of Debt can be understood as how much a bank would charge the target company for a loan. How much would it cost to take a loan with the target company’s cash flows as collateral? Here the formula is less complicated:
After tax cost of debt = (10Y Risk-Free Rate + Credit Spread based on Rating) * (1-Tax Rate)
First, you pick the 10Y risk-free rate and then add a credit spread based on the company’s credit rating. In other words, you pick the base risk-free rate and add the risk premium of the target company based on its rating. If you are dealing with smaller companies that are not rated, you might as well just ask the CFO what quote they received for their last credit offer. Then, you have to multiply by the reverse tax rate because interest expenses of debt are tax-deductible.
5. Discount all Cash Flows and Terminal Value
Now that we have our 5-year forecast, the Unlevered Free Cash Flow, the Terminal Value and the Discount Rate, we can put it all together. The last step is to discount all cash flows and the Terminal Value with the WACC:
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4 + CF5/(1+r)^5 + TV/(1+r)^5
CF = Cash Flow (Unlevered Free Cash Flows)
r = Discount Rate (WACC)
TV = Terminal Value (Gordon Growth or Exit Multiple)
Once you have summed up all your discounted cash flows and the discounted Terminal Value, you now have the Enterprise Value of the target company. This is the end of a DCF analysis.
Strengths and weaknesses of a DCF analysis
But you are not done yet regarding DCF questions. Once you have walked through your DCF analysis, the interviewer will usually ask about the strengths and weaknesses of this valuation method. We want to see whether you can put things into context vs. just mindlessly memorizing facts. The DCF is a fundamental approach to derive a company valuation reflecting the future development of a specific company vs. relying on multiples of comparable companies
(+) Fundamental approach that reflects the future development of a specific company that is based on free cash flow and not just EBITDA or EBIT multiple
(+) Suitable to valuate stable and cashflow positive business models
(+) Enables a strategic investor to assess potential synergies and price them within a “new joint business plan” vs. the standalone case
(+) Reflects the time value of money
(+) Applicable for smaller and private companies, where listed comparable companies are hard to find
On the other hand, the quality of the valuation is heavily driven by the soundness of the underlying business plan, which is time-consuming to prepare
(-) The underlying business plan takes time and is data intensive
(-) Valuation of DCF is primarily driven by the soundness of the business plan. Are growth assumptions too strong? Are margins improvements realistic? Is Capex projected realistically? The management team may try to inflate a DCF with over-optimistic growth rates
(-) Unsuited to value cashflow negative companies that are eventually going to be profitable in the future
Where does it leave us?
Ok, so this was quite a lot to take in. Do you need to remember all of this? Yes. Everything in this post is fair game in an interview situation. Do you need to know all the formulas? Yes. That’s also fair game.
In an interview situation, this whole part would cover 5 to 10 minutes, maybe 15 minutes at max. You must be able to fluently walk through all of the moving parts of this question. You will 100% get this question. This is one of the fundamental questions you must master. There is no way around it if you want to get into Investment Banking.
Don’t get overwhelmed and work your way through the five main building blocks as outlined in this post:
Create a 5-year forecast with reasonable assumptions
Derive the Unlevered Free Cash Flow
Calculate the Terminal Value
Determine the Discount Rate
Discount all Cash Flows and Terminal Value
We hope that you could see the difference between academia and interview prep. In college, you get a plethora of slides that would derive and explain the mystical concepts of a DCF analysis. In an interview situation, you get 5 to 10 minutes to condense all that knowledge into a concise answer. You get one chance to walk through the concepts while the stakes are a lot higher.
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