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Could you explain the concept of present value and how it relates to company valuations? The present value concept is based on the premise that "a dollar in the present is worth more than a dollar in the future" due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today. For intrinsic valuation methods, the value of a company will be equal to the sum of thepresent value of all the future cash flows it generates. Therefore, a company with a high valuation would imply it receives high returns on its invested capital by investing in positive net present value ("NPV") projects consistently while having low risk associated with its cash flows. What is equity value and how is it calculated? Often used interchangeably with the term market capitalization (“market cap”), equity value represents a company's value to its equity shareholders. A company's equity value is calculated by multiplying its latest closing share price by its total diluted shares outstanding, as shown below: Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding How do you calculate the fully diluted number of shares outstanding? The treasury stock method ("TSM") is used to calculate the fully diluted number of shares outstanding based on the options, warrants, and other dilutive securities that are currently "in-the-money" (i.e., profitable to exercise). The TSM involves summing up the number of in-the-money ("ITM") options and warrants and then adding that figure to the number of basic shares outstanding. In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact. What is enterprise value and how do you calculate it? Conceptually, enterprise value ("EV") represents the value of the operations of a company to all stakeholders including common shareholders, preferred shareholders, and debt lenders. Thus, enterprise value is considered capital structure neutral, unlike equity value, which is affected by financing decisions. Enterprise value is calculated by taking the company's equity value and adding net debt, preferred stock, and minority interest. Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest How do you calculate equity value from enterprise value? To get to equity value from enterprise value, you would first subtract net debt, where net debt equals the company’s gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets.
Equity Value = Enterprise Value – Net Debt – Preferred Stock – Minority Interest Which line items are included in the calculation of net debt? The calculation of net debt accounts for all interest-bearing debt, such as short-term and long- term loans and bonds, as well as non-equity financial claims such as preferred stock and non- controlling interests. From this gross debt amount, cash and other non- operating assets such as short-term investments and equity investments are subtracted to arrive at net debt. Net Debt = Total Debt – Cash & Equivalents When calculating enterprise value, why do we add net debt? The underlying idea of net debt is that the cash on a company's balance sheet could pay down the outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company's debt, and many leverage ratios use net debt rather than the gross amount. What is the difference between enterprise value and equity value? Enterprise value represents all stakeholders in a business, including equity shareholders, debt lenders, and preferred stock owners. Therefore, it's independent of the capital structure. In addition, enterprise value is closer to the actual value of the business since it accounts for all ownership stakes (as opposed to just equity owners). To tie this to a recent example, many investors were astonished that Zoom, a video conferencing platform, had a higher market capitalization than seven of the largest airlines combined at one point. The points being neglected were:
- The equity values of the airline companies were temporarily deflated given the travel restrictions, and the government bailout had not yet been announced.
- The airlines are significantly more mature and have far more debt on their balance sheet (i.e., more non- equity stakeholders). Could a company have a negative net debt balance and have an enterprise value lower than its equity value? Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies will have enterprise values lower than their equity value. If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value represents the value of a company's operations, which excludes any non-operating assets. When you think about it this way, it should come as no surprise that companies with much cash (which is treated as a non-operating asset) will have a higher equity value than enterprise value. Can the enterprise value of a company turn negative? While negative enterprise values are a rare occurrence, it does happen from time to time. A negative enterprise value means a company has a net cash balance (total cash less total debt) that exceeds its equity value. If a company raises $250 million in additional debt, how would its enterprise value change? Theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised shouldn't impact the enterprise value, as the cash and debt
Transaction comps value a company based on the amount buyers paid to acquire similar companies in recent years. What is Discounted Cash Flow Analysis ("DCF")? DCFs value a company based on the premise that its value is a function of its projected cash flows, discounted at an appropriate rate that reflects the risk of those cash flows. What is Leveraged Buyout Analysis ("LBO")? An LBO will look at a potential acquisition target under a highly leveraged scenario to determine the maximum purchase price the firm would be willing to pay. What is Liquidation Analysis? Liquidation analysis is used for companies under (or near) distress and values the assets of the company under a hypothetical, worst-case scenario liquidation. Among the DCF, comparable companies analysis, and transaction comps, which approach yields the highest valuation? Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factor in control premiums. Control premiums can often be quite significant and as high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation. Which of the valuation methodologies is the most variable in terms of output? Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of the different valuation methodologies. Relative valuation methodologies such as trading and transaction comps are based on the actual prices paid for similar companies. While there'll be some discretion involved, the valuations derived from comps deviate to a lesser extent than DCF models. Contrast the discounted cash flow (DCF) approach to the trading comps approach. Discounted Cash Flow (DCF) Advantages
- The DCF values a company based on the company’s forecasted cash flows.
- This approach is viewed as the most direct and academically rigorous way to measure value.
- Considered to be independent of the market and instead based on the fundamentals of the company. Disadvantages
- The DCF suffers from several drawbacks; most notably, it's very sensitive to assumptions.
- Forecasting the financial performance of a company is challenging, especially if the forecast period is extended.
- Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around three- quarters of the implied valuation. Trading Comps Advantages
- Trading comps value a company by looking at how the market values similar businesses.
- Thus, comps relies much more heavily on market pricing to determine the value of a company (i.e., the most recent, actual prices paid in the public markets).
- In reality, there are very few truly comparable companies, so in effect, it's always an “apples and oranges” comparison. Disadvantages
- While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced, it's vulnerable to how the market is not always right.
- Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company’s fundamentals.
- Comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF). How can you determine which valuation method to use? Each valuation method has its shortcomings; therefore, a combination of different valuation techniques should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more defensible approximation and sanity- check your assumptions. The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa). For example, an analyst valuing an acquisition target may look at the past premiums and values paid on comparable transactions to determine what the acquirer must realistically expect to pay. The analyst may also value the company using a DCF to help show how far market prices are from intrinsic value estimates. Another example of when the DCF and comps approaches can be used together is when an investor considers investing in a business - the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuations derived using a DCF (although it bears repeating that the DCF's sensitivity to assumptions is a frequent criticism). Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals? That could be argued as an inaccurate statement. While a comps analysis often yields different valuations from a DCF, that's only because of inconsistent implicit assumptions across both approaches. If the implicit assumptions of the comps analysis were entirely consistent with the explicit assumptions of the DCF analysis, the valuations using both approaches would theoretically be equal. When you apply a peer-derived multiple to value a business, you're still implicitly making assumptions about future cash flows, cost of capital, and returns that you would make explicitly when building a DCF. The difference is, you're relying on the assumptions used by others in the market. So when you perform relative valuation, you assume the market consensus to be accurate or at least close to the right value of a company and that those investors in the market are rational. What does free cash flow (FCF) represent? Free cash flow ("FCF") represents a company's discretionary cash flow, meaning the cash flow remaining after accounting for the recurring expenditures to continue operating.
more favorable rates since their default risk has decreased. Thus, it's ordinary to see leverage ratios increase in proportion with the company's maturity. Why would a company issue equity vs. debt (and vice versa)? Equity Advantages
- No required payments, unlike debt, giving management more flexibility around repayment.
- Dividends to equity shareholders can be issued, but the timing and magnitude are at the board and management’s discretion.
- Another advantage of equity is that it gives companies access to a vast investor base and network. Disadvantages
- Issuing equity dilutes ownership, and equity is a high cost of capital.
- Public equity comes with more regulatory requirements, scrutiny from shareholders and equity analysts, and full disclosures of their financial statements.
- The management team could lose control over their company and be voted out by shareholders if the company underperforms. Debt Advantages
- The interest expense on debt is tax- deductible, unlike dividends to equity shareholders (although recent tax reform rules limit the deduction for highly levered companies).
- Debt results in no ownership dilution for equity shareholders and has a lower cost of capital.
- Increased leverage forces discipline on management, resulting in risk-averse decision- making as a side benefit. Disadvantages
- Required interest and principal payments that introduce the risk of default.
- Loss of flexibility from restrictive debt covenants prevents management from undertaking a variety of activities such as raising more debt, issuing a dividend, or making an acquisition.
- Less room for errors in decision-making, therefore poor decisions by management come with more severe consequences. What are share buybacks and under which circumstances would they be most appropriate? A stock repurchase (or buyback program) is when a company uses its cash-on-hand to buy back some of its shares, either through a tender offer (directly approach shareholders) or in the open market. The repurchase will be shown as a cash outflow on the cash flow statement and be reflected on in the treasury stock line items on the balance sheet. Ideally, the right time for a share repurchase to be done should be when the company believes the market is undervaluing its shares. The impact is the reduced number of shares in circulation, which immediately leads to a higher EPS and potentially a higher P/E ratio. The buyback can also be interpreted as a positive signal by the market that the management is optimistic about future earnings growth.
Why would a company repurchase shares? What would the impact on the share price and financial statements be? A company buys back shares primarily to move cash from the company's balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash as with dividends, a share repurchase removes shareholders. The impact on share price is theoretically neutral - as long as shares are priced correctly, a share buyback shouldn't lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can positively or negatively affect share price movement, depending on how the market perceives the signal. Cash-rich but otherwise risky companies could see artificially low share prices if investors discount that cash in their valuations. Here, buybacks should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator. Conversely, if shareholders view the buyback as a signal that the company's investment prospects are not great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash, lower perceived growth and investment prospects). On the financials, the accounting treatment of the $100 million share buyback would be treated as: Cash is credited by $100 million Treasury stock is debited by $100 million Why might a company prefer to repurchase shares over the issuance of a dividend?
- The so-called "double taxation" when a company issues a dividend, in which the same income is taxed at the corporate level (dividends are not tax-deductible) and then again at the shareholder level.
- Share repurchases will artificially increase EPS by reducing the number of shares outstanding and can potentially increase the company's share price.
- Many companies increasingly pay employees using stock-based compensation to conserve cash, thus share buybacks can help counteract the dilutive impact of those shares.
- Share buybacks imply a company's management believes their shares are currently undervalued, making the repurchase a potential positive signal to the market.
- Share repurchases can be one-time events unless stated otherwise, whereas dividends are typically meant to be long-term payouts indicating a transition internally within a company.
- Cutting a dividend can be interpreted very negatively by the market, as investors will assume the worst and expect future profits to decrease (hence, dividends are rarely cut once implemented).
multiple cash flows) accounted for, rather than just smoothing out the investment returns. CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making. How would you evaluate the buy vs. rent decision in NYC?
- First, I would have to make assumptions to allow for a proper comparison, such as having enough upfront capital to make a down payment and the investment period being ten years.
- Under the 1st option, I assume I buy and will have to pay the monthly mortgage, real estate tax, and maintenance fees (which will be offset by some tax deductions on interest and depreciation) during this investment period. Then, I'll assume that I could sell the property at a price that reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to a sale, I can calculate my IRR and compare this IRR to the IRR from renting.
- For the 2nd option, I would start by estimating the rental cost of comparable properties, factoring in rent escalations over ten years. Since there's no initial down- payment required, I would put that money to work elsewhere, such as an investment in the stock market, in which I would assume an annual return over the ten years consistent with the long-term historical return on the stock market (5-7%). I could then compute an IRR based on the inflows/(outflows) and compare the two IRRs to make an informed decision.
- I would keep in mind that this comparison is not precisely "apples to apples." For example, investing in an NYC property is riskier than investing in the stock market due to the leverage and lower liquidity. NYC real estate is liquid, but not as liquid as public stocks. If the two IRRs were identical, I would probably go with renting as it does not appear that I am being compensated for the added risk. How would you value a painting? A painting has no intrinsic value, generates no cash flows, and cannot be valued in the traditional sense. The pricing of the painting is a function of what someone will pay for it in the market, rather than being anchored by its fundamentals. To determine the approximate price, you would have to analyze comparable transactions to see the amount others paid to purchase similar paintings in the past. When would it be appropriate to use a sum-of-the-parts approach to valuing a company? In a sum-of-the-parts ("SOTP") analysis, each division of a company will have its unique risk/return profile and need to be broken up to value the entire company more accurately as a whole. Thus, a different discount rate will value each segment, and there'll be distinct peer groups for the trading and transaction comps. Upon completing each division's valuation, the ending values would be summed up to arrive at the total value. An example of when SOTP analysis (or break-up analysis) would be used is when the company being valued has many operating divisions in unrelated industries, each with differing risk-profiles (e.g., conglomerate).
How does valuing a private company differ from valuing a public company? The main difference between valuing a private and public company is the availability of data. Private companies are not required to make their financial statements public. If you're provided private company financials, the process is similar to public companies, except that private company financial disclosures are often less complete, standardized, and reliable. In addition, private companies are less liquid and should thus be valued lower to reflect an illiquidity discount (usually ranges between ~10-30%). What is an illiquidity discount? The illiquidity discount used when valuing private companies is related to being unable to exit an investment quickly. Most investors will pay a premium for an otherwise similar asset if there's the optionality to sell their investment in the market at their discretion. Therefore, a discount should be applied when performing trading comps since shares in a public company include a premium for being sold in the public markets with ease (called the "liquidity premium"). Walk me through a DCF. The most common approach to building a DCF is the unlevered DCF, which involves the following steps:
1. Forecast Unlevered Free Cash Flows ("FCFF" or "UFCF"): First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage, should be forecast explicitly for a 5 to 10 year period. 2. Calculate Terminal Value ("TV"): Next, the value of all unlevered FCFs beyond the initial forecast period needs to be calculated – this is called the terminal value. The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach. 3. Discount Stage 1 & 2 CFs to Present Value ("PV"): Since we are valuing the company at the current date, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital ("WACC"). 4. Move from Enterprise Value → Equity Value: To get to equity value from enterprise value, we would need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the value of non-operating assets such as cash or investments and subtract debt. Then, we would account for any other non-equity claims such as minority interest. 5. Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value by diluted shares outstanding as of the valuation date. For public companies, the equity value per share that our DCF just calculated can be compared to the current share price. 6. Sensitivity Analysis: Given the DCF’s sensitivity to the assumptions used, the last step is to create sensitivity tables to see how the assumptions used will impact the implied price per share. Conceptually, what does the discount rate represent? The discount rate represents the expected return on an investment based on its risk profile (meaning, the discount rate is a function of the riskiness of the cash flows). Put another way, the discount rate is the minimum return threshold of an investment based on comparable investments with similar risks. A higher discount rate makes a company's cash flows less valuable, as it implies the investment carries a greater
If a company has no debt on its capital structure, its WACC will be equivalent to its cost of equity. Most mature companies will take on a moderate amount of leverage once their operating performance stabilizes because they can raise cheaper financing from lenders. How is the cost of equity calculated? The cost of equity is most commonly estimated using the capital asset pricing model ("CAPM"), which links the expected return on a security to its sensitivity to the overall market (most often S&P 500 is used as the proxy). Cost of Equity (Re) = Risk Free Rate + Beta × Equity Risk Premium How do you determine the risk-free rate? The risk-free rate ("Rf") should theoretically reflect the yield to maturity of default-free government bonds of equivalent maturity to the duration of each cash flow being discounted. However, the lack of liquidity in the longest maturity bonds has made the current yield on 10-year US treasury notes the preferred proxy for the risk-free rate for US-based companies. What effect does a low-interest-rate environment have on DCF-derived valuations? If the market's prevailing interest rates are at low levels, valuations based on DCFs will become higher since the discount rate will be lower from the decreased risk-free rate, all else being equal. There has been much debate around normalized risk-free rates. Aswath Damodaran has argued against the usage of normalized rates and has written that "you should be using today's risk-free rates and risk premiums, rather than normalized values when valuing companies or making investment assessments." Define the equity risk premium used in the CAPM formula. The equity risk premium ("ERP") measures the incremental risk (or excess return) of investing in equities over risk-free securities. Historically, the ERP has ranged between 4% to 6% based on historical spreads between the S&P 500 returns over the yields on risk-free bonds. Equity Risk Premium (ERP) = Expected Market Return − Risk Free Rate Explain the concept of beta (β). Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to the broader market. Said another way, beta equals the covariance between expected returns on the asset and the market, divided by the variance of expected returns on the market. A company with a beta of 1.0 would expect to see returns consistent with the overall stock market returns. If the market has gone up 10%, the company should see a return of 10%. A company with a beta of 2.0 would expect a return of 20% if the market had gone up 10%. Beta/Market Sensitivity Relationship β = 0→No Market Sensitivity β < 1→Low Market Sensitivity β > 1→High Market Sensitivity β < 0→Negative Market Sensitivity What is the difference between systematic risk and unsystematic risk?
Systematic Risk: Otherwise known as undiversifiable risk (or market risk), this is the risk inherent within the entire equity market rather than specific to a particular company or industry. This type of risk is unavoidable and cannot be mitigated through diversification. Unsystematic Risk: In contrast, unsystematic risk is the company-specific (or industry) risk that can be reduced through portfolio diversification. The effects of diversification will be more profound when the portfolio contains investments in different asset classes, industries, and geographies. Does a higher beta translate into a higher or lower valuation? A company with a high beta suggests more risk and will exhibit higher volatility than the market (i.e., higher sensitivity to market fluctuations). Thus, a higher discount rate will be used by investors to value the company's cash flows, which directly leads to a lower valuation, all else being equal. What type of sectors would have higher or lower betas? A useful question to ask yourself when assessing beta is: "Would consumers require (or demand) this product or service during a recession?" High Beta: A beta of >1 would mean the industry is highly cyclical and be more volatile than the broad market. For example, the automobile, semiconductors, and construction industry have higher betas since most consumers only purchase cars and new homes during positive economic growth. Low Beta: A beta of < 1 suggests the security is less volatile than the broad market. Consumer product stores that sell necessary, everyday goods such as toiletries and personal hygiene products would have a low beta. Other sectors with low betas are hospitals/healthcare facilities and utilities, which provide essential goods and services required by consumers regardless of the prevailing economic climate. What are the benefits of the industry beta approach? The industry β approach looks at the β of a comparable peer group to the company being valued and then applies this peer-group derived beta to the target. The benefits are that company-specific noise is eliminated, which refers to distorting events that could cause the correlation shown in its beta to be less accurate. So the peer-group derived beta is "normalized" since it takes the average of the unlevered betas of comparable businesses and then relevers it at the target capital structure of the company being valued. The implied assumption is that the company's business risk will converge with its peer group over the long run. This approach also enables one to arrive at an industry-derived beta for private companies that lack readily observable betas. To perform a DCF analysis for a private company, the industry beta approach would be required as privately-held companies don't have readily observable betas. What are the flaws of regression betas?
1. Backward Looking: The standard procedure to estimate the beta is through a regression model that compares the historical market index returns and company returns, in which the slope of the regression corresponds to the beta of the stock. However, this past performance (and correlation) may not be an accurate indicator of the stock's future performance. 2. Large Standard Error: The regression model is sensitive to the assumptions used, such as the index chosen to be the proxy for the market return. There are also
The required return on the debt will increase with the debt level because a more highly levered business has a higher default risk. As a result, the "optimal" capital structure for most companies includes a mixture of debt and equity. As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax-deductibility of interest expense (i.e., the "tax shield" benefits). WACC continues to decrease until the optimal capital structure is reached. But once this threshold is surpassed, the cost of potential financial distress off sets the tax advantages of debt, and the WACC will reverse course and begin an upward trajectory as the risk to all debt and equity stakeholders increases. Besides the risk of a company becoming overburdened with leverage, debt also comes with more constraints (i.e., covenants) that restrict activity and prevent them from exceeding certain leverage ratios or maintaining a coverage ratio above a certain threshold. What is the difference between WACC and IRR? Internal Rate of Return: The IRR is the rate of return on a project’s expenditures. Given a beginning value and ending value, the IRR is the implied interest rate at which the initial capital investment would have to grow to reach the ending value. Alternatively, it's defined as the discount rate on a stream of cash flows leading to a net present value (NPV) of 0. Weighted Average Cost of Capital: The WACC (or cost of capital) is the average minimum required internal rate of return for both debt and equity providers of capital. Thus, an IRR that exceeds the WACC is an often-used criterion for deciding whether a project should be pursued. Which would have more of an impact on a DCF, the discount rate or sales growth rate? The discount rate and the sales growth rate will be sensitized in a proper DCF model, but the discount rate's impact would far exceed that of operational assumptions such as the sales growth rate. How is the terminal value calculated? There are two common approaches to calculate the terminal value ("TV"):
1. Growth in Perpetuity Approach: Often called the Gordon Growth method, the growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the explicit forecast period and then inserting this assumption into the static perpetuity formula. 2. Exit Multiple Approach: The exit multiple approach calculates the terminal value by applying a multiple assumption on a financial metric (usually EBITDA) in the terminal year. The multiple reflects the multiple of a comparable company in a mature state. Why is it necessary to discount the terminal value back to the present? Under both approaches, the terminal value represents the present value of the company's cash flows in the final year of the 1st stage of the explicit forecast period right before entering the perpetuity stage. The TV calculated is the present value of a growing perpetuity at the very end of the stage 1 projection of cash flows. Thus, this future value must be discounted back to its present value (PV) since the DCF is based on what a company is worth today, the current date of the valuation. For the perpetuity approach, how do you determine the long-term growth rate?
The long-term growth rate is the rate that the company will grow into perpetuity. That being said, it should range somewhere between 1% to 3% (sometimes up to 5%). Often, GDP or the risk-free rate are proxies for g. This growth rate must reflect the steady-state period when growth has slowed down to a sustainable rate. A hypothetical question to ask would be: "Can this company grow at X% for the next hundred years?" If not, then the perpetuity growth rate should be adjusted downward to be more realistic. What is the argument against using the exit multiple approach in a DCF? In theory, a DCF is an intrinsic, cash-flow based valuation method independent of the market. By using the exit multiple approach, relative valuation is being brought into the valuation. However, the exit multiple approach is widely used in practice due to being easier to discuss and defend in terms of justifying the assumptions used. What is the purpose of using a mid-year convention in a DCF model? By using the mid-year convention, we are treating the projected cash flows as if they're generated at the midpoint of the given period. Without this mid-year adjustment, the DCF implicitly assumes that all cash flows are being received at the end of the year. This would be inaccurate since cash flows are generated steadily throughout the year, depending on the industry. The compromise is to use a mid-year convention that assumes the CFs are received in the middle of the year. Since the projected cash flows are received earlier, the implied valuation of the company would increase because of the earlier received cash flows. For example, if the cash flow you're discounting is Year 5 and the discount factor is 5, the mid-year convention would use a discount factor of 4.5 since we are assuming half a year has passed before the cash flow is generated. Could you give me an example of when the mid-year convention might be inappropriate? While the mid-year convention in a DCF is standard practice, it may be inaccurate for highly seasonal companies. Many retail companies experience strong seasonal patterns in demand, and sales are disproportionally received in the 3rd and 4th quarters. This is particularly the case for retailers that have a niche in winter clothing. For example, the mid-year convention may be an inappropriate adjustment for Canada Goose, a Canadian company that focuses primarily on winter clothing. The unadjusted, period-end assumption may be more appropriate in this scenario. How would raising additional debt impact a DCF analysis? The enterprise value based on an unlevered DCF should theoretically remain relatively unchanged since the DCF is capital structure neutral. But if the debt raised changed the capital structure weights substantially, the implied valuation could change. As the percentage of debt in the capital structure increases, the cost of debt increases from the higher default risk (which lowers the implied valuation). Imagine that two companies have the same total leverage ratio with identical free cash flows and profit margins. Do both companies have the same amount of default risk? If one company has significantly more cash on its balance sheet, it'll most likely be better positioned from a risk perspective. When assessing leverage risk, a company's excess cash should be considered since this cash could help paydown debt. Hence, many consider cash to be "negative debt" (i.e., the implied assumption of net debt).
For example, imagine a company whose current share price is $60 issued raised $ million several years ago by issuing 10 million preferred shares, each granting the holder the right to collect either $50 per preferred share (its liquidation value) or to convert it to one share of common stock. Since the current share price is greater than the liquidation value, we would assume that the preferred stock is converted for calculating the diluted share count. When conversion into common stock is assumed to calculate the share count in a valuation, the preferred stock should be eliminated when calculating net debt to be consistent and avoid double counting. How would you handle convertible bonds in the share count? Convertible bonds are assumed to be converted into common stock if the conversion price of the bond is lower than the current share price. For example, imagine a company whose current share price is $60 issued raised $ million several years ago by issuing a bond convertible into 10 million shares of common stock. Since the current share price is greater than the conversion price, we assume the bond is converted to calculate diluted shares. If conversion into common stock is assumed to calculate the share count, the convertible bonds should be eliminated from the balance sheet when calculating net debt to be consistent (and avoid double-counting). How should operating leases be treated in a DCF valuation? They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar to debt obligations than to a simple expense (i.e., tenants should present the lease obligation as a liability on their balance sheet as they do for long-term debt). In fact, the option to account for leases as an operating lease was eliminated starting in 2019 for that reason. Therefore, when operating leases are significant for a business (retailers and capital- intensive businesses), the rent expense should be ignored from the free cash flow build- up, and instead, the present value of the lease obligation should be reflected as part of net debt. For forecasting purposes, do you use the effective or marginal tax rate? The choice between whether to use the effective or marginal tax rate boils down to one specific assumption found in valuation methods such as the DCF: the tax rate assumption used will be the tax rate paid into perpetuity. In most cases, the effective tax rate will be lower than the marginal tax rate, mainly because many companies will defer paying the government. Hence, line items such as deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are created. If you use the effective tax rate, you implicitly assume this deferral of taxes to be a recurring line item forever. But this would be inaccurate since DTAs and DTLs unwind, and the balance eventually becomes zero. The recommended approach is to look at the historical periods (i.e., past 3-5 years) and base your near-term tax rate assumptions on the effective tax rate. But by the time the 2nd stage of the DCF is approaching, the tax rate should be "normalized" and be within close range of the marginal tax rate. How does a lower tax rate impact the valuation from a DCF?
Greater Free Cash Flows: A lower tax rate would result in more net income as fewer taxes have to be paid to the government, meaning more earnings retention and higher cash flow. Higher Cost of Debt: A lower tax rate results in a higher after-tax cost of debt and a higher re-levered beta, all else being equal. If the tax rate is reduced, that would mean the after-tax cost of debt would rise, and the benefit from the tax-deductibility of interest (“tax shield”) would be reduced. Higher Beta : A lower tax rate would result in a higher levered beta, which would cause the cost of equity and WACC to increase. While the last two implications suggest a lower valuation, the net impact on the company's valuation would be specific to the company's fundamentals, and one would have to flow through all the changes in a DCF model to see if the increased FCF offsets the increased WACC. How does a dividend discount model (DDM) differ from a discounted cash flow model (DCF)? The dividend discount model ("DDM") stipulates that the value of a company is a function of the present value of all its future dividends paid out, whereas the discounted cash flow states a company is worth the sum of the present value of all the future free cash flows it generates. The DDM will forecast a company's future dividends based on a dividend per share ("DPS") and growth rate assumptions - which are then discounted using the cost of equity. For the terminal value calculation, an equity value based multiple will be used, most commonly P/E. Therefore, the DDM directly calculates the equity value and then equity value per share (similar to levered DCFs, but different from unlevered DCFs). What are the major drawbacks of the dividend discount model (DDM)? Forward-looking valuation methods each have their shortcomings, and the DDM is no exception, given its sensitivity to assumptions such as the dividend payout ratio, dividend growth rate, and required rate of return. But some additional drawbacks that help explain why DDM is used less often include:
- The DDM cannot be used on high-growth companies as the denominator would turn negative since the growth rate would exceed the expected return rate.
- The DDM is more suitable for large, mature companies with a consistent track record of paying out dividends, but even then, it can be very challenging to forecast out the growth rate of dividends paid.
- Most companies don't pay out any dividends, especially as share buybacks have become common.
- The DDM neglects buybacks, an increasingly important source of returns for shareholders.
- If the dividend payout amounts reflected true financial performance, then the output would be similar to the traditional DCF. However, poorly run companies can still issue large dividends, distorting valuations.
