Mastering the art of Discounted Cash Flow ("DCF") analysis is a cornerstone for those aspiring to excel in investment banking interviews. DCF analysis delves into the profound understanding of a company's intrinsic value, future cash flows, and the time value of money—essential elements in the toolkit of a successful investment banker.

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Assume that you have 2 companies: A and B which generate the same amount of cash flow over a 5-year time horizon. However, company A generates 80% of the cash flow within the first 2 years whereas company B generates the cash flow evenly across each time period. Which company is worth more ceteris paribus assuming that both companies cease to exist after the 5-year time period?

The net present value (“NPV”) of company A is higher (i.e. it’s worth more) because it returns the cash back sooner (assuming that the interest rate is positive). The further cash flows are away in the future, the higher the applied discount rate. In other words, money has a time value and the sooner you get the money the better.

What is the method behind a DCF valuation?

In a DCF, firm value is calculated by discounting future cash flows which are available to all capital providers (i.e. equity and debt).

How much would you be willing to pay for a cow using DCF logic?

Determine the cash flows that the cow will produce over its expected useful life and discount those cash flows to the present moment with an appropriate cost of capital.

Explain in detail how a DCF calculation works?

First, you need 5 to 10 years of financial projections for the company to calculate the cash flows in the forecast period. Towards the end of the projection period, the company needs to reach a steady state where the financials of the company normalise, and the high-growth period is over. The free cash flows to the firm are calculated under the assumption that the company is all-equity financed, that is, the marginal tax rate is directly applied on EBIT.

Second, the cash flows are then discounted to present values using the weighted average cost of capital (“WACC”). Note that the WACC is calculated not with the current capital structure, but with the target capital structure.

Third, the value coming from the cash flows beyond the projection period is covered by the terminal value. There are two ways to calculate the terminal value: using the Gordon growth model or via an exit multiple on EBITDA. Independent of the method used, the terminal value is then discounted to the present using the WACC and added to the present value of the cash flows of the projection period in order to get to the firm value of the business.

In what case does using a DCF to value a company make sense?

A DCF only makes sense if the company already generates high and predictable cash flows which is the case for most mature companies. In that case, the analyst is able to make reasonable predictions for the cash flows over the next 5 years.

What are the advantages of a DCF?

In theory, the DCF is the perfect valuation tool. If all the inputs used are correct, the DCF yields the true underlying value of the business

The DCF only requires information about the business plan as well as info on the target capital structure and interest rates for the WACC. No info about competitors is needed for a DCF which is particularly useful for companies that don’t have good public peer set.

What are the disadvantages of a DCF?

While the DCF is in theory the perfect valuation tool, it is highly sensitive to key inputs (i.e. especially to WACC and the terminal growth rate). Relatively small changes in those inputs have large effects on the resulting firm value which is why the DCF is easily manipulatable. The DCF is therefore often used to confirm the multiple valuation and the analyst is asked to “back-solve” the DCF accordingly.

Businesses with high growth rates have most of their value in the terminal value (i.e. the value of the business which results from cash flows which are more than 5-10 years out in the future). Since it’s not possible to reliably predict these cash flows, the DCF becomes less reliable.

The WACC is held constant in the DCF, however, as the company evolves, the WACC will naturally evolve as well and the DCF does not take this into consideration.

How are the free cash flows to the firm (“FCFF”) calculated in the DCF method?

Is the free cash flow to the firm (“FCFF”) which is calculated in the DCF the real cash flow of the business?

No, the DCF FCFF is not the real cash flow of the business because the FCFF takes the assumption that the business is only equity-financed. This simplifying assumption is used because the DCF wants to arrive at firm value which is the cash flow to all capital providers. Therefore, the cash flow used in the DCF is before interest expense and dividend payments.

What is WACC and how is it calculated?

WACC stands for weighted average cost of capital. It is the average interest expense (i.e. cost of capital) weighted by how much debt and equity capital the business uses.

Where equity and debt are the market values for the equity capital and debt capital respectively, and R is the interest rate (or expected return) and t is the marginal tax rate.

In the above WACC calculation, how do you determine the cost of equity?

The cost of equity is typically calculated via the capital asset pricing model (“CAPM”) as follows:

The expected return on equity therefore depends on beta, that is, the correlation of the stock with the market. If the stock has a beta of 1, then the return on equity equals the return of the market. If the stock “overreacts” vs the markets, that is, it for example increases (decreases) 10% if the market increases (decreases) by 5%, then the investor wants to be compensated for the higher risk.

While there are other ways in corporate finance theory to calculate the return on equity (see Fama French Factor Modell for example), the CAPM model is widely used in practise in investment banking.

In the WACC calculation, how do you determine the cost of debt?

The cost of debt is defined as the risk-free rate plus the company-specific credit spread (i.e. the premium that the company has to pay above the risk-free rate for its debt which is based on its respective creditworthiness).

The cost of debt for a company can be determined by looking at the coupons of recently issued bonds (in case there was no original issue discount or premium in which case you would have to calculate the yield to maturity). In case no bonds have been recently issued, you calculate the yield to maturity on less recent bonds to get an indication for the interest rate the company would have to pay. The reason the current YTM must be calculated is because the debt was issued in the past and any news (either regarding the company or the economy) will impact the company’s ability to raise debt (and therefore using a previous coupon rate is not necessarily correct).

If, for example, a company previously issued a £100m bond at 10% interest rate with a 10-year maturity and the debt is currently trading at a discount of 98, then the YTM of that bond is calculated and used as the current cost of debt. If the bond is currently trading at a discount of 98, then this means that investors now demand a higher return than the initial 10% coupon; if inversely, the bond was trading at a premium of 102, then this would mean that investors are ok with a lower return than the fixed 10% coupon. In case the company does not have any outstanding bonds, you can alternatively look at peer companies to determine their cost of debt using the above methods.

How do you calculate the return of the market?

Typically, the analyst will not be asked in practise to calculate the return of the market, instead, this input is taken from the research team who publishes these figures. There is no clear consensus in academics or practise on how to calculate the return of the market precisely, but most methodologies revolve around calculating the return that leading stock indexes have generated for investors over a long period of time. Typically, the return of the market over a sufficiently long period of time is between 6-8%.

How would you explain what beta is to your parents?

The beta of a company A describes how much that stock is expected to move in line with the general market. A beta over >1 means that if the market increases by 1%, then the stock of A is expected to move up by more than 1%. If the beta is 1, then the stock will move in line with the market. If 0<beta<1, then the stock will move in the same direction as the market but to a lesser extent. For example, if the market then drops by 1%, then the stock is expected to drop by less than 1% so e.g. just 0.5%.

Is it possible that the beta of a company is negative?

Yes, it’s not common but possible. A negative beta would mean that if the market increases, the individual asset would decrease. One possible example is the stock price of a gold manufacturer. Gold is oftentimes viewed as a safe haven asset and investors buy stocks and sell gold in a bull market and buy gold and sell stocks in a bear market, leading (in theory) to a negative beta.

How would you rank the betas for Procter & Gamble, General Motors and Newmont Goldcorp (i.e. a gold miner)?

General Motors has the highest beta out of the 3 as automotive is a cyclical industry and highly dependent on the state of the economy. We can therefore safely assume that GM’s beta is above 1, for example at 1.3. Procter & Gamble is a highly diversified consumer goods company and therefore much less impacted by the state of the economy because people still need to buy food and pampers even during a recession. As a result, we can expect the beta of P&G to be above 0, but below 1, for example at 0.5. A goldminer like Newmont Goldcorp makes most of his money when the gold price is high which is typically the case during a recession. Therefore, a goldminer can be expected to have a negative beta or at least one that is close to zero.

What impact does operating leverage have on the beta of a company?

High operating leverage means that the company has a large share of fixed costs. This means that when revenues increase, the costs increase under proportionally because a large share of the cost base is fixed. In that scenario, the company increases its profit margins when revenues go up. Vice versa, if revenues decrease, the cost base cannot be reduced to the same extent as revenues and therefore the profit margin is impacted over proportionally. As a result, more operating leverage (similar to more financial leverage) makes a company riskier and increases its beta.

What is the difference between unlevered beta (or asset beta) and levered beta?

The unlevered beta is the beta of the business if it is fully funded by equity capital and hence has no debt on the balance sheet. In reality, most companies do have debt on their balance sheet. Increasing levels of debt make a company riskier as the share of equity capital decreases. Hence, the levered beta (in case the company has debt) is higher than the unlevered beta.

Assume that company A changes its capital structure from 100% equity to 80% equity and 20% debt – what would you expect to happen to WACC?

You would expect WACC to go down because the cost of debt (at that relatively low leverage) is low (and definitely lower than the cost of equity in any case); plus, debt has the benefit of the tax shield which is expressed in the (1-t) part of the WACC calculation.

What would be a reasonable long-term growth rate in the Gordon growth model?

A reasonable long-term growth rate would be in line with the country’s nominal GDP growth (i.e. real GDP growth + inflation). If the long-term growth rate of the company is larger than the country’s long-term GDP growth, then the company will eventually take over the country and own everything which does not make much sense as an assumption. Reasonable long-term growth rates are therefore – depending on the country – between 1% and 4%.

What is the difference between unlevered and levered free cash flow?

Unlevered free cash flow is the cash flow that is available to all providers of capital whereas levered free cash flow is the cash flow to equity i.e. the cash flow that’s available to equity holders after all other claims have been paid out.

Assume you are doing a DCF and have the choice between a one-off €100 increase in revenues, a €100 decrease in operating expenses or a €100 decrease in capital expenditures. Which one would you pick to maximise valuations?

The increase in revenue would be the worst option out of the three because it is likely to come with an increase in COGS depending on the composition between volume and price. If the increase in revenues purely comes from an increase in price, then it unlikely that there would be an increase in COGS; if, however, the revenue increase is also driven by a volume increase then this is likely to result in higher COGS. In any case, taxes then need to be deducted from the net effect to arrive at the cash flow impact.

The decrease in operating expenses is therefore better than the increase in revenues because it doesn’t come with any increases in COGS or other expenses. However, the decrease in operating expenses also doesn’t go straight to cash flows because it still needs to be tax effected.

Purely based on the cash impact, the decrease in capex has the biggest positive impact as it goes straight to the cash flow.

Follow-up question: Would you prefer a €100 reduction in capex or NWC?

The problem with a reduction in capex is that it likely means that your revenues are going to be lower in the following periods because you are investing less money whereas a reduction in NWC might just be due to better NWC management.

Follow-up question: How would the answer to the initial question change if the changes in revenue, operating expenses, and capex are not one-offs but recurring?

If these changes are recurring and not one-offs, the answer would change because then the terminal value (e.g. based on the multiple approach) would be calculated based off a higher EBITDA. Since EBITDA multiples are oftentimes double digit numbers (e.g. 15x), a €100 decrease in operating costs increases EBITDA by €100 which in terms increases the TV by 15x * €100 = €1,500.