25 Questions on DCF Valuation (and my
opinionated answers)
Everybody who does discounted cashflow valuation has opinions on how to do it right. The
following is a list of 25 questions that I believe every valuation analyst has struggled with
at some point in time or the other and my answers to them. As the heading should make
clear, I do not believe that I have the final word on any of them. So feel free to disagree,
and let me know that you do. Maybe we can muddle through to the right answer. Cheers!
Question Answer
All valuations begin with an estimate of free cashflow. The free cashflow to the firm is
computed to be:
After-tax Operating Income
- (Capital Expenditures - Depreciation)
- Change in working capital
= FCFF
Netting out cashflows to and from debt (subtract out interest and principal payments and
add back cash inflows from new debt) yields the free cashflow to equity (FCFE)
1. Operating income is defined to be revenues less operating expenses and
should be before financial expenses (interest expenses, for example) and capital
expenses (which create benefits over multiple periods). Specify at least two items Answer
that currently affect operating income that fail this definitional test and explain
what you would do to adjust for their effects.
2. Operating income can be volatile both as a result of the normal ebb and flow
of business and as a result of accounting transactions (one time income and
Answer
expenses). Should you smooth or normalize operating income and if so how do you
do it?
3. In computing the tax on the operating income, there are three choices that you
can use - effective tax rate (about 29% for the average US company in 2003),
marginal tax rate (35-40% for most US companies) and actual taxes paid.
a. Which one would you choose? Answer
b. What happens if you are a multinational and are in several countries with very
different tax rates?
c. What happens if you are reporting an operating loss?
4. Many companies grow through acquisitions, some of which they pay for with
cash and some with stock. In computing capital expenditures, should you include Answer
any of the acquisitions, only acquisitions funded with cash or all acquisitions?
5. Depreciation and amortization includes a number of different items. Some of
them are tax deductible (like conventional depreciation on assets) but some are not
(like amortization of goodwill). In computing depreciation, should you include all Answer
depreciation and amortization or only tax-deductible depreciation and
amortization?
6. The conventional accounting definition of working capital is current assets
minus current liabilities and includes cash and marketable securities in current
assets and short term debt in current liabilities.
Answer
a. Should you consider all cash, operating cash or no cash at all when you
compute working capital?
b. Should you consider short term debt as part of current liabilities?
Estimating growth is where your valuation and guessing skills come most into play. While
you can estimate growth by looking at the past or at what analysts are forecasting, you
should consider the fundamentals.
7. Most of us have seen the equations for sustainable growth. In particular, the
growth in earnings per share = (1 - payout ratio) * Return on equity.
a. Can you use the same equation to compute growth in operating income?
b. Under what assumptions will this sustainable growth rate also be equal to your
Answer
expected growth rate?
c. Increasing the amount you reinvest back into the business (reduce the payout
ratio or increase the reinvestment rate) will increase the growth rate for any
company that is prfitable. Will it also increase value?
8. How long can high growth last? Answer
Now let's consider the big enchilada - terminal value - at the end of the high
growth phase. There are three ways in which terminal value can be estimated -
liquidation value for the assets, a multiple of earnings or revenues in the terminal
year or by assuming that cashflows grow at a constant rate forever after your
terminal year.
9. How do you decide which approach to use to estimate terminal value? Answer
10. Assuming that you use the perpetual growth model, can the stable growth rate
Answer
be negative?
11. What effect will increasing the growth rate in perpetuity have on terminal
Answer
value?
Moving below the line, let us talk about the discount rate to use in valuation. If the
cashflows being discounted are cashflows to the firm, the discount rate is a weighted
average of the cost of equity and the cost of debt, weighted by the market values of each
component.
12. Debt can be defined in many ways - total liabilities, total debt or long term
Answer
debt. What would you include in debt?
13. Why do we use market value weights to come up with a cost of capital instead
Answer
of book value weights?
14. In private businesses, neither debt nor equity is traded. In most publicly traded
firms, equity has a market value but a significant portion (or often all) of the debt
is not publicly traded.
Answer
a. How do you get market value of debt when all or even some of your firm's debt
is bank debt and not publicly traded? How would you compute an updated cost of
debt for an unrated company with bank debt?
b. How do you get a market value of equity for a private business?
15. Can the weights change from year to year in computing the cost of capital? Answer
16. There are a number of different risk and return models in finance used to
compute the cost of equity but they all assume that the marginal investor is well
diversified. If you use these models to estimate costs of equity for private or closely Answer
held firms, are you likely to under or over estimate the cost of equity? How would
you fix the bias?
17. Multinationals now operate and trade in different markets and different
currencies. Which riskfree rate should you use to value a company (Nestle, for Answer
instance)?
18. Most analysts estimate risk premiums by looking at historical data in the
Answer
United States. What are the perils of historical premiums?
19. Increasingly, we are called upon to value companies in emerging markets in
Asia and Latin America and we have to estimate risk premiums there.
a. Should there be an additional country risk premium for investing in a Brazilian
or a Chinese company?
b. If yes, how would you go about estimating it? Answer
c. Once you estimate the country risk premium, should the same premium be
added on for all companies in that country? If you don't think so, how would you
go about estimating a company's exposure to country risk?
Getting from the DCF value to the value of equity can be a messy process. You have to
consider what you have not valued yet and what other claims there might be on the equity
of a firm.
20. An alternate approach to discounted cashflow valuation is the adjusted
present value approach, where you value the firm with no debt (unlevered firm)
first and then consider the value effects of debt. What is the fundamental difference Answer
between the cost of capital approach and the APV approach and why might they
give you different answers?
21. Discounted cashflow valuations are usually based upon the assumption that
your firm will survive as a going concern. If you are valuing a young firm or a
Answer
distressed firm where there is a significant likelihood that the firm will not make it
as a going concern, how do you reflect that in your valuation?
22. What have you not valued yet? (In other words, what do you need to add on to
Answer
the present value?)
23. What do you need to subtract from firm value to get to the value of equity? Answer
24. It is common practice in valuation to add a premium for control this value or
subtract out a discount (minority, marketability, private company etc.). Is this a Answer
reasonable practice?
25. How do you get from the value of equity to the value of equity per share? Answer