11/13/11

1.) Project FCF for a certain period of time:

EBIT(1-tax rate)+D &A - change in networking captial - cap ex

2.) Project cash flows beyond that period. Need a terminal value.

Use a growth model or multiple. I would use the EBITDA multiple.

3.) Now, discount that back to the present using the WACC.

4.) Sum of the terminal value calculation and the FCF.

Comments (63)

11/13/11

id probably add in how u calculate wacc

and what kind of assumptions you make at the start

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11/13/11

Looks good just make sure you can defend your statements if they begin to pick i.e. (want to use Levered/Unlevered Beta in WACC, drawbacks to DCF, UFCF considerations etc.)

'Before you enter... be willing to pay the price'

11/13/11

What if they asked you what issues could arise a from using the multiple method and how'd you justify using that.

11/13/11

Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

11/13/11
bluefalcon:

Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

I can answer some of those, but Im not sure how deep they would want me to get.

Best Response
11/13/11
bluefalcon:

Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

I disagree with this - don't go into more detail than what you have to. otherwise you are bound to get yourself into unnecessary trouble. that being said, you should be able to answer all the questions from the post above, as they are likely to come up in the context of valuations.

Personally, this is how I would go about it (similar to you, but with a few alterations):

First give a 1 or 2 sentence introduction of what a DCF is (ie, an intrinsic valuation of a company based on its FCF).
This is the order I'd walk through the steps:

-Project a company's FCF
-Calculate the company's discount rate (WACC if using unlevered FCF/cost of equity if levered)
(I like mentioning the discount rate at this point because you could theoretically need it to calculate the Terminal value)
-Calculate a company's TV
(briefly mention the two ways you could do this - gordon growth or multiples method)
-Discount the FCF and TV and sum up everything to derive firm's intrinsic value
-If need to get to Implied Equity Value, then walk through necessary adjustments; create sensitivities since you want to look a range of values.

once you are done, then ask the interviewer if he/she would like you to go into more detail. chances are they will want you to, but this approach minimizes the chances of you "losing" your interviewer by talking to much and appearing to be out of focus.

Capitalist

11/13/11

i dont think anyone wants a story.

I hit the main points. if they ask follow up questions i answer them.

11/13/11

hit main points and let interviewer ask you follow-up questions... no reason to talk yourself in a hole right off the bat

11/13/11

acrnymous check inbox

11/13/11

3 main things you need:

  1. projection period
  2. wacc
  3. exit method

we project operating performance of the company into the future (5 years normally) and calculate free cash flow from this.

calculate the wacc as weighted average of cost of debt and equity... use this to discount the free cash flows calculated in our projection period.

use either exit multiple method or perpetuity growth method to estimate terminal value. for EMM, we assume the company will sell for a similar TEV/EBITDA multiple at the end of the projection period. for PGM, we assume the company will grow at a certain rate forever, so we use the formula to get terminal value and then discount that back to time 0.

that should be all you need... they'll ask follow up questions.

11/13/11

Know the strengths and weaknesses of the analysis, how it compares to other valuation methods, etc. Other than that don't go into too much detail, you don't wanna bore them. I typically get a couple of follow up questions at the end and usually they interrupt at certain points if they want you to get more detailed

11/13/11

ibankingfaq.com actually gives a really great summary on this question too... I would mention that DCF tends to be the most variable of the three main valuation methodologies due to the transaction assumptions you undertake

and as others mentioned there's no need to talk yourself into a corner... if you hit the main points the interviewer will most likely be sufficed... worst case if you are unsure you can ask if that's what they were looking for or if they wanted more detail...

11/13/11

The only question I ask is if its a Levered DCF or Unlevered DCF. Important distinction.

11/13/11

Yup. But that's about it.

11/13/11

There is no such thing as an "unlevered" or "levered" DCF.

There is, however "unlevered" and "levered" FCF's being used to calculate the discounted cash flows.

For all intents and purposes, assume you are using unlevered free cash flows and baking in the cost of debt into the WACC when you discount those cash flows.

That's it.

11/13/11

so you don't say anything more specific about how you project the B/S and derive the CF statement and maknig the model balance, etc?

11/13/11
jamar:

so you don't say anything more specific about how you project the B/S and derive the CF statement and maknig the model balance, etc?

Dont answer questions you weren't asked, dude.

11/13/11

^^jamar for a DCF you're just using basic projection assumptions, most (if not all) of the time you're not going to build a CF or BS statement, you'll just use assumptions for capex (% of D&A typically) & working cap.

11/13/11

really......so only three-statement for merger/lbo models? how do you project interest income/expense? EBIT margin assumptions, etc?

11/13/11

should we define the equations?

11/13/11

you're a sophmore- i'd like to see you put together a three-statement

11/13/11
jamar:

you're a sophmore- i'd like to see you put together a three-statement

go easy on me

11/13/11

you're a sophmore- i'd like to see you put together a three-statement

11/13/11

Thanls for the response jhoratio, please check inbox

11/13/11

You don't need to project interest income/expense for a dcf, you're tax affecting your EBIT so it's not involved. You're not going to project based on EBIT margins (usually), but rather EBITDA margins since this is your starting point in the DCF. These are based on a number of different assumptions, but in reality you use either management guidance or research estimates. 3 statements models are used for full merger models and LBOs, which are not as common anymore as a quick DCF analysis.

11/13/11

Keyboard is right, usually you just have EBITDA and you just subtract out the provision for taxes that you see in the income statements you have. Makes it easier, which is what investment banking is really all about.

So,

EBITDA
Less: taxes
Less: Capex
Less: Increase in NWC

equals

FCF <-----Discount this.

11/13/11

Where is a part about adjusting WACC and/or other assumptions in order to get the final value your MD wants to see?

11/13/11
The Phantom:

Where is a part about adjusting WACC and/or other assumptions in order to get the final value your MD wants to see?

Lol +1

11/13/11
The Phantom:

Where is a part about adjusting WACC and/or other assumptions in order to get the final value your MD wants to see?

This is funny. We were finalizing a pitch yesterday and our valuation field was tight, except DCF was an outlier, quite a bit above the rest. Since we wanted DCF in line with our other valuation methods ("slightly higher"), my MD goes to me, "why are we running this at 15% WACC?" Well, because we ran our comps WACC template and that's what it is, approx. 15%. "Screw that. Keep bumping it up until the top part of the valuation reaches $x." Ended up being 22.5%... and he was cool with it.

So for those of you prospective monkeys who think posters like The Phantom are kidding with shit like this, or at least embellishing... he's not.

11/13/11

is this what bankers use in pitches, etc? and then if a deal comes around, they three statement it?

11/13/11
jamar:

is this what bankers use in pitches, etc? and then if a deal comes around, they three statement it?

Not necessarily. Last week I built out from scratch a 3 statement, dcf and accretion/dilution for an MD and the pitch has yet to be made. I think it was for his, call it, "internal use."

11/13/11

vert good post, helpful, as i flubbed that one

11/13/11

I would note that for insurance companies (not brokers) a 3 statement is often needed due to required capital etc.

11/13/11

I always tried to keep this answer very broad so the follow up questions would be easy. I didn't give much detail and it always seemed to work:

1) project cash flows for an explicit period
2) calculate terminal value
3) determine discount rate
4) discount back to pv
5) sum pv's and that's NPV

Follow up's to this answer are usually easy questions like how do you get terminal value and how do you get a discount rate.

This approach never failed when I was interviewing.

11/13/11

.

11/13/11

I always find these "walk me through" model questions to be hard in live interviews... despite the fact that I can easily build a DCF... it's just ASKING you to forget something / skip over something... there's pressure, etc... I'd prefer a "harder" but pointed/focused technical question

11/13/11

Yes, you need to first calculate a discount rate before you can calculate a terminal value.

  1. Project future cash flows - in my experience, look at historical growth, margins, etc., really the worst part for me, annual reports suck.
  2. Calculate a discount rate (I've only had experience using WACC).
  3. Calculate a terminal value - here, use discount rate minus growth rate in perpetuity, which I have been assuming as 4% (but also performing a sensitivity analysis for +- 1% growth rate and discount rate for a range).
  4. Discount projected cash flow with terminal value added to the last projected year to arrive at Enterprise Value, then find value per share - in my experience, I just subtracted debt and divided by diluted shares.

Thought I'd go through it as a personal exercise.

Out of curiosity, analysts on this board, how long does it take you to do a DCF? How long did it take you when you first started?

11/13/11

save

11/13/11

^agreed

11/13/11

^agreed

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11/13/11

.

11/13/11

a dirty cash fiasco?

11/13/11

Assuming that your interviewer is assessing your knowledge of Unlevered FCF, you would simply subtract D&A from your EBITDA to get EBIT (this is to ensure that it is unaffected by the Tax Shield). Then you would go ahead with the standard equation: Unlevered FCF = EBIT(1-Tc) + D&A - CapEx - Change in Working Capital

11/13/11

Thank you SingularityVC!

11/13/11

SingularityVC:

Assuming that your interviewer is assessing your knowledge of Unlevered FCF, you would simply subtract D&A from your EBITDA to get EBIT (this is to ensure that it is unaffected by the Tax Shield). Then you would go ahead with the standard equation: Unlevered FCF = EBIT(1-Tc) + D&A - CapEx - Change in Working Capital


why can't you just EBITDA(1-t)? can you elaborate on the concept of tax shield?
11/13/11

kyc133enydc:

SingularityVC:

Assuming that your interviewer is assessing your knowledge of Unlevered FCF, you would simply subtract D&A from your EBITDA to get EBIT (this is to ensure that it is unaffected by the Tax Shield). Then you would go ahead with the standard equation: Unlevered FCF = EBIT(1-Tc) + D&A - CapEx - Change in Working Capital

why can't you just EBITDA(1-t)? can you elaborate on the concept of tax shield?

Depreciation is an expense that reduces taxable income, and if I reduce my income by $10 and my tax rate is 40%, the amount of tax I pay goes down by $4. That's where the tax shield concept comes in.

So if you use EBITDA(1-T), you would be overstating the amount of tax that you need to pay, and thus would underestimate free cash flow.

11/13/11

I may be wrong, but wouldn't you calculate income tax by finding EBT and multiplying it by the tax rate? Then you subtract that from EBITDA to get EBIAT, from which you subtract CAPEX and the change in NWC to get unlevered free cash flow, correct? Wouldn't finding the income tax expense by multiplying the tax rate by EBIT be overstating the income tax expense by not accounting for the tax shield effects of debt (interest expenses of debt)? I could be completely wrong on this, but which is right?

11/13/11

Leveraged Bailout:

I may be wrong, but wouldn't you calculate income tax by finding EBT and multiplying it by the tax rate? Then you subtract that from EBITDA to get EBIAT, from which you subtract CAPEX and the change in NWC to get unlevered free cash flow, correct? Wouldn't finding the income tax expense by multiplying the tax rate by EBIT be overstating the income tax expense by not accounting for the tax shield effects of debt (interest expenses of debt)? I could be completely wrong on this, but which is right?


my understanding is that since interest expenses are free from tax, tax is only based on EBIT.
11/13/11

I think Extelleron put it really well. Basically, the point of UFCF is to figure out free cash flow as if the company has no debt, and then you account for the tax shield effects of debt when calculating cost of debt in WACC. The company's income taxes are calculated from EBT, so when you calculate taxes for calculating EBIAT they will be higher because they will be x% of EBIT, where x is your tax rate. Income taxes are calculated from EBT because the debt (or more precisely the interest payments on it) is tax deductible, so that's where the value added by a tax shield comes from.

11/13/11

Leveraged Bailout:

I may be wrong, but wouldn't you calculate income tax by finding EBT and multiplying it by the tax rate? Then you subtract that from EBITDA to get EBIAT, from which you subtract CAPEX and the change in NWC to get unlevered free cash flow, correct? Wouldn't finding the income tax expense by multiplying the tax rate by EBIT be overstating the income tax expense by not accounting for the tax shield effects of debt (interest expenses of debt)? I could be completely wrong on this, but which is right?

When you are calculating unlevered free cash flow, you do not want to take into account interest tax shields. If you include interest tax shields, then that isn't representative of the cash flow the company would generate if it had no debt. And if you then took those cash flows including interest tax shield and discounted them at WACC, you would be double counting the tax advantage of debt because WACC includes the cost of debt after tax.

So when you are calculating unlevered free cash flow, you don't want to use the "real" tax; you want the tax the company would pay if it had no debt.

11/13/11

I had assumed that you would take into account debt shields because you aren't necessarily looking for the the companies free cash flow in the absence of debt, you are just looking at the cash available to pay creditors and stockholders. Interesting, so you calculate UFCF as if the company has no debt, but then the advantage of having debt as a tax shield is accounted for in the calculation of dost of debt under WACC, right?

11/13/11

thanks.

11/13/11

As an exercise to get your head around this, look at an lbo model from macabacus.com. You should be able to see how you walk from EBITDA down to FCF. Post-debt service and tax, you then can see FCF to equity. That's the basis for your DCF inputs.

Those who can, do. Those who can't, post threads about how to do it on WSO.

11/13/11

Thank you SSits!

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