Why do you use unlevered free cash flow instead of levered?

Unlevered cash flow is before interest, so it belongs to all capital providers and pairs with WACC to give enterprise value. Levered cash flow is after interest and debt repayment, belongs to equity only, and pairs with the cost of equity. Mixing the two is the classic mistake.

Perpetuity growth or exit multiple, which is better?

Neither is better; use both and cross check. Perpetuity growth ties value to fundamentals but is sensitive to small rate changes. An exit multiple ties value to the market. Back out the implied multiple from one and the implied growth rate from the other and see if both are reasonable.

What terminal growth rate should I use?

Something at or below long run nominal GDP growth, usually 2 to 3 percent for a US company. A rate above the economy's growth implies the company eventually becomes larger than the economy.

When would you not use a DCF?

For banks and insurers, where interest is part of operations and free cash flow is not well defined, and for very early stage companies or ones with unpredictable cash flows, where the terminal value is nearly all of the answer.

What is the mid year convention?

Discounting each year's cash flow as if it arrives in the middle of the year (0.5, 1.5, 2.5 years) rather than the end, since cash comes in throughout the year. It raises the value slightly. The worked example above uses end of year discounting for simplicity.

Walk me through a DCF: the interview answer, worked

A DCF values a company as the present value of its future cash flows. You project unlevered free cash flow for five to ten years, calculate a terminal value for everything after, discount both to today at the weighted average cost of capital to get enterprise value, then subtract net debt and divide by diluted shares to get a value per share.

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What is the answer you give out loud?

Give the five steps in order, one or two sentences each, in about a minute. Name the key formulas as you go, because the follow ups will test each one. Then stop and let the interviewer pick where to dig.

Project unlevered free cash flow for five to ten years: build revenue and margins down to EBIT, tax it, add back D&A, subtract capex and the increase in net working capital.
Calculate a terminal value at the end of the projection, either with the perpetuity growth method or an exit multiple of EBITDA.
Discount each year's cash flow and the terminal value to today at WACC, the blended cost of the company's debt and equity.
Add the present values to get enterprise value, then subtract net debt and other claims such as preferred stock and noncontrolling interest to get equity value.
Divide equity value by diluted shares for a value per share, and show how it changes with WACC and the terminal assumptions.

How do you calculate unlevered free cash flow?

Unlevered free cash flow is the cash the business produces before paying anyone who funded it, so it belongs to both debt and equity holders. That is why it is discounted at WACC and gives enterprise value. The formula: EBIT times one minus the tax rate, plus D&A, minus capex, minus the increase in net working capital.

Worked example at a 25 percent tax rate: EBIT of 140 is taxed at 25 percent, leaving 105. Add back 25 of D&A, subtract 25 of capex and 5 of working capital investment, and unlevered free cash flow is 100. Interest is never subtracted, because the cost of debt is already in the discount rate.

How do you calculate WACC?

WACC is the percentage of capital that is equity times the cost of equity, plus the percentage that is debt times the after tax cost of debt, using market values, not book values. The cost of equity comes from CAPM: the risk free rate plus beta times the equity risk premium.

Worked example: the risk free rate is 4 percent, beta is 1.2, and the equity risk premium is 5 percent, so the cost of equity is 4 plus 6, or 10 percent. Debt costs 6 percent before tax, 4.5 percent after a 25 percent tax rate. With 70 percent equity and 30 percent debt, WACC is 0.7 times 10 plus 0.3 times 4.5, which is 7.0 plus 1.35, or 8.35 percent. The valuation below rounds WACC to 10 percent so the arithmetic is easy to follow.

Debt is cheaper than equity because lenders are paid first and interest is tax deductible.
WACC rises with the risk free rate, beta, the equity risk premium, or credit spreads.
Adding debt lowers WACC at first, then raises it once default risk pushes up both the cost of debt and the levered beta.

What does a full DCF look like with real numbers?

Here is a complete three year DCF you can check with a calculator. Assumptions: unlevered free cash flow of 100, 110, and 121 in years one to three, a 10 percent WACC, 3 percent terminal growth, end of year discounting, net debt of 300, and 100 diluted shares.

The answer is about 13 per share. Notice that the terminal value is about 83 percent of enterprise value. That is normal for a short projection, and it is why interviewers ask about terminal value assumptions so often.

Discount the projection years: 100 divided by 1.10, 110 divided by 1.21, and 121 divided by 1.331 are each about 90.91, so the three years are worth about 272.7 today.
Terminal value by perpetuity growth: year three cash flow grown one year, 121 times 1.03, is 124.6; divide by WACC minus growth, 0.10 minus 0.03, for a terminal value of about 1,780.4 at the end of year three.
Discount the terminal value three years: 1,780.4 divided by 1.331 is about 1,337.7.
Enterprise value: 272.7 plus 1,337.7 is about 1,610.4.
Equity value: 1,610.4 minus 300 of net debt is about 1,310.4.
Value per share: 1,310.4 divided by 100 diluted shares is about 13.10.

How sensitive is the answer to the assumptions?

Very, which is the point of the sensitivity table. Using the same example, small changes in the discount rate or growth rate move enterprise value by ten percent or more, almost all of it through the terminal value.

Sanity check the terminal value from the other direction too. If year three EBITDA were 200, a terminal value of 1,780 implies about 8.9 times EBITDA. If peers trade far from that, one of your assumptions is off.

Base case, 10 percent WACC and 3 percent growth: enterprise value about 1,610.
Growth cut to 2 percent: about 1,432.
WACC raised to 11 percent: about 1,407.
WACC lowered to 9 percent: about 1,882.

Which DCF follow ups should you drill?

The DCF question is a door to a dozen follow ups: why unlevered, which discount rate goes with which cash flow, how to unlever beta, the mid year convention, when a DCF does not work. The live questions below come from the question bank you can drill, with answer notes that match this guide.

1.Walk me through the three financial statements.
2.What is the difference between levered and unlevered free cash flow, and which discount rate goes with each?
3.A company repays 50 of debt principal. Walk me through the statements.
4.What are the five steps of revenue recognition under ASC 606?
5.Should equity value use the book value or the market value of equity?
6.How do you get from a peer multiple to an implied share price for the target?
7.A company has cash of 50, receivables of 100, inventory of 200, and PP&E of 300. Assume recoveries of 100%, 80%, 50%, and 30%. It owes 250 of secured debt and 150 of unsecured debt. What does each class recover?
8.Should the exit multiple be applied to the final year's EBITDA or the next year's?
9.Two coins are flipped and at least one is heads. What is the probability both are heads?
10.A stock trades at 12 times earnings. What is its earnings yield?

Drill these with answers

Questions students ask

Why do you use unlevered free cash flow instead of levered?: Unlevered cash flow is before interest, so it belongs to all capital providers and pairs with WACC to give enterprise value. Levered cash flow is after interest and debt repayment, belongs to equity only, and pairs with the cost of equity. Mixing the two is the classic mistake.
Perpetuity growth or exit multiple, which is better?: Neither is better; use both and cross check. Perpetuity growth ties value to fundamentals but is sensitive to small rate changes. An exit multiple ties value to the market. Back out the implied multiple from one and the implied growth rate from the other and see if both are reasonable.
What terminal growth rate should I use?: Something at or below long run nominal GDP growth, usually 2 to 3 percent for a US company. A rate above the economy's growth implies the company eventually becomes larger than the economy.
When would you not use a DCF?: For banks and insurers, where interest is part of operations and free cash flow is not well defined, and for very early stage companies or ones with unpredictable cash flows, where the terminal value is nearly all of the answer.
What is the mid year convention?: Discounting each year's cash flow as if it arrives in the middle of the year (0.5, 1.5, 2.5 years) rather than the end, since cash comes in throughout the year. It raises the value slightly. The worked example above uses end of year discounting for simplicity.