Intermediate Valuation & DCF Interview Questions for Finance

If only one valuation method could be chosen, Discounted Cash Flow (DCF) would be preferred for its focus on a company’s intrinsic value based on future cash flows.

Key Arguments:

• Intrinsic Value Focus: DCF looks at the company’s own future cash flow generation rather than market-based comparables.
• Long-term Sustainability: It provides insights into a company's long-term financial health and growth potential.
• More Fundamental Approach: Unlike relative methods (Comps, Precedent Transactions), DCF doesn’t depend on market sentiment or comparable companies.
• Comprehensive Analysis: DCF incorporates detailed assumptions about cash flows, growth rates, and cost of capital to offer an in-depth valuation.

In a Discounted Cash Flow (DCF) analysis, the value of a company is determined by calculating the Present Value (PV) of its Free Cash Flows (FCF) and the Present Value of its Terminal Value (TV). The process involves the following steps:

1. Project Free Cash Flows (FCF): Forecast the company’s Free Cash Flows over a period of 5 to 10 years, considering revenue growth, operating expenses, and capital expenditures.
2. Calculate the Discount Rate: Determine the company’s Weighted Average Cost of Capital (WACC), which represents the discount rate used to bring future cash flows to present value.
3. Discount the Free Cash Flows: Apply the WACC to discount the projected Free Cash Flows to their present value over the forecast period.
4. Calculate the Terminal Value: Estimate the Terminal Value at the end of the projection period, using either the Multiples Method or the Gordon’s Growth (Perpetuity) Method.
5. Discount the Terminal Value: Discount the Terminal Value back to its present value using the same WACC.
6. Sum the Values: Finally, add the discounted Free Cash Flows to the discounted Terminal Value to arrive at the company’s total enterprise value.

Free Cash Flow (FCF) is important because it reflects the company’s ability to generate cash after capital expenditures, which is essential for its long-term sustainability and valuation.

• It shows actual cash generation available for debt repayment, reinvestment, or shareholder returns.
• It is more accurate than the net income, as it excludes non-cash items and accounting adjustments.
• It is key input for estimating a company’s intrinsic value.

To calculate Free Cash Flow (FCF), the following steps are necessary:

1. Project Revenue Growth: Estimate how much the company’s revenue will grow over the forecast period, based on historical data or market trends.
2. Calculate Operating Income (EBIT): Use the assumed operating margin to calculate EBIT, which shows the company’s earnings from operations before interest and taxes.
3. Calculate NOPAT: Apply the tax rate to EBIT to calculate Net Operating Profit After Tax (NOPAT), showing profit after taxes.
4. Adjust for Key Items: From the Cash Flow Statement, adjust for non-cash charges (like depreciation), changes in working capital, and capital expenditures (CapEx).
5. Arrive at Unlevered FCF: After adjustments, you get Unlevered Free Cash Flow, which reflects the company’s cash generation after necessary investments.

To discount Free Cash Flows (FCFs) to their present value, the following steps are involved:

1. Determine the Discount Rate (WACC): The discount rate used to bring future cash flows to present value is typically the Weighted Average Cost of Capital (WACC). This rate reflects the company's overall cost of capital, accounting for the cost of debt and the cost of equity, weighted according to the company’s capital structure.

2. Discount the FCFs: Once the WACC is determined, it is used to discount each projected Free Cash Flow (FCF) to the present value.

3. Sum the Discounted FCFs: After discounting each year’s FCF, sum them up to get the total present value of the company’s FCFs.

The cost of equity in a DCF analysis is primarily influenced by:

1. Company Size and Risk: Smaller companies are generally considered riskier and therefore have a higher cost of equity, as investors require higher returns to compensate for the additional risk.
2. Risk-Free Rate: The risk-free rate (usually based on government bond yields) sets the baseline for the cost of equity. As the risk-free rate increases, the cost of equity typically increases as well.
3. Beta: Beta measures the company’s systematic risk relative to the overall market. A higher beta (greater volatility compared to the market) leads to a higher cost of equity.

Changes in a company’s capital structure affect the cost of equity as follows:

1. Additional Debt: When a company increases its debt, it raises its financial risk, which in turn increases the cost of equity. Equity investors demand a higher return to compensate for the higher risk associated with increased leverage.
2. Additional Equity: Issuing more equity reduces the proportion of debt in the capital structure, which lowers financial risk and, therefore, reduces the cost of equity. Investors view a less leveraged company as less risky.

To calculate the Terminal Value (TV) in a Discounted Cash Flow (DCF) analysis, there are two common methods: the Multiples Method and the Gordon Growth Method (also called the Perpetual Growth Method).

1. Multiples Method: This method is often used and involves applying an EBITDA multiple (or sometimes other multiples like EV/EBIT or EV/Sales) based on public comps (comparable companies) in the industry. The multiple is typically derived from market transactions and gives a range for the Terminal Value.

2. Gordon Growth Method (Perpetual Growth Method): The Gordon Growth Method assumes that the company will continue to operate indefinitely, growing at a stable rate. 
 

To arrive at the final valuation, the Present Value (PV) of the Terminal Value needs to be aded to the PV of the Free Cash Flows (FCFs) in the projected period. This gives the Enterprise Value (EV) of the company.

The two components that have the most significant influence on the final DCF valuation are:

1. Discount Rate (WACC): The Weighted Average Cost of Capital (WACC) is crucial because it is used to discount future cash flows to their present value. A higher WACC reduces the present value of future cash flows, leading to a lower valuation, while a lower WACC increases the valuation.
2. Terminal Value: The Terminal Value represents the value of the company beyond the projection period and typically makes up a large portion of the total valuation. Changes in the terminal growth rate or assumptions about future growth can have a significant impact on the Terminal Value, and in turn, the overall company valuation.