1/7/23, 7:54 PM 25 DCF valuation questions

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 Answer
over multiple periods). Specify at least two items 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 expenses). Should you smooth or Answer
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 any of the acquisitions, only Answer
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
Answer
goodwill). In computing depreciation, should you include all 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.
Answer
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 expected
growth rate?
c. Increasing the amount you reinvest back into the business (reduce the payout ratio or increase

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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 be negative? Answer
11. What effect will increasing the growth rate in perpetuity have on terminal value? Answer

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 debt. What would
Answer
you include in debt?
13. Why do we use market value weights to come up with a cost of capital instead of book value
Answer
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.
a. How do you get market value of debt when all or even some of your firm's debt is bank debt Answer
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 Answer
estimate costs of equity for private or closely 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 Answer
riskfree rate should you use to value a company (Nestle, for instance)?
18. Most analysts estimate risk premiums by looking at historical data in the United States. What
Answer
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? Answer
b. If yes, how would you go about estimating it?
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 Answer
effects of debt. What is the fundamental difference 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 distressed firm where there is a Answer
significant likelihood that the firm will not make it as a going concern, how do you reflect that in
your valuation?

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22. What have you not valued yet? (In other words, what do you need to add on to the present Answer
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 Answer
discount (minority, marketability, private company etc.). Is this a reasonable practice?
25. How do you get from the value of equity to the value of equity per share? Answer

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