Walk me through a DCF? (NEW) | Interview Answer

Summary

This video script offers a comprehensive guide to impressing investment banking interviewers with a complete DCF (Discounted Cash Flow) analysis. It covers the three main steps of projecting free cash flows, calculating terminal value using multiples or the Gordon growth model, and discounting future cash flows to present value using the weighted average cost of capital. The script also addresses common pitfalls, such as adjusting for stub periods and mid-year discounting, to ensure accuracy in valuation. It concludes with a teaser for a financial modeling course and a call to action for further learning.

Takeaways

• 📚 The DCF (Discounted Cash Flow) is a method of valuing a company by discounting its future cash flows to present value.
• 🔍 There are two main valuation approaches: intrinsic valuation (DCF) and relative valuation (comparables analysis and precedent transactions).
• 🏦 Intrinsic valuation, unlike relative valuation, values a company based on its own cash flow generation rather than comparisons to others.
• 🔢 A DCF analysis involves three main steps: projecting free cash flows, calculating terminal value, and discounting future cash flows back to present value.
• 📈 Free cash flow projection requires adjustments to EBIT for taxes, capex, depreciation, and changes in working capital.
• 🌐 Terminal value can be calculated using either the multiples approach or the Gordon growth method, with the former being more common in investment banking.
• 📉 The multiples approach uses an exit multiple from industry research to estimate the terminal value based on EBIT or revenue.
• 📈 The Gordon growth method assumes perpetual growth at a low single-digit rate, using the formula FCF * (1 + g) / (WACC - g).
• 💡 The weighted average cost of capital (WACC) is used as the discount rate in the DCF process to find the present value of future cash flows.
• ⏱ Adjustments for timing issues, such as stub periods and mid-year discounting, are crucial for an accurate DCF analysis.
• 👨‍🏫 Including stub periods and mid-year discounting in your DCF explanation can impress interviewers, as many candidates overlook these details.
• 📚 Understanding and addressing common follow-up questions on DCF, such as the use of unlevered vs. levered free cash flow, can demonstrate depth of knowledge.

Q & A

What are the two main valuation approaches discussed in the script?

The two main valuation approaches discussed are intrinsic valuation, which includes the Discounted Cash Flow (DCF) method, and relative valuation, which includes comparables analysis and precedent transactions.

What is the basic principle behind the DCF method?

The basic principle behind the DCF method is to discount the future cash flows of a company to determine its present value, based on its own ability to generate cash flow.

How many steps are there in performing a DCF analysis as per the script?

There are three main steps in performing a DCF analysis: projecting the free cash flows, calculating the terminal value, and discounting the projected cash flows and terminal value back to present value.

What is the formula used to calculate EBITDA in the script?

EBITDA is calculated by taking EBIT (Earnings Before Interest and Taxes), then adjusting for taxes (EBIT times (1 - tax rate)), subtracting capex, adding back depreciation (as it's a non-cash expense), and finally subtracting net changes to working capital.

What are the two approaches to calculate the terminal value in a DCF analysis?

The two approaches to calculate the terminal value are the multiples approach, where an exit multiple is multiplied by the EBITDA of the fifth year, and the Gordon growth method, which assumes a perpetual growth rate and uses the formula: (FCF of year 5 * (1 + growth rate)) / (WACC - growth rate).

Why might the Gordon growth method be considered less practical in real-world investment banking?

The Gordon growth method might be considered less practical because it assumes that a company will grow forever, which is an unrealistic assumption given that no company has continued to grow indefinitely throughout history.

What is the weighted average cost of capital (WACC) and how is it used in a DCF analysis?

WACC is the average rate that a company expects to pay to finance its assets, taking into account the cost of equity and debt. It is used as the discount rate in a DCF analysis to convert future cash flows into present value terms.

What are the two issues with DCF analysis that the script suggests candidates often overlook?

The two issues often overlooked are the stub period, which adjusts for the time period of the cash flow if the analysis is not starting in January, and the mid-year discounting period, which accounts for the fact that businesses generate cash throughout the year, not just at year-end.

How can a candidate impress an interviewer during an investment banking interview when discussing DCF?

A candidate can impress an interviewer by not only explaining the DCF process correctly but also by including the stub period and mid-year discounting period in their explanation, as most candidates do not cover these aspects.

What additional resources are suggested in the script for someone looking to learn more about DCF and other investment banking interview questions?

The script suggests considering a financial modeling course for a real-life DCF module and other valuation methodologies in Excel, as well as checking out other videos for a breakdown of investment banking interview questions and answers.

Outlines

00:00

📈 Understanding the DCF Method in Investment Banking

The first paragraph introduces the importance of the Discounted Cash Flow (DCF) method in investment banking interviews. It highlights that while most candidates answer the question correctly, they often fail to provide a complete response. The speaker, NASA, shares their experience in investment banking since 2013 and emphasizes two valuation approaches: intrinsic (DCF) and relative valuation. The intrinsic valuation is based on a company's ability to generate cash flow, likened to the value of a house based on its rental potential. The DCF process involves three steps: projecting free cash flows, calculating terminal value, and discounting future cash flows back to present value using the weighted average cost of capital (WACC). The paragraph also mentions two methods for terminal value calculation: the multiples approach and the Gordon growth method, with a preference for the former in practice due to its simplicity and the unrealistic assumption of perpetual growth in the latter.

05:04

🔍 Enhancing the DCF Analysis with Stub Period and Mid-Year Discounting

The second paragraph delves into the nuances of the DCF analysis that are often overlooked by candidates during interviews. It discusses the need for adjusting the DCF for the time value of money by considering the stub period and the mid-year discounting convention. The stub period accounts for the fact that cash flows may not be collected evenly throughout the year, while the mid-year discounting adjusts the discounting period to reflect that cash is generated throughout the year, not just at year-end. The paragraph warns of the pitfalls of ignoring these adjustments, which can lead to an inaccurate valuation. It also suggests that including these considerations in interview responses can impress interviewers, as most candidates do not mention them. The speaker invites viewers to explore a financial modeling course for a practical demonstration and mentions common follow-up questions related to DCF, advising to check out mock interviews for a comprehensive list of potential questions and ideal answers.

Keywords

💡DCF (Discounted Cash Flow)

DCF is a valuation method used to determine the value of an investment based on its ability to generate cash flows. It is central to the video's theme as it is the primary focus of the explanation. The video outlines the process of discounting future cash flows of a company to arrive at its current value, using this method to impress interviewers in the investment banking industry.

💡Intrinsic Valuation

Intrinsic valuation is a method of evaluating an asset by determining its intrinsic value, which is its true value based on its fundamentals. The video mentions it as one of the two valuation approaches, with DCF being a form of intrinsic valuation where the company's value is determined by its own cash-generating ability.

💡Relative Valuation

Relative valuation is another method of asset valuation, where the value of a company is determined by comparing it to similar companies or transactions. The video contrasts this with intrinsic valuation, using the analogy of a house's value being dependent on the neighbor's house to illustrate the concept.

💡EBIT (Earnings Before Interest and Tax)

EBIT is a measure of a company's profit that excludes interest and tax expenses. In the script, EBIT is used as a starting point for projecting free cash flows in a DCF analysis, highlighting its importance in understanding a company's financial performance.

💡Tax Rate

The tax rate is the percentage of a company's income that is paid to the government as taxes. In the DCF process described in the video, the EBIT is adjusted by subtracting the product of EBIT and the tax rate to account for the impact of taxes on a company's cash flow.

💡CapEx (Capital Expenditure)

CapEx refers to the funds a company spends to acquire, upgrade, and maintain its assets. The video script explains that CapEx is subtracted from EBIT in the DCF process to reflect the costs necessary to maintain the business's operations.

💡Depreciation

Depreciation is the allocation of the cost of a tangible asset over its useful life and is a non-cash expense. In the DCF method, depreciation is added back to the adjusted EBIT because it reduces taxable income without affecting cash flow.

💡Working Capital

Working capital represents the liquid assets of a company that can be converted into cash within a short period. The script mentions adjusting for net changes to working capital in the DCF process to reflect the short-term liquidity needs of the business.

💡Terminal Value

Terminal value is the value of a company's cash flows beyond the projection period in a DCF analysis. The video discusses two methods for calculating terminal value: the multiples approach and the Gordon growth method, emphasizing its significance in estimating the long-term value of a company.

💡Weighted Average Cost of Capital (WACC)

WACC is the average rate that a company expects to pay to finance its assets, weighted by the relative proportion of each type of financing. The video explains that WACC is used as the discount rate in the DCF process to determine the present value of future cash flows.

💡Stub Period

A stub period is an adjustment made in a DCF analysis to account for the time value of money when the cash flows are not received at the end of the year. The video script points out the importance of using a stub period to avoid inflating the value of the cash flows, ensuring a more accurate DCF analysis.

💡Mid-Year Discounting

Mid-year discounting is a method used in DCF analysis to adjust the discounting period by 0.5 to reflect that cash flows are generated throughout the year, not just at year-end. The video emphasizes the necessity of using mid-year discounting for a more precise valuation.

Highlights

The importance of providing a complete answer when explaining the Discounted Cash Flow (DCF) in investment banking interviews.

Introduction to two main valuation approaches: intrinsic (DCF) and relative valuation (comparables analysis and precedent transactions).

Explanation of intrinsic valuation, where a company's value is based on its ability to generate cash flow.

DCF is the process of discounting a company's future cash flows to determine its value.

Step-by-step guide on projecting free cash flows, including adjustments for taxes, capex, depreciation, and changes in working capital.

The significance of revenue growth assumptions in projecting cash flows for a company.

Two methods for calculating terminal value: the multiples approach and the Gordon growth method.

The prevalence of using exit multiples from research reports in the multiples approach for terminal value calculation.

Critique of the Gordon growth method due to its unrealistic assumption of perpetual growth.

The practicality of using the multiples method in investment banking over the Gordon growth method.

How to discount future cash flows and terminal value back to present terms using the weighted average cost of capital.

The problem of assuming cash flows are collected at the end of the year and the need for mid-year discounting.

The issue of discounting full year's cash flow when the interview may not be in January and the use of stub periods.

The impact of not using stub periods and mid-year discounting on the accuracy of DCF analysis.

Advice on impressing interviewers by including stub periods and mid-year discounting in DCF explanations.

Invitation to view a financial modeling course for a detailed demonstration of DCF and other valuation methodologies.

Common follow-up questions in DCF analysis and the importance of understanding them for investment banking interviews.

Encouragement to like, share, and comment on the video for further questions and engagement with the content.

Transcripts

in almost every single investment

banking interview you will get asked

walk me through a DCF or tell me about

the DCF now the good thing is most

people do get this right but they give

an incomplete answer so in this video

I'm going to show you how to fully

answer this question and give an answer

that will impress your interviewer hi

I'm NASA I started in MSN banking in

2013 and I've recruited and interviewed

over a dozen candidates in investment

banking there are two valuation

approaches there is intrinsic valuation

which is the DCF and then there is a

relative valuation which is comparables

analysis and precedent transactions

which we've already gone through where

the value of the company which you're

valuing is dependent on either what

similar companies are being valued at or

what similar companies has already been

valued at now you can think of it as the

value of your house is dependent on the

value of your neighbor's house now

whereas intrinsic valuation the value of

the company which you're valuing is

dependent purely on its own ability to

generate cash flow so think of it as the

value of your house is purely dependent

on its ability to generate or rent and

we're going to encapsulate the future

rent in one figure and that's the value

which we're going to place only your

house so simply put a DCF is discounting

the future cash flow of a company and

that's how we value a company and you

can pretty much do a DCF in three steps

step number one is projecting the free

cash flows and you can have a projected

out five years ten years ideally you

want to stay as short as possible

because then your formal accurate and

how you project this out is by getting a

bit EBIT is earnings before interest and

tax once you have a bit you then tax

adjusted because we live in a world

where we have to pay taxes so a bit

times one minus the tax rate you'll then

take away

capex because you have to pay in order

to maintain the business you will then

add back depreciation and

because those are non-cash expenses and

then you'll take away net changes to

working capital once you have that you

then project it out five years or ten

years into the future and the rate at

which you're going to grow this is going

to be dependent on your growth revenue

growth assumptions step number two we've

already projected out five years of cash

flows but we are going to assume that

our company is going to be operating

longer than five years and in fact it's

going to operate forever so we have to

encapsulate the cash flow of year six to

infinity in one number and there are two

approaches to this and this is known as

a terminal value there is the multiples

approach this is more widely used in

investment banking this is where we're

going to use an exit multiple multiplied

by the EBIT de or ef5 so we get the FIV

beta or EBIT or revenue and then we'll

multiply it by an exit multiple this

exam multiple we're going to get from

equity of research reports so other

investment bankers that I've already

done this analysis for our company or a

very similar company and once we

multiply this X are multiple with the

EBIT da that's going to be our terminal

value now that's the first approach the

second approach is going to be the

golden growth method now here we're

going to assume that our company is

going to be growing forever and it's

going to be growing at a very low

single-digit either GDP rate or

inflation rate of the company which

operates any so we will get the free

cash flow of year five and then we'll

multiply by 1 plus at the birth rate and

we'll divide that by the weighted

average cost of capital - at the growth

rate and that's the Gordon growth method

as a quick side note in reality most

investment bankers will just depend on

the multiples method because one is

quicker to calculate and second the

Gordon growth method assumes that

companies are going to be growing

forever now there hasn't been a single

company in human history that has gone

on for longer than a couple hundred

years so it's irrational to assume that

a company is going to forever be growing

now we still calculate both methods but

we use the Gordon growth method as a

sanity check as a

of actually using in our analysis step 3

now that we've calculated the future

cash flows of our company and the

terminal value we now need to discount

those back into present terms and we're

going to use the weighted average cost

of capital as our discounting rate so

once we've calculated our weighted

average cost of capital are you work

were then going to use a simple formula

of free cash flow over 1 plus the

weighted average cost of capital ^ the

period you're in so if you're in your 1

1 year to power of 2 and once we've

calculated that will then do all of them

and add them up and that's going to be

the value of your DCF ie the enterprise

value of this company and that's pretty

much it now remember in the beginning I

said most candidates give a correct

answer but they give an incomplete

answer and the reason is because they

just stop here and they completely

ignore two problems facing the DCF

you're assuming that you're in January

and when you discount the future cash

flows you're going to be collecting it

throughout the year so for example in

year 1 when we calculated our first year

cash flow and discounting it we're

assuming we're currently in January and

we have to the end of December to

collect all of this money but what if

it's July the 1st what if half of the

year has already gone then can you still

discount a full year's cash flow well no

you can't so in that case you have to

use a stub period a stub period is going

to adjust for of the calendar ization or

the time period of this cash flow so

it's only going to be discounting half

of this cash flow so instead of using ^

1 we're going to be using the power of

Northpoint 5 and then we're going to

adjust for subsequent yes problem number

2 we're also assuming that we're going

to be collecting this cash flow at the

end of the year so we're going to be

collecting this cash flow on December

31st of every single year but we know

that businesses generate cash throughout

the year so we have to use the mid yet

discounting period so we're going to be

incrementing our discounting period by

0.5 and if we

use the stub period and the midea

discounting period your DCF analysis is

completely wrong because you're going to

be inflating the value of the cash flows

and now you're going to be getting a

higher number than what you should be

getting or low number some cases so it's

really important that you understand how

this works now every single investment

banker has to do this in practice

in the real world so when you're

answering this question during your

interviews and if you include the stub

period and the mid-year discounting

period you are going to impress your

interviewer because 90% of candidates do

not include this in their answer now how

do you combine a stub period and a

mid-year discounting period now that's

far more easily explained by doing a

large demonstration or an Excel model

and if you like to see a real-life DCF

module as well as other valuation

methodologies in Excel then consider

looking at our financial modeling course

where we'll show you step by step what

investment banking analyst an associate

to do when they do these financial

modeling processes and more importantly

how do they interpret the results after

you get asked what is a DCF or walk me

through a DCF there are twenty to thirty

very common follow-up questions which

analysts and associates would typically

get and if you're an intern from a

finance background you can also get them

some of these follow-up questions would

be in a DCF do you use unlevered free

cash flow or levered free cash flow and

why what proportion of the DCF is

attributable to terminal value typically

in a DCF

are you trying to find the enterprise

value or the equity value why do we use

the weighted average cost of capital and

what is the formula behind it how do you

unlevered beta and real elevator now

there are around 20 to 30 of these very

common DCF follow-up questions and if

you ask you know more then have a look

at our Investor mock interview guys for

a full list of all of the questions you

can get ask as well as the ideal answers

and also be sure to check out our other

videos where we go through other

investment banking interview questions

and break down how to answer it okay so

if this video has helped you better

understand how to walk

DCF then be sure to like it and share it

and as well as leave us a comment if

there are any other questions which you

have I always check and read the comment

section so I'll be sure to apply to you

if I don't apply to you in the comment

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