Walk me through a DCF? (NEW) | Interview Answer
Summary
TLDRThis 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
📈 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.
🔍 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.
Mindmap
Keywords
💡DCF (Discounted Cash Flow)
💡Intrinsic Valuation
💡Relative Valuation
💡EBIT (Earnings Before Interest and Tax)
💡Tax Rate
💡CapEx (Capital Expenditure)
💡Depreciation
💡Working Capital
💡Terminal Value
💡Weighted Average Cost of Capital (WACC)
💡Stub Period
💡Mid-Year Discounting
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
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