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.