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 |
|
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 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. |
Answer |
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 normalize operating income
and if so how do you do it? |
Answer |
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. |
Answer |
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 acquisitions funded with
cash or all acquisitions? |
Answer |
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 goodwill). In computing
depreciation, should you include all depreciation and amortization
or only tax-deductible depreciation and amortization? |
Answer |
| 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. 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? |
Answer |
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. |
|
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. |
Answer |
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 you include in debt? |
Answer |
13.
Why do we use
market value weights to come up with a cost of capital instead
of book value weights? |
Answer |
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 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? |
Answer |
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 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? |
Answer |
17.
Multinationals
now operate and trade in different markets and different currencies.
Which riskfree rate should you use to value a company (Nestle,
for instance)? |
Answer |
18.
Most analysts
estimate risk premiums by looking at historical data in the United
States. What are the perils of historical premiums? |
Answer |
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. 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? |
Answer |
| 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 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? |
Answer |
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 significant likelihood that
the firm will not make it as a going concern, how do you reflect
that in your valuation? |
Answer |
22.
What have you
not valued yet? (In other words, what do you need to add on to
the present value?) |
Answer |
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 discount (minority, marketability, private company
etc.). Is this a reasonable practice? |
Answer |
25.
How do you get
from the value of equity to the value of equity per share? |
Answer |