Wednesday, May 28, 2008

The most recent poll I took on this blog asked, "Do you know how to walk through a DCF in an interview?". The results are as follows:

  • 13 People or 39% of you responded: YES

  • 7 People or 21% of you responded: KIND OF

  • 13 People or 39% of you responded: NOT AT ALL

If you are one of the 13 people who DO know how, that's awesome! Keep up the good work! For those of you who responded 'KIND OF' or 'NOT AT ALL', this is the blog post for you. Walking through a DCF or Discounted Cash Flow valuation should be second nature by the time you sit down in an investment bank to interview for a position with them. Below, I have written an easy outline to use that covers how to walk through a DCF in an interview. MEMORIZE THIS OUTLINE! Memorize every bullet point, every question, every formula, and know what everything means!!!

A trick to interviewing is to not tell the interviewer on the first try everything you know about a DCF. When you are initially asked this question, answer by giving the bullet points 1-4. This is your first level of knowledge. Now, the interviewer will ask you some follow up questions about the DCF and you will have more information to give them.

**It is important to note that if you had told the interviewer all you knew to begin with, then when they ask a follow up question it will be more technical and you will most likely not know the answer, which will increase the likelihood that you make a less than favorable impression and don't get the job.**

Next, you should notice the bullet points under each of the 4 sections. These are possible follow up questions you will be asked. Memorize these questions and the answers and you will be 'Golden' in your interview.

  • Walk me through a Discounted Cash Flow (DCF) valuation.

    1. Project out the Free Cash Flows (FCF) for a given period of time

      • How long should your project out the FCFs?
        • Typically is 5 to 10 years

      • Why would you choose 5 years vs. 10 years?
        • 5 years for more volatile companies, such as technology companies
        • 10 years for less volatile companies, such as industrial companies

      • How do you derive FCF?
        • FCF =
        • EBIT x (1 – Tax Rate)
        • + Depreciation and Amortization
        • - Capital Expenditures
        • - Net Increase in Working Capital: (Current Assets – Current Liabilities)

    2. Use a Terminal Value (TV) calculation on your final year FCF 5 or 10

      • Gordon Growth Model (also known as the Perpetual Growth Model)
        • (FCF,year 5 or 10)(1+g)
          (Discount rate (WACC) - g)

      • Multiples Method
        • (FCF, year 5 or 10) * Multiple
        • Multiple will vary based on each deal, industry, timing, etc...

    3. Discount the FCFs at some required rate of return

      • Weighted Average Cost of Capital (WACC)
        • WACC = [E /(D + E)]*CAPM + [D /(D + E)]*DebtInterestRate*(1 - T)
          • E = Equity Value
          • D = Debt Value
          • CAPM = Capital Asset Pricing Model
          • T = Tax Rate

      • Capital Asset Pricing Model (CAPM)
        • CAPM = rf + Beta*(rm - rf)
          • rf = Risk free interest rate (T-Bill rate)
          • Beta = stock volatility
          • rm - rf = excess market return

    4. Sum these discounted FCFs to get the Net Present Value (NPV)

    Pros of DCF
    • Produces the closest thing to intrinsic stock value
    • Relies on FCF, which are trustworthy because FCF cut through reported earning "guesstimates" and tracks the money left over for investors
    • Identifies where companies value is coming from and if current stock price is justified

    Cons of DCF
    • If assumptions are wrong/incorrect then the output will be inaccurate
    • Terminal Value calculation projects the FCF into the future at the same rate, which will clearly never happen
    • The debt to equity ratio is held constant in the WACC


    paul said...

    can u demonstrate this with numbers? thnx.

    Anonymous said...

    Thank you! An example with concrete numberes would be great! -H

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