RE - DCF Valuation

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IB Interview Guide, Module 4: Valuation and DCF Analysis

Table of Contents:
Overview & Key Rules of Thumb ........................................................................................ 2
Key Rule #1: The Big Idea Behind DCF Analysis and Valuation ....................................... 2
Key Rule #2: DCF – How to Project Free Cash Flow ........................................................ 4
Key Rule #3: DCF – Discount Rates and WACC ............................................................. 15
Key Rule #4: DCF – Terminal Value ............................................................................... 26
Key Rule #5: How Different Factors Affect the DCF...................................................... 35
Key Rule #6: DCF – More Advanced Points [OPTIONAL] .............................................. 40
Key Rule #7: Comparable Public Companies (Public Comps) ....................................... 51
Key Rule #8: Precedent Transactions (M&A Comps) .................................................... 60
Key Rule #9: Other Valuation Methodologies [OPTIONAL] .......................................... 64
Key Rule #10: How to Put Together and Use a Full Valuation ...................................... 71
Key Rule #11: The Trade-Offs of Different Methodologies .......................................... 76
Interview Questions .......................................................................................................... 79
The Purpose of Valuation.............................................................................................. 79
DCF Analysis – Walking Through and Explaining It ....................................................... 82
DCF Analysis – Calculating Free Cash Flow ................................................................... 87
DCF Analysis – Discount Rates and WACC .................................................................... 92
DCF Analysis – Calculating the Terminal Value ........................................................... 102
DCF Analysis – More Advanced Features ................................................................... 107
Factors That Affect a DCF Analysis.............................................................................. 111
Public Comps and Precedent Transactions ................................................................. 113
Other Valuation Methodologies ................................................................................. 120
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Overview & Key Rules of Thumb

If you’ve already read and understood the guides and lessons on Present Value and IRR,
Accounting, and Equity Value and Enterprise Value, this guide will be straightforward.
The main difference is that this guide is about the real-life applications of those topics, not the
theory behind them.
This section ties together all these concepts to create something that is useful in real life: An
integrated valuation model for a company.
It goes back to Implied vs. Current Value: Is a company undervalued, overvalued, or valued
appropriately?
With an Excel-based valuation, you can answer that question and then use the results to advise
a client or invest your money.
Key Rule #1: The Big Idea Behind DCF Analysis and Valuation
We’ve continually referenced this formula:

Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow
Growth Rate < Discount Rate.
If a company’s Discount Rate and Cash Flow Growth Rate stay the same forever, then it should
be worth the amount predicted by this formula.
But that is never true in real life.
A company may grow quickly in its early days, but then slow down as it gets bigger and more
mature.
And a company’s Discount Rate might be very high early on, but then drop to a much lower
level as its risk and potential returns both decline.
Since the Discount Rate and Cash Flow Growth Rate change over time, valuation is more
complicated than this simple formula.
There are two main ways to reflect this reality more accurately:
1. Project a company’s cash flows, and possibly its Discount Rate, in detail in the near term
– the next 5, 10, or 15 years. And then assume that its Cash Flow Growth Rate and
Discount Rate stay the same after that in the Terminal Period, and value the company in
that period using the formula above. Discount the values from both periods and add
them together.
2. Use valuation multiples for the company’s near-term financial results – the next year or
two – and don’t rely on cash flow projections at all. Remember that valuation multiples
are shorthand for cash flow-based valuation, assuming you’ve picked appropriate peer
companies.
Method #1 is called the Discounted Cash Flow (DCF) Analysis, and it’s the most theoretically
correct way to value a company.
For example, you might project a company’s cash flows over the next 10 years, and conclude
that their Present Value is $1,200 at a Discount Rate of 10% and that the Present Value of the
cash flows in its Terminal Period is $1,500.
Based on that, the company’s Implied Value is $2,700.
Since you’re valuing a company based on its cash flows, as opposed to external factors like
other companies, this method is often called intrinsic valuation.
Method #2 is known as relative valuation. To use it, you have to collect sets of “comparable”
companies and M&A transactions, calculate their valuation multiples, and then apply those
multiples to the company you’re valuing.
For example, similar companies in the sector trade at EV / EBITDA multiples of between 10x and
12x.
Your company has an EBITDA of $200, so its Implied Enterprise Value should, therefore, be
between $2,000 and $2,400.
There are other methodologies as well, but these are the most important ones.
Once you’ve valued a company using both relative and intrinsic valuation, you can see how its
Implied Value compares with its Current Value.
For example, maybe the company’s Current Enterprise Value is $2,000.
But based on the analysis above – a DCF that produced an Implied Value of $2,700, and
comparable companies that showed an Implied Value between $2,000 and $2,400, the
company seems undervalued.
As an investment banker advising this company, you might use this analysis to tell the Board of
Directors the price they might get if they decide to sell the company.
If you’re an investor at a private equity firm or hedge fund, you might use this information to
conclude that the company is undervalued and that it could be a good investment if its stock
price increases.
Return to Top.
Key Rule #2: DCF – How to Project Free Cash Flow
The first step in a DCF analysis is to project the company’s cash flows in the explicit forecast
period.
“Explicit forecast period” usually means the next 5-10 years, but it could mean 15-20+ years,
depending on the company and industry.
As you know from the guide(s) to valuation metrics and multiples, there are different types of
“cash flow”: Free Cash Flow, Levered Free Cash Flow, and Unlevered Free Cash Flow.
You should use Unlevered Free Cash Flow in pretty much all DCF analyses.
That means that you need to project the following items:
1. Revenue.
2. COGS and Operating Expenses.
3. Taxes.
4. Depreciation & Amortization (and sometimes other recurring, non-cash add-backs).
5. The Change in Working Capital.
6. Capital Expenditures.
You ignore huge chunks of the company’s Income Statement and Cash Flow Statement,
including Net Interest Expense, Other Income / (Expense), most of the non-cash adjustments,
the entire Cash Flow from Financing section, and most of the Cash Flow from Investing section.
You ignore them because those items are non-recurring or relate only to specific investor
groups rather than all investors.
Unlevered FCF represents the company’s recurring business cash flow that is available to ALL
investors.
You might remember that we previously defined Unlevered FCF this way:
• Unlevered Free Cash Flow: NOPAT + Non-Cash Adjustments and Change in Working
Capital from CFS – CapEx.
NOPAT corresponds to items #1, #2, and #3 above (Revenue, COGS and Operating Expenses,
and Taxes), and the Change in Working Capital and CapEx correspond to items #5 and #6 above.
We do not include all the “Non-Cash Adjustments” – just Depreciation & Amortization and not
much else.
There are 2 reasons for that:
1) Most of these non-cash adjustments, aside from D&A, are non-recurring (e.g., Gains and
Losses, Impairments, and Write-Downs). And when you project Free Cash Flow, you
ignore these non-recurring items.
2) And stock-based compensation, the other common, recurring item in this section, is
NOT a real non-cash expense and should not be added back to calculate FCF. And, per
the definition above, it relates only to a specific investor group (Equity investors).
SBC is not a non-cash expense in the same way D&A is because it creates additional shares and
dilutes the existing investors.
Think about it like this: Let’s say you have a house worth $10 million, and you pay someone to
manage it for you.
Instead of paying him a cash salary of $100,000 per year over 5 years, you award him a 1%
ownership stake in the house each year. By the end, he owns 5% of the house.
If you decide to sell the house after 5 years, you’ll receive only $9.5 million – not $10.0 million –
because someone else owns a portion of it.
Sure, you haven’t paid this person a cash salary, but he still costs you money because he has
reduced your ownership in the house!
It’s the same with Stock-Based Compensation: If you add it back as a non-cash expense,
you’re getting a “free lunch” because you’re not reflecting the cash payouts associated with
it, nor are you reflecting the additional shares that get created.
The main non-cash adjustment that doesn’t fit into the guidelines above is Deferred Taxes.
You can include it, but it should decrease as book vs. cash-tax timing differences reverse.
So, if Deferred Taxes initially represent 20% of total Income Taxes, they shouldn’t stay at 20%
throughout the entire forecast period; they should drop to a much lower percentage, such as 3-
5%, by the end. ???
Here’s what we will project and what we won’t project for Steel Dynamics, starting with the
Income Statement:
And then on the Cash Flow Statement:
You leave out most of the Cash Flow from Investing and Cash Flow from Financing sections,
with one exception:
How to Make the Projections

Once you’ve decided what to include and what to exclude, you make the actual projections for
Unlevered FCF.
This process depends on the company’s industry and business segments, but here are the
general set of steps to follow:
1) Project Revenue.
You could use several approaches to project revenue depending on how much time you have
and how much detail you need:
1. Simple % Growth Rate (e.g., assume that revenue grows at 5% per year).
2. Units Sold * Average Selling Price (e.g., assume the company sells 1,000 widgets for $10
each).
3. Market Share * Market Size (e.g., assume the company captures 10% of a $1 billion
market).
You must be able to justify your numbers, which means that methods #2 and #3 are better if
you have the time to use them.
We used method #2 for Steel Dynamics:
We assumed that the company ships a certain amount of steel in each segment and sells each
ton for a certain dollar amount. These figures keep changing until revenue growth decreases to
a much lower level by the end of Year 10 (FY 25 here).
2) Assume an Operating (EBIT) Margin or Project COGS and OpEx.

Similar to step #1, you could make this part simple or complex depending on the time and
resources available.
The simplest approach is to make the company’s Operating Income, or EBIT, a percentage of
revenue and to make it grow or decline or over time to reflect business trends.
But you could also project expenses based on individual employees and major categories like
rent and marketing, and make everything grow at different rates.
For Steel Dynamics, we kept it relatively simple and projected Operating Margins by Segment:
And then we summed up the revenue and operating income for each segment within the Free
Cash Flow projections:
3) Calculate NOPAT (Net Operating Profit After Taxes).

You should use the company’s effective tax rate to calculate Net Operating Profit After Taxes:
EBIT * (1 – Tax Rate) = NOPAT.
Don’t get hung up on effective vs. statutory rates; just use a percentage that’s in-line with
historical rates:
The taxes here should NOT reflect the tax benefits of Debt (i.e., the ability to deduct interest
expense) since this is an Unlevered analysis.
4) Project Depreciation & Amortization and Possibly Other Non-Cash Adjustments.

You often project D&A as a percentage of revenue and use the average historical percentage or
make it decrease slightly over time as CapEx spending falls.
Deferred Income Taxes as a percentage of Income Statement Taxes should decrease over time
because they represent simple timing differences.
Something is wrong with your analysis if Deferred Taxes are a major value driver. They should
almost always decline over time as these timing differences reverse:
There may be other items in this section that are recurring, related to the company’s core
business, and available to all investors, such as Deferred Rent and Deferred Commissions.
For those, the same methodology applies: Use the average historical percentage of revenue or
make the percentages decline since these items represent simple timing differences.
You could make this step more complicated by setting up a full PP&E schedule and splitting
CapEx and D&A into different segments, but that’s unnecessary for a quick analysis.
5) Project the Change in Working Capital.

If you’ve already built a full 3-statement projection model for the company, this part is easy:
Link to the Change in Working Capital from the Cash Flow Statement projections.
If not, simplify it and project the Change in Working Capital as a percentage of the Change in
Revenue or as a percentage of Revenue.
Remember what the “Change in Working Capital” means: Does the company generate more
cash than expected as it grows, or does it require more cash to fuel that growth?
In other words, as the company’s sales grow, is its Change in Working Capital positive or
negative?
We used a simple approach for Steel Dynamics:
6) Project Capital Expenditures.
Capital Expenditures must be linked to the company’s sales growth.

Some models assume that CapEx drives revenue – for example, as an airline purchases more
planes, it can sell more tickets and fly more passengers.
But it doesn’t always work like that; CapEx grows with revenue, but it doesn’t necessarily drive
revenue.
Some companies, such as those in the software and services sectors, also depend far less on
CapEx for sales growth.
It’s reasonable to make CapEx a percentage of revenue because that reflects both the
company’s maintenance and growth spending:
Notice how D&A as a % of Revenue comes close to but doesn’t exactly equal CapEx as a % of
Revenue. If the company is growing, these percentages should be different!
Some sources claim that CapEx “should equal” D&A by the end, but that is completely wrong,
at least if you assume continued cash flow growth beyond the end of the projected period.
That assumption might make more sense if the company were stagnant or declining by the end.
7) Calculate Unlevered FCF.

Start with NOPAT, factor in the non-cash adjustments, add or subtract the Change in Working
Capital, and subtract CapEx to calculate Unlevered FCF:
You might also include supplemental information, such as the growth rates and margins for
different metrics, at the bottom.
You can check your work up to this point by calculating the growth rates for Revenue,
Unlevered FCF, and EBITDA.
A company’s FCF should grow more and more slowly until the end of the forecast period, and
then it should grow at a low, constant rate – the Terminal Growth Rate – into perpetuity.
If your analysis does NOT reflect these slowing growth rates, or the rates are much higher than
GDP growth by the end of the forecast period, then you need to re-think your assumptions:
You should also check:
• Operating Margins and Items as Percentages of Revenue: These should stabilize so that
they are no longer changing much by the end of the forecast period.
• Case Study Instructions: Are you reflecting everything outlined in the case study
instructions or the instructions from the senior banker? For example, if they told you to
assume a pricing decline followed by a recovery, do your revenue projections match up?
• ROIC, ROE, ROA, and Other Metrics: You could check the returns-based metrics to make
sure they stabilize by the end of the forecast period, but this will require more work
since you’ll have to track Debt, Equity, and Total Assets.
If anything above is problematic, you can fix it by extending the projection period and
assuming slowing growth rates and stabilizing percentages as you move toward the end of that
period.
Return to Top.
Key Rule #3: DCF – Discount Rates and WACC
Once you’ve projected the company’s Unlevered Free Cash Flow in this explicit forecast period,
you discount those cash flows at the appropriate Discount Rate.
The Discount Rate represents the opportunity cost for the investor – what he or she could earn
each year by investing in other, similar companies.
A higher Discount Rate means the risk and potential returns are both higher; a lower Discount
Rate implies lower risk and lower potential returns.
A higher Discount Rate makes a company less valuable because it means the investor has better
options elsewhere; a lower Discount Rate makes a company more valuable because it means
the investor has worse options elsewhere.
You can invest in a company in many ways: You can purchase its common shares, buy its bonds,
buy its Preferred Stock, or purchase other securities it issues.
Since companies have multiple sources of capital, they also have multiple Discount Rates, and
each part of the capital structure has a different rate.
The most important Discount Rates for valuation/DCF purposes are:
• Cost of Equity: This represents the “opportunity cost” for just the company’s common
stock – what investors could earn from stock price increases and dividends.
• Cost of Debt: This one is for the company’s outstanding debt, and it represents what
investors could earn from interest and changes in the market value of debt.
• Cost of Preferred Stock: This one is similar to the Cost of Debt, but it’s for Preferred
Stock, which tends to have higher coupon rates; also, Preferred Dividends are not tax-
deductible.
To determine the overall Discount Rate for the company, you calculate WACC, the Weighted
Average Cost of Capital:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt * + Cost of Preferred
Stock * % Preferred Stock
WACC always pairs with Unlevered FCF because both WACC and Unlevered FCF represent all
the investors in the company.
If you invest proportionally in the company’s entire capital structure, WACC gives you the
expected, long-term annualized return.
For example, if the company uses 80% Equity and 20% Debt and it has a 40% tax rate, and you
decide to invest $1,000 in the company, you could calculate WACC with the following method:
• Cost of Equity: Similar companies’ stock prices have increased by 8% per year, on
average, and their dividends have yielded an additional 2%. The Cost of Equity is 10%.
• Cost of Debt: The effective yield on the company’s Debt is 6%, and other companies also
have yields of around 6%.
• WACC: It equals 10% * 80% + 20% * 6% * (1 – 40%) = 8.7%.

So, you should expect to earn an average of $87 on your initial $1,000 over the very long term
(with big fluctuations in between).
A significant portion of this gain will come from stock price appreciation, so you won’t earn
anything close to $87 in cash until you sell your entire investment.
The Cost of Debt and Cost of Preferred Stock
These represent the rates the company would pay if it issued additional Debt or Preferred
Stock.
You can’t predict what those rates will be, but you can make a rough approximation by using
the current coupon rates on the company’s Debt or Preferred Stock.
So, if the company has $1,000 of bonds and the coupon rate is 5.0%, that’s the company’s Pre-
Tax Cost of Debt. Interest paid on Debt is tax-deductible, so you multiply by (1 – Tax Rate) to
use it in the WACC formula.
If the company has $1,000 of bonds at a coupon rate of 5.0% and another $1,000 of bonds at a
coupon rate of 6.0%, then its Pre-Tax Cost of Debt is 5.5%.
If the company has $1,000 in Preferred Stock, and it issues $100 in Preferred Dividends per
year, the Cost of Preferred Stock is 10.0%. Preferred Dividends are not tax-deductible, so you
do not multiply by (1 – Tax Rate).
You could also look at the Yield to Maturity (YTM) on the Debt, which reflects its current
market price, or you could look at coupon rates or the YTM of Debt issued by peer companies.
With the YTM, the basic idea is that if a company’s bonds trade at a discount to par value (e.g.,
they were issued at $1,000, but you can buy them for $990 right now), then the yield is higher
than the coupon rate on the bond.
That’s because you can purchase the bonds for only $990 but receive $1,000 at the end, as well
as the interest in between. If the stated coupon rate is 5.0%, the actual yield is more like 5.2%
over a 5-year holding period in this scenario.
The opposite applies to bonds trading at a premium to par value: The yield you receive will be
less than the coupon rate on the bond since you get back less upon maturity.
Since YTM reflects market conditions, it might be closer to the rate the company would pay on
additional Debt.
Steel Dynamics had ~$2.6 billion of Debt on its Balance Sheet at the time of this valuation, but
the fair market value of the Debt was $2.7 billion.
To estimate the Cost of Debt, we calculated the company’s annual interest expense and divided
it by this $2.7 billion figure:
That resulted in a Pre-Tax Cost of Debt of 5.11% vs. 5.25% if we had ignored the market value of
Debt. This difference is so small that it barely matters, but for some companies, it could be
much bigger.
Finally, a more academic approach is to take the Risk-Free Rate – the coupon rate on
government bonds in the country – and then add a “default spread” based on the company’s
expected credit rating after it issues additional Debt.
For example, if the company’s EBITDA / Interest is currently 2x and is expected to remain below
2.5x following another issuance, that might imply a BB+ credit rating.
Companies with BB+ credit ratings might pay, on average, 2.50% above the Risk-Free Rate on
Debt they issue.
So, if the Risk-Free Rate is currently 3.00%, then the company’s Pre-Tax Cost of Debt is 5.50%.
You could use any of these methods to estimate the Cost of Debt, and for most healthy
companies, they will produce similar results.
The only difference between the Cost of Debt and Cost of Preferred Stock is that you have to
multiply the Cost of Debt by (1 – Tax Rate) since interest on Debt is tax-deductible.
But Preferred Dividends are not tax-deductible, so you don’t do this for Preferred Stock.
Preferred Stock is uncommon in most industries, so you rarely calculate the Cost of Preferred;
Steel Dynamics and all of its peer companies had no Preferred Stock, so we skipped this step.
The Cost of Equity
The Cost of Equity is much trickier to determine because you cannot observe it directly.
It tells you how much a company’s stock “should” return each year, on average, over the long
term, factoring in both stock price appreciation and dividends.
You usually use the Capital Asset Pricing Model (CAPM) to determine the Cost of Equity:
Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta.
The Risk-Free Rate (RFR) represents what you could earn on “safe” government bonds
denominated in the same currency as this company’s cash flows.
If it’s a French company but it has mostly U.S.-based customers, and it records its financials in
U.S. Dollars, you would use the current rate on U.S. Treasury bonds.
You usually use the rate on 10-year government bonds to match the projection period of the
DCF, but 20-year or 30-year rates are common as well.
Levered Beta tells you how volatile this stock is relative to the market as a whole, factoring in
both the intrinsic business risk and the risk introduced by leverage (i.e., Debt).
If Beta is 1.0, when the market goes up by 10%, this company’s stock goes up by 10%.
You could calculate Beta based on the company’s stock price history or via analysis of peer
companies.
And the Equity Risk Premium (ERP) represents the percentage the stock market will return
each year, on average, above and beyond the rate on “safe” government bonds.
This one is always linked to the company’s country and local stock market, but no one ever
agrees on how to calculate it.
The main points of disagreement are:
• Do you use historical numbers or projected ones? Projected ones make more sense,
but how can you “project” stock market performance?
• Do you use the arithmetic or geometric mean?
• What period do you use? Do you go back 10 years? 20? 50? 100?
Finance textbooks use numbers ranging from 3% to 11% for the ERP; we tend to use numbers in
the middle of that range, such as 6-8%, for companies in developed countries like the U.S. and
U.K.
You could also look at sources such as Damodaran’s data on the ERP in different countries and
time periods to estimate it based on historical performance.
The Equity Risk Premium will be significantly higher in emerging markets (Africa, Latin America,
parts of Asia, etc.) because the risk and potential returns are both higher.
If the company operates in multiple countries, you might “weight” the Equity Risk Premium and
multiply the ERP in each country by the percentage of revenue from that country to determine
the company-wide ERP.
Don’t obsess too much over these calculations.
No one agrees on how to calculate the Discount Rate, and in interviews, case studies, and
modeling tests, it’s far more important to project a company’s cash flows reasonably.
The Process of Calculating Cost of Equity
Theoretically, you could use a company’s historical Beta in the Cost of Equity calculation and
leave it at that.
But it’s better to look at peer companies and use the median figure from those.
The whole point of a valuation is to determine a company’s Implied Value: What it should be
worth according to your views.
Using the company’s past performance for Beta corresponds more closely to its Current Value
rather than its Implied Value, which runs counter to the purpose of a valuation.
So, just like you might calculate EV / EBITDA for similar companies and then apply the median
multiple to the company you’re valuing, you do something similar with Beta.
But it’s not as simple as using the median Beta from similar companies.
Beta always reflects 2 risks: Inherent business risk and risk from leverage.
When you look up a company’s Beta in Google Finance or Bloomberg, it reflects both those
risks.
Each peer company has a different capital structure, so the risk from leverage will differ for
each one.
To remove this risk from leverage and isolate the inherent business risk, you have to “un-lever
Beta.”
And then you have to “re-lever Beta” to make it reflect the risk from the leverage of the
company you’re valuing.
Unlevered vs. Levered Beta has nothing to do with Unlevered vs. Levered Free Cash Flow.
You complete this process of un-levering and re-levering Beta regardless of the type of Free
Cash Flow you’re using.
That’s because you always calculate the Cost of Equity, and the same components always go
into the Cost of Equity.
Here’s a simple example: Let’s say that “Levered Beta” for a peer company is 1.00, and the
company has $500 of Debt and an Equity Value of $1,000. Its tax rate is 40%.
Leverage accounts for part of this company’s risk, so you need to reduce Beta by removing the
risk from leverage:
Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 – Tax Rate) + Preferred / Equity
Ratio)
Unlevered Beta = 1.00 / (1 + $500 / $1000 * (1 – 40%)) = 0.7692.
This result means that 23% of this company’s risk comes from Debt. It’s not 33% (1.00 / (1 +
$500 / $1,000)) because the tax-deductibility of interest reduces the risk of Debt.
The formula includes a “1 +” in front of “Debt / Equity Ratio * (1 – Tax Rate)” to ensure that
Unlevered Beta is always less than or equal to Levered Beta.
You look up the financial information for each peer company, un-lever Beta for each one, and
calculate the median Unlevered Beta:
It’s best to use the market values of Debt, Equity, and Preferred Stock, but it matters most for
Equity; it’s not the end of the world if you can’t find it for Debt or Preferred Stock.
Then, you re-lever this median Unlevered Beta by flipping around the formula above:
Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 – Tax Rate) + Preferred / Equity
Ratio)
Let’s say the median Unlevered Beta for the peer companies is 0.80. The company we’re
valuing has $800 in Debt, Equity of $2,000, no Preferred Stock, and a tax rate of 40%.
We can re-lever Beta with this formula:
Levered Beta = 0.80 * (1 + $800 / $2000 * (1 – 40%))
Levered Beta = 0.992.
You can interpret this result as: “If we ignore the risk from the company’s Debt, its stock price is
~80% correlated with the stock market as a whole. But once we factor in that risk from Debt, its
stock price is nearly 100% correlated with the overall market.”
We could then use this result to calculate Cost of Equity for the company.
If the Risk-Free Rate is 2.50%, the Equity Risk Premium is 7.00%, and Levered Beta is 0.992:
Cost of Equity = 2.50% + 7.00% * 0.992 = 9.44%.
Just one small problem: You don’t necessarily want to use the company’s current capital
structure to calculate the Cost of Equity!
This point goes back to the core purpose of valuation: Calculating a company’s Implied Value
and comparing it with the company’s Current Value.
You un-lever Beta from the peer companies and re-lever it to move closer to that Implied Value,
and you should do something similar with the capital structure.
Finance textbooks tell you to use the company’s “optimal capital structure” or “targeted capital
structure” to do this.
So, if the company eventually plans to use 40% Debt, 50% Equity, and 10% Preferred Stock,
then you should use those figures when re-levering Beta to calculate Cost of Equity.
But in real life, companies never disclose their planned capital structures.
“Optimal capital structure” is the mix of Debt, Equity, and Preferred Stock that minimizes
WACC, but it’s impossible to observe or calculate.
So, you often use the median capital structure percentages of the peer companies and apply
them to your company to determine its “optimal” or “targeted” structure.
Let’s say that we analyzed the peer companies for this company with $800 of Debt and Equity
of $2,000. The median Debt / Total Capital Ratio was 20%, and the median Equity / Total Capital
Ratio was 80%.
Our company has Total Capital of $2,800, so these percentages tell us that it “should have” 20%
* $2,800, or $560, of Debt, and 80% * $2,800, or $2,240, of Equity.
As a result, the calculations for both Levered Beta and Cost of Equity change:
Levered Beta = 0.80 * (1 + $560 / $2,240 * (1 – 40%)) = 0.92.
Cost of Equity = 2.50% + 7.00% * 0.92 = 8.94%.
The interpretation is simple: Since the company should have less Debt in the future, the risk
from leverage will be lower, which means that Levered Beta and Cost of Equity will be lower.
You can still use the company’s current capital structure, but you should then use its Historical
Levered Beta – avoid the peer companies altogether – to keep things consistent.
Here’s what it looks like in real life for Steel Dynamics:
The screenshot above might resemble a bag of skittles, but the takeaway is simple: There are
many ways of calculating the Cost of Equity.
No single method is necessarily “the best,” so you look the range of outputs from different
methods to estimate it.
Putting It All Together to Calculate WACC
Now you understand everything that makes WACC tricky to calculate:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred
• You could use the company’s current capital structure or optimal/targeted capital
structure for the percentages of Equity, Debt, and Preferred Stock.
• There are different approaches for calculating Cost of Equity, including un-levering and
re-levering Beta from peer companies or using the company’s historical Beta.
• No one agrees on the appropriate Equity Risk Premium in the Cost of Equity calculation.
• And there are different approaches (Coupon rates, YTM, issuances from peer
companies) for calculating the Cost of Debt and Cost of Preferred Stock.
Our advice remains the same: Don’t over-think the calculation.
Rather than assuming that one approach is “the best,” look at a variety of approaches and use
the range of results. Here’s an example for Steel Dynamics:
When you create sensitivity tables to analyze the company’s Implied value under different
assumptions, you’ll link the Discount Rates in the tables to these ranges.
Discounting the Cash Flows
Once you have WACC, you can go back to the Free Cash Flow projections and discount FCF in
each year to its Present Value.
You could use the built-in NPV function in Excel, or you could use the formula you learned in
the first guide:
Present Value = Cash Flow / ((1 + Discount Rate) ^ Year #)
The only question is whether or not you should use the same Discount Rate each year.
After all, couldn’t a company’s risk profile change as it matures over time?
Yes, it could. So, if the company is changing significantly in the explicit forecast period, you
should change its Discount Rate over time.
You might assume that the company’s “long-term” Discount Rate is close to the rate for mature
companies in its industry.
If WACC is currently higher than that, you might start out at a higher number and make it
decline to the “mature company rate” over time.
For example, if the company’s current WACC is between 11% and 13%, and WACC for mature
companies in the industry is between 8% and 9%, you might start it at 12% and reduce it by
0.4% per year until it reaches 8.4% in Year 10.
For Steel Dynamics, we used the same WACC each year because:
1) The company is mature and isn’t expected to change significantly in the future.
2) Other mature companies in this industry have WACCs in a similar range.

So, we used the same Discount Rate each year, discounted each cash flow to its Present Value,
and summed up everything as follows:
We have now completed the first part of this analysis – projecting the company’s Unlevered
Free Cash Flow in the explicit forecast period and discounting everything to Present Value.
Return to Top.
Key Rule #4: DCF – Terminal Value
Once you’ve projected the company’s Unlevered FCF, calculated the Discount Rate, and
summed up the Present Value of FCF each year, you calculate the company’s value in the far-
future period, otherwise known as the Terminal Period.
You also move back to my favorite formula:
Growth Rate < Discount Rate
This formula alone doesn’t let you value any company because the company’s Cash Flow, Cash
Flow Growth Rate, and Discount Rate change over time.
As a result, you project the company’s cash flows explicitly for the first 5, 10, or 15 years.
But in the Terminal Period, you assume that the company’s Discount Rate and Cash Flow
Growth Rate stay the same.
The company’s Cash Flow might keep changing, but the two other components of that formula
remain constant.
The company’s value in this Terminal Period is called its Terminal Value, and you can use the
same formula to calculate it:
Terminal Value = Unlevered FCF in Year 1 of Terminal Period / (WACC – Terminal Unlevered FCF
Growth Rate)
Since you need the Unlevered FCF in Year 1 of the Terminal Period, you must project FCF one
year beyond the end of the explicit forecast period.
You often do that by multiplying the last FCF in the forecast period by (1 + Terminal Growth
Rate).
So, if you expect the company’s FCF to grow at 3% indefinitely, you might assume that its first
FCF in the Terminal Period equals its Final Forecast Year FCF * 1.03.
That’s why people often write the formula like this:
Terminal Value = Final Forecast Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate –
Terminal FCF Growth Rate)
This calculation is known as the Gordon Growth Method.
The Terminal FCF Growth Rate should be low – below the GDP growth rate of the country, and
perhaps in-line with the rate of inflation.
If the economy as a whole is growing at 3% per year, no company could ever grow at 5% into
perpetuity.
If it did, eventually it would be bigger than the entire economy!
Even if a company grows at a higher rate initially, growth always slows down over time.
Here’s a growth progression that makes sense and another one that does not make sense:
• Makes Sense: In the explicit forecast period, FCF Growth is 10% in Year 1, and it declines
to 3% by Year 10. The Terminal FCF Growth Rate is 2%.
• Does Not Make Sense: In the explicit forecast period, FCF Growth is 10% in Year 1, and
it declines to 8% by Year 10. The Terminal FCF Growth Rate is 6%.
The second scenario doesn’t make sense because FCF growth doesn’t decline enough in the
explicit forecast period, and the Terminal FCF Growth Rate is far too high.
In developed markets such as the U.S., U.K., and Canada, you should use percentages in the low
single digits (i.e., 1-3%) for the Terminal FCF Growth Rate.
But even in emerging markets, no company can grow at 6% forever.
China or India might be growing at 6-7% per year right now, but that rate will slow down
eventually, and individual companies will grow at even lower rates.
So, even if you’re in an emerging market, you shouldn’t use a dramatically higher number for
the Terminal FCF Growth Rate: Maybe 3-4% instead of 1-2%, but not 6-7%.
If the company’s FCF growth rate far exceeds this percentage, even at the end of a 10-year
period, you might extend the projection period to 15, 20, or even 30 years so that you can
assume more of a decrease in the growth rate over time.
The FCF growth rate at the end of the explicit forecast period should be fairly close to the
Terminal FCF Growth Rate.
From the last section, you know that multiples are shorthand for valuation, which means that
you can also calculate the Terminal Value using the Multiples Method.
Terminal Value = Terminal EBITDA or EBIT or NOPAT or FCF Multiple * Relevant Metric
You might base the Terminal Multiple on the multiples of publicly traded peer companies, but
you often apply a substantial discount because multiples tend to decrease over time.
If the Discount Rates of the peer companies are similar – which should be the case if you’ve
selected them properly – then higher multiples imply higher growth rates.
This relationship explains why young, fast-growing companies tend to trade at higher multiples,
while older, mature companies tend to trade at lower multiples.
The Discount Rate will decline as companies grow bigger, but the expected growth rate will
decline by more than the Discount Rate in most cases.
As a result, the denominator in the “Company Value” formula (Discount Rate – Cash Flow
Growth Rate) will get bigger, and the output of the formula will decrease.
So, if the peer companies are trading at EBITDA multiples between 10x and 12x, you might
assume 8x to 10x for your initial range in the analysis.
Here are the calculations for Steel Dynamics:
The Most Important Point: Cross-Check Your Work!

Neither method for calculating Terminal Value is “better”: They just offer different advantages
and disadvantages.
For example, if there are no truly comparable companies, the Multiples Method is useless.
But if your country’s long-term GDP growth is highly uncertain, or your country’s government is
unstable, the Gordon Growth Method might not work so well.
Rather than relying on a single method, the BEST solution is to use each method to cross-
check your work.
For example, let’s say that you pick 3% for the Terminal FCF Growth Rate. That produces a
Terminal Value of $1.5 billion, which represents a Terminal EBITDA Multiple of 10.0x.
The peer companies are currently trading at EBITDA multiples of 12.0x – 14.0x, so this result
seems reasonable.
But now let’s say that you pick a Terminal EBITDA Multiple of 8.0x, which produces a Terminal
Value of $2 billion. The implied Terminal FCF Growth Rate is 6%.
Now you have a problem because this number is way too high. You need to pick a lower
multiple so that the implied Terminal FCF Growth Rate makes more sense.
Calculating the implied Terminal Multiple if you’ve used the Gordon Growth Method is
straightforward: Take the Terminal Value and divide by EBITDA, EBIT, or any other metric in the
final year.
If you’ve used the Multiples Method, you can use algebraic manipulation to back into the
Implied Growth Rate:
Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal
FCF Growth Rate)
Implied Terminal FCF Growth Rate = (Terminal Value * Discount Rate – Final Year FCF) /
(Terminal Value + Final Year FCF)
We’re not going to show the full derivation, but you start by multiplying both sides of the first
equation by (Discount Rate – Terminal FCF Growth Rate), and then you use algebra to isolate
the Terminal FCF Growth Rate term.
Use both methods to cross-check your work and ensure that your Terminal Value
assumptions are reasonable.
If your assumptions are not reasonable, then you need to pick new ones or extend the forecast
period. Here are the calculations for Steel Dynamics:
Based on these results, our assumptions seem reasonable.

Discounting and Summing the PV of the Terminal Value
Once you’ve calculated the Terminal Value, you must discount it back to its Present Value.
Remember that the Terminal Value represents a company’s value from Year 5, 10, or 15,
onward into infinity as of the end of Year 5, 10, or 15.
But you’re calculating what the company is worth today.
You can discount the Terminal Value using the same formula we used for the FCF:
Present Value = Terminal Value / ((1 + Discount Rate) ^ Year #)
However, it’s slightly better to use the “Cumulative Discount Factor” just in case you’ve
assumed a changing Discount Rate in the forecast period.
With Steel Dynamics, our Cumulative Discount Factor at the end of Year 10 was 0.390, so we
multiplied each Terminal Value by this 0.390 to calculate the Present Values.
Then, we added the PV of the Terminal Value to the PV of the Free Cash Flows:
In an Unlevered DCF analysis, adding these two terms together gives you the company’s
Implied Enterprise Value.
You could stop at this point and compare that to the company’s Current Enterprise Value.
And for private companies, you do stop here.
But if the company is public, you must complete one final step: Back into the company’s
Implied Equity Value and Implied Share Price.
To move from Enterprise Value to Equity Value, you add non-core-business Assets and subtract
Liability and Equity line items that represent other investor groups.
Then, you divide by the company’s diluted share count to calculate its Implied Share Price,
which you then compare to its Current Share Price.
Here are the calculations for Steel Dynamics:
In real life, you would make the diluted shares calculation circular and calculate the share count
based on the Implied Share Price, but we skipped that to simplify this model.
Technically, you should also value out-of-the-money options and subtract them to calculate the
company’s Implied Equity Value since they represent potential future ownership.
However, these options tend to be worth little, and banks rarely make this adjustment. Also,
option valuation can get quite complicated, and it’s not worth completing in a quick analysis.
There is one last point to be careful of: Don’t double-count items.
It’s the same principle that you learned with valuation multiples: If an expense is included in the
denominator, you should exclude the corresponding Asset or Liability in the numerator and vice
versa.
In a DCF analysis, if you include an expense within FCF, you should exclude the Asset or
Liability that corresponds to that expense when moving from Implied Enterprise Value to
Implied Equity Value, and vice versa.
For example, let’s say that your FCF projections include the company’s Rental Expense within
Operating Expenses, so Operating Income and NOPAT are lower as a result.
You should not then capitalize the company’s Operating Leases and subtract them as a Debt-
like item when moving from Implied Enterprise Value to Implied Equity Value.
You’ve already counted them directly within FCF, so you’d be double-counting if you did this.
Similar logic applies to the Pension Expense and Unfunded Pensions: The Service Cost counts as
an operating expense and should always be in FCF.
But the Interest Expense, Expected Return on Plan Assets, Amortization of Net Losses or Gains,
and Other Adjustments are all financing costs that you should exclude from Unlevered FCF.
In the end, you should subtract the Unfunded Portion of the Pension as a Debt-like item when
moving from Implied Enterprise Value to Implied Equity Value.
This rule also explains why you exclude Interest Income and Interest Expense when calculating
Unlevered FCF.
If you included them, you would not subtract Debt and add Cash to move from Implied
Enterprise Value to Implied Equity Value – you’d already have Implied Equity Value!
Putting It All Together: What the Steel Dynamics DCF Tells You
The output of a DCF gives you the company’s Implied Share Price (or Implied Enterprise Value
or Equity Value) across a range of assumptions.
You can then determine whether the company seems overvalued, undervalued, or valued
appropriately.
Since the company’s Implied Value varies widely, the DCF analysis is most useful for
determining whether or not a company is greatly mispriced.
It’s useless for detecting differences of, say, 2% or 5%.
You use the DCF, and valuation in general, to see if a company is mispriced by, say, 50%, 80%,
or 100%.
The results for Steel Dynamics indicate that the company is overvalued by around 25%.
If you look at sensitivity tables based on Terminal Value and WACC, you get these results:
Based on these tables, it seems exceptionally likely that the company is overvalued because its
Implied Share Price is always below its Current Share Price of $24.97.
Even with the most optimistic assumptions, we don’t quite reach $24.97 (only $24.48 in the
top-left-hand corner of the second table).
We’re less certain about the amount by which it is overvalued, but 20-30% might be a decent
guess.
Return to Top.
Key Rule #5: How Different Factors Affect the DCF
Interview questions on factors that impact a DCF and the Discount Rate are common.
For example:
• Will Cost of Equity be higher for a $500 million or $5 billion company?
• Will a 1% difference in revenue or a 1% difference in the Discount Rate make a greater

impact on the DCF?
• How does a company’s WACC change as it uses more Debt?

To understand these questions fully, you need to play around with the Excel file(s) included in
this course and see how these changes affect everything.
But here’s the high-level summary:
* Assumes the same capital structure percentages – if the capital structure changes, this one
could go either way.
** Assumes the company has Debt. If it does not, taxes won’t make an impact because there
won’t be any tax savings from interest paid on Debt.
Overall Impact and Key Drivers
The Discount Rate and Terminal Value make the biggest impact on the DCF output.
That’s because the Discount Rate affects everything and because the PV of the Terminal Value
often represents over 50% of the company’s Implied Value.
Changes in revenue growth, operating margins, and CapEx can also make an impact, but the
changes must be much larger to make the same impact as a fairly small change to one of the
assumptions above.
For example, increasing the Discount Rate from 8% to 9% will make a far bigger impact than
increasing the revenue growth rate from 8% to 9%, or increasing the operating margin from 8%
to 9%.
Since the Terminal Value contributes so much to the company’s total value, small changes to
the Terminal FCF Growth Rate or Terminal Multiple can also make a big impact on the output.
Company Size and Geography
Smaller companies tend to be riskier – they have higher growth potential, but also a higher
chance of failing.
As a result, they tend to have higher Costs of Equity and Debt and higher WACC figures than
larger companies.
Similarly, companies in emerging markets also tend to be riskier, with higher growth potential
but also a higher risk of collapsing due to political instability.
So, the Cost of Equity, Cost of Debt, and WACC will be higher, and their Implied Values from a
DCF will be lower.
Debt and Equity Levels
Be very careful with these questions because the impact of Debt is not so straightforward.
Recall the diagrams from the guides to Equity Value and Enterprise Value:
As a company uses more Debt, its Cost of Debt and Cost of Equity will both increase.
More Debt makes the company riskier for everyone and increases the chance of bankruptcy,
which would be catastrophic for all investors.
The tricky part is that WACC decreases initially, but then starts increasing.
Debt is cheaper than Equity, but past a certain point, the added risk from too much Debt starts
to outweigh the cost benefits:
And here’s the same annotated diagram we looked at previously:
One implication is that if a company goes from some Debt to no Debt, WACC will not change
predictably because it depends on what “some Debt” means.
For example, in the diagram above, the company’s WACC at an 80% Debt / Total Capital Ratio is
9.5%. So, removing Debt would reduce its WACC to 7.7% in this case.
But if the company had a 30% Debt / Total Capital Ratio, its WACC would be 7.2%. So, removing
Debt would increase its WACC to 7.7% now!
Risk-Free Rate
A higher Risk-Free Rate (i.e., if government bonds in the country start offering higher coupon
rates) increases the Cost of Equity and Cost of Debt, and, therefore, WACC.
When government bonds start offering higher rates, investors also start demanding higher
rates on corporate bonds, and stock-market investors start seeking higher returns as well.
With a higher Risk-Free Rate, all investors have better options elsewhere.
As a result, a company’s implied value from a DCF will decline.
Equity Risk Premium
A higher Equity Risk Premium will increase the Cost of Equity and WACC because it means that
the stock market is expected to return a higher percentage above the Risk-Free Rate.
It won’t affect the Cost of Debt because Debt investors earn fixed interest on their investments;
stock-market performance is irrelevant to them.
So, if the ERP increases, the company’s Implied Value in a DCF decreases; if it decreases, the
company’s Implied Value increases.
Beta
This one works the same way as the ERP above: Higher Beta increases the Cost of Equity and
WACC and reduces a company’s Implied Value, and a lower Beta does the opposite.
Just like the ERP, it does not affect the Cost of Debt.
A higher Beta means more stock price volatility. If a company’s Beta is 1.00, investors will
expect this company’s stock price to increase by 10% when the market goes up by 10%.
But if its Beta is now 1.10, investors will expect this company’s stock price to increase by 11%
when the market goes up by 10%.
Since investors’ expectations increase, the company’s Implied Value to them decreases.
Tax Rate
A higher tax rate reduces the Cost of Debt because it increases the tax benefits of Debt.
Think about a simple example: If the coupon rate is 10%, the After-Tax Cost of Debt is 10% * (1
– 40%) = 6% at a 40% tax rate, but 10% * (1 – 50%) = 5% at a 50% tax rate.
But a higher tax rate will also reduce the Cost of Equity because you use that tax rate when re-
levering Beta: Re-Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 – Tax Rate)).
A higher tax rate enhances the cost benefits of Debt, which means that additional Debt is also
less risky for the Equity investors.
So, WACC decreases with a higher tax rate, assuming the company has Debt.
The company’s Implied Value from a DCF is harder to predict, but it usually decreases because a
higher tax rate also reduces the company’s Free Cash Flow.
That FCF reduction tends to make a bigger impact than these changes to the Discount Rate,
especially since lower FCF also means a lower Terminal Value.
Other Changes and Factors
We haven’t covered every possible factor here, but if you understand these concepts, you can
answer any question about a DCF and the Discount Rate.
For example, if the company starts using additional Equity, that’s the same as using less Debt,
so all those changes would apply.
Additional Preferred Stock is similar to additional Debt, but there’s no tax benefit, which tends
to make Preferred Stock more expensive than Debt and less expensive than Equity.
So, the Cost of Equity will increase, and WACC will decrease initially and then start increasing.
If the interest rate on Debt increases, the Cost of Debt will increase and WACC will also
increase; the Cost of Equity won’t change.
If a change increases the company’s Free Cash Flow, the company’s Implied Value will increase
because the whole analysis is based on the Present Value of Free Cash Flows.
Return to Top.
Key Rule #6: DCF – More Advanced Points [OPTIONAL]
There are a few more advanced topics related to the DCF analysis; you’re unlikely to get
interview questions on these topics, so you can consider this section optional.
The Mid-Year Convention and Stub Periods
When you use discount periods of 1, 2, 3, 4, and so on, it’s not accurate because these numbers
imply that the company’s cash flows arrive at the end of each year.
But that’s not true: The company generates cash flow every day, and on average, that cash
flow is evenly distributed throughout each year.
So, it is more accurate to use discount periods such as 0.5, 1.5, 2.5, and 3.5 when you’re
calculating the Cumulative Discount Factor and the Present Value of Free Cash Flows.
Using these discount periods in a DCF is known as the “Mid-Year Convention” because you’re
assuming that the cash flows arrive midway through each year rather than at the end.
The company’s Implied Value will increase because the cash flows arrive earlier, and money
today is worth more than money tomorrow.
Here is the Steel Dynamics analysis before and after making this change:
BEFORE:
AFTER:
The PV of each Unlevered Free Cash Flow increases because it’s generated earlier.
There’s another, trickier feature that results from timing differences as well: Stub periods.
When you value a company on a specific date, much of its cash flow for the year has already
been generated (unless you’re valuing it on January 1st).
So, you have to reduce the projected cash flow for the year by the amount that the company
has already generated.
For example, if it’s April 30th, the company is projected to generate $1,000 in FCF for the year,
and it has already generated $300, you would subtract out that $300 and use $700 for the FCF
in the first period of a DCF.
But you can’t just subtract the already-generated cash flow – you must also change the
discount periods because April 30th to December 31st represents a fraction of a year.
This period from April 30th to December 31st is called the stub period.
To determine the discount period for this stub period, take the remaining days of the year and
divide by the total days in the year.
For example, if you’re valuing a company on April 30th, there are 245 days until December 31st
and 365 days in the year, assuming it’s not a leap year.
Since 245 / 365 = 0.671, 0.671 will be the discount period for this first year.
The first discount period in a DCF will be 0.671 rather than 1.000, the next period will be 1.671
rather than 2.000, and the next one will be 2.671 rather than 3.000.
You subtract cash flow only in the first period; the cash flow in all the subsequent years is the
same because no cash flow for Years 2, 3, and beyond has been generated as of April 30th.
You can also combine the stub period with the mid-year convention.
If you do this, the first discount period will be the stub period fraction divided by 2.
Continuing with the April 30th example, dividing by 0.671 by 2 gives you 0.336.
By doing this, you’re saying, “Let’s assume that the cash flow arrives midway between now –
April 30th – and the end of the year – December 31st.”
“Midway through the year” means August 31st here.
In each period AFTER that first one, you take the normal discount period and subtract 0.5.
Here are the normal and mid-year discount periods for a valuation on April 30th, 2014:
You do NOT keep dividing the “Normal Discount Period” by 2 – you do that only in Year 1!
If you divided the FY 15 “Normal Discount Period” by 2, you’d be saying that the cash flow for
FY 15 arrives midway between April 30th, 2014 and December 31st, 2015.
In other words, you’d be saying that the 2015 full-year cash flow arrived on March 1st, 2015.
But that’s not what happens! If you assume the 2015 cash flow is evenly distributed, it should
arrive on June 30th, 2015 – midway through that year.
By using the correct discount period – 1.171 – for FY 15, you’re saying:
“Hey, today is April 30th, 2014. We don’t get any 2015 cash flows in the year 2014, so let’s add
that whole stub period of 0.671. We do get cash flows in 2015, but they arrive midway
through the year, so let’s add 0.5 to reflect the fact that we get them midway through 2015.
0.671 + 0.500 = 1.171.”
If you go out another year, you have to add 0.671 for the remainder of FY 14, 1.000 for all of FY
15 (since no 2016 cash flows arrive then), and then 0.500 for the cash flows that arrive midway
through FY 16.
That gives you 2.171 for the mid-year discount period.
The mid-year convention and stub periods impact the Present Value of a company’s Free Cash
Flows, but they also affect the Terminal Value and PV of Terminal Value calculations.
The PV of Terminal Value is easier to explain, so we’ll start there: In an analysis with a 10-year
explicit forecast period, you use the Normal Discount Period – not the Mid-Year Discount
Period – to discount the Terminal Value to its Present Value.
So, if this is 9.671 because of an April 30th valuation date, you’d use 9.671 rather than 10.000 in
the PV of Terminal value formula.
But if you’re not factoring in the stub period, and so the Normal Discount period is just 10.000,
you’d use 10.000 to discount the Terminal Value.
Only stub periods affect this part – the mid-year convention does not because the Terminal
Value should account for the mid-year convention or ignore it altogether.
If you calculate the Terminal Value using the Multiples Method, the mid-year convention
doesn’t factor in because you apply the multiple to the company’s full-year financial figures in
the final year of the forecast period.
It’s as if you’re assuming the company gets sold at the end of that year, and, as a result, the fact
that cash flows arrived midway through each year before that is irrelevant.
If you use the Gordon Growth Method, the same formula still applies, but you have to multiply
the Terminal Value by (1 + Discount Rate) ^ 0.5 to “move it back” to the very end of the last
year in the forecast.
Making this adjustment lets you compare the Terminal Values produced by both methods.
If you did not do this, then you would have to discount each Terminal Value using a different
period, which we strongly recommend against.
The Normalized Terminal Year
Even if you project only 10 years of a company’s FCF, you may have to go one year beyond that
because the final year may not be truly representative of the company into perpetuity.
For example:
• What if a key patent expires for a pharmaceutical company in Year 9 or 10?
• What if the company has a huge Other Intangibles balance that it’s amortizing each
year, but which goes away completely in Year 10?
• What if the company’s planned CapEx or its expected operating margins will be very
different after Year 10?
• What if the company’s FCF Growth in Year 10 is very different from the range of
Terminal FCF Growth Rates you’ve selected?
In all these cases, it’s worthwhile to create a Normalized Terminal Year and then use the FCF
from this year in the Terminal Value calculations.
Here’s an example of a pharmaceutical company (Jazz) that suffers from these problems:
As a result of this Normalized Terminal Year FCF, you no longer multiply the Year 10 FCF by (1 +
Terminal FCF Growth Rate) to calculate the first Free Cash Flow in the Terminal Period – you
use the FCF in this Normalized Terminal Year instead.
Creating a Normalized Terminal Year could make the company’s Implied Value from a DCF
higher or lower depending on your assumptions.
However, in most cases, the Normalized Terminal Year will reduce a company’s Implied Value
because you tend to adjust down the company’s growth rate and margins in this year.
Net Operating Losses
Remember one of the key principles for calculating FCF and backing into the company’s Implied
Equity Value at the end:
If you include an income or expense line item within Free Cash Flow, you should NOT factor in
the corresponding Asset or Liability when going from Implied Enterprise Value to Implied
Equity Value.
The opposite applies if you have excluded an income or expense line item from FCF.
So, it’s easiest to count Net Operating Losses as non-core-business Assets and add them when
moving from Implied Enterprise Value to Implied Equity Value at the end.
But you could also make them reduce the company’s cash taxes each year, similar to the setup
in the lessons and guides on NOLs:
You’d have to create a separate schedule and then record a positive entry under Deferred
Income Taxes since the company’s cash flow increases when NOLs are applied.
We strongly recommend against this setup for a few reasons:
1) What if the NOLs haven’t been used up by the end of the forecast period? You’ll run
into problems because the FCF projections alone won’t capture their full value.
2) It takes more work to set up the analysis this way, and it doesn’t add much since the
Balance Sheet value of the NOLs represents their future tax savings anyway.
3) If the company has negative Pre-Tax Income, that would create extra NOLs and would
increase the chances of the full NOL balance not being utilized by the end.
Noncontrolling Interests and Equity Investments (Associate Companies)
Leave Net Income Attributable to/from these items out of the FCF projections.
You could follow the inclusion/exclusion principle and include Net Income Attributable to
Noncontrolling Interests and Net Income from Equity Investments in FCF, and then exclude
Noncontrolling Interests and Equity Investments from the Enterprise Value to Equity Value
calculation…
…But think of the challenges that presents:
• In an Unlevered analysis, you’d have to reverse the partially-owned companies’ taxes,

net interest expense, and other income/expense so you can determine their EBITs, and
then subtract or add the relevant percentages of their EBITs.
• And most companies don’t disclose nearly enough information to do that.
• This process would be easier in a Levered DCF (see the next section), but that analysis
presents many other problems, such as inconsistent FCF and disagreement over certain
calculations.
The Bottom Line: Noncontrolling Interests and Equity Investments should not affect the
company’s Unlevered FCF at all.
Just include these items at the end when moving from Implied Enterprise Value to Implied
Equity Value.
The Levered DCF, Adjusted Present Value (APV), and Other Variations
In addition to the standard Unlevered DCF analysis, which we strongly recommend in almost all
cases, there is also the Levered DCF analysis.
In this one, you calculate the Free Cash Flow available to only equity investors in the company,
and you calculate the company’s Implied Equity Value directly.
That creates many differences in the analysis, including:
1) Cost of Equity, Not WACC – Since Levered FCF is only available to equity investors, you
use the Discount Rate that represents only the equity investors.
2) Subtract the Net Interest Expense and Add/Subtract Net Borrowings – These items all
affect the cash flow to equity investors, so you must factor them in. Effectively, you start
with Net Income rather than NOPAT and factor in changes in the company’s Debt
principal as well.
NOTE: There is some controversy over exactly what to add/subtract – some people say
all changes in Debt, some say just the repayments, some say just the mandatory
repayments, and the list goes on.
3) Terminal Value with P / E or Equity Value-Based Multiples – You’re only considering

equity investors, so the Terminal Value must use an Equity Value-based multiple (if
you’re not using the Multiples Method to calculate it).
4) Calculate Implied Equity Value Directly at the End – You don't need a "bridge" between
Equity Value and Enterprise Value because the analysis never produces the Implied
Enterprise Value. In a Levered DCF, adding the PV of Free Cash Flows and the PV of the
Terminal Value gives you the Implied Equity Value directly.
5) You Must Reflect the Items Formerly in the Bridge in the FCFs Instead – So, you now
need to factor in the tax savings from NOLs, Interest Income and Interest Expense, and
Preferred Dividends if the company has Preferred Stock (and more!).
We strongly recommend against using a Levered DCF unless someone has specifically asked
you to build one.
Here are some of the many problems with it:
1) It takes more time and effort to build because you have to project the company’s Cash
and Debt balances, Net Interest Expense, and changes in Debt principal.
2) The FCF numbers are more volatile than the ones produced by an Unlevered DCF
because Debt principal repayments can be $0 in some years and massive in others. Also,
companies don’t necessarily issue extra Debt on a recurring, predictable schedule.
3) You will NOT get the same results from a Levered DCF analysis because it is almost
impossible to pick “equivalent” assumptions.
4) There’s disagreement over how to calculate Levered FCF: Some people factor in all Debt
issuances and repayments, some factor in all repayments but no issuances, and some
factor in only mandatory repayments.
An Unlevered DCF is easier to set up, less ambiguous, and more consistent.
There are a few specialized cases where a Levered DCF might be helpful
(restructuring/bankruptcy scenarios, changing capital structures, or REITs that issue and repay
Debt constantly), but in 99% of cases, the Unlevered DCF is superior.
A related concept is the Adjusted Present Value (APV) analysis. It’s similar to an Unlevered DCF,
but it values the “tax shield” from a company’s Debt and then adds the value of that tax shield
to the company’s Implied Enterprise Value.
You still calculate Unlevered Free Cash Flow and Terminal Value in the same way, but a few
other components change:
• Discount Rate: You use the Unlevered Cost of Equity instead of WACC. To calculate it,
you un-lever Beta for each peer company and take the median, but you do not re-lever
Beta according to the subject company’s capital structure or the median capital
structure percentages of the peer companies. Then, you use this median Unlevered Beta
in the usual formula for Cost of Equity and keep the Risk-Free Rate and Equity Risk
Premium the same.
• Interest Tax Shield: You project the company’s Net Interest Expense and multiply it by
the Tax Rate to determine the tax savings from interest. But you also have to ensure
that this number is less than the total amount of Taxes in the EBIT  NOPAT calculation.
If it’s not, you use that total tax number instead and use the excess interest tax shield to
offset future taxable income.
• Discount Rate for Interest Tax Shield: Once again, you use the Unlevered Cost of Equity.
• Interest Tax Shield Terminal Value: You calculate the Terminal Value of the Interest Tax
Shield with Tax Rate * Debt in Terminal Year * Unlevered Cost of Equity * (1 + Terminal
FCF Growth Rate) / (Unlevered Cost of Equity – Terminal FCF Growth Rate)2
That formula says that the value of the future benefits from the Tax Shield is proportional to
the company’s Tax Rate, Debt, and how quickly its cash flows are growing relative to the
Discount Rate.
You sum up the Present Value of the Unlevered FCFs, the PV of Terminal Value, the PV of
Interest Tax Shields, and the PV of the Interest Tax Shield Terminal Value to get the company’s
“Adjusted Present Value,” which is a variation of its Implied Enterprise Value.
You would then back into the company’s Implied Equity Value and Implied Share Price with the
same “bridge” between Enterprise Value and Equity Value.
Some people argue that that the APV method produces “more accurate results” because it
takes into account the interest rate on Debt, while the Unlevered DCF does not.
It’s true that the APV method fixes that one specific issue, but it also creates many new
problems:
• No Downside for Debt: It’s incorrect to include only the benefits of Debt without also
factoring in the major downside: The increased risk of bankruptcy. You could attempt to
add this risk to the APV analysis, but no one agrees on how to estimate the probability
of bankruptcy.
• Overstated Values for Firms with High Debt Balances: The APV method will produce
high values for companies with very high Debt balances because of the Interest Tax
Shield. But companies with high Debt balances should see lower implied values because
the risk of bankruptcy starts to outweigh the tax benefits of Debt at this stage.
• The Requirement to Project Interest Expense: It takes extra time and effort to forecast
the company’s Interest Expense because you must project its Debt and Cash balances
into the future.
While the traditional Unlevered DCF has its flaws, using WACC for the Discount Rate accounts
for both the tax benefits of Debt and the added bankruptcy risk.
The APV method, by contrast, solves one minor issue with the Unlevered DCF but creates other,
more serious problems in the process, which is why we recommend against it unless someone
asks for it specifically.
Return to Top.
Key Rule #7: Comparable Public Companies (Public Comps)
“Valuation” refers to the discounted cash flow (DCF) analysis.

The other valuation methodologies, such as comparable public companies and precedent
transactions, are just shorthand for valuation.
Instead of projecting and analyzing a company’s cash flows, you compare the company to
other, similar companies (or similar companies that were acquired) and use the valuation
multiples from those companies to value the one you’re looking at.
Even though these methodologies are less rigorous, they are still useful because they let you
cross-check your results from the DCF analysis.
Also, in some sectors, such early-stage technology startups, the DCF is less useful because it
requires too much guesswork about far-in-the-future events.
To use comparable public companies to value a company, you can follow these steps:
1) Select the appropriate set of comparable companies.
2) Determine the metrics and multiples you want to use.
3) Calculate the metrics and multiples for all the companies.
4) Apply the median (or 25th or 75th or other percentile) multiples to your company to
estimate its Implied Enterprise Value and Implied Equity Value.
Here’s the detail behind each step:
1) Select the Appropriate Set of Comparable Companies
You normally start with a broad set of companies and then narrow it based on industry,
geography, and size.
You could get the names of companies from Google Finance, Capital IQ, equity research, or
even a company’s filings where it lists its competitors.
If you’re valuing Steel Dynamics, you might start by looking at all steel manufacturing
companies in the world.
There are hundreds of companies worldwide, so you have to narrow the set based on
geography, industry, and size to get companies that are more similar to STLD.
A set of 5-10 companies is a good target – a set of 50 companies is too large to be
“comparable,” while a set of 1-2 companies is less useful because the data is too limited.
For Steel Dynamics, we used this screen:
• Geography: U.S.
• Industry: Steel Manufacturers
• Size: Projected revenue between $1 billion and $20 billion USD
This screen is important because you want these companies to have similar DISCOUNT RATES.
As always, it goes back to my favorite formula:
By picking “similar companies,” you’re ensuring that the Cash Flow and Discount Rate for the
companies are in similar ranges.
Therefore, if one company trades at higher multiples than another, its Cash Flow Growth Rate
should be higher (in theory).
In this example with Steel Dynamics, we can look at the 6 companies and say: “They’re all about
the same size and are in the same industry, so their Discount Rates and Cash Flow figures are
similar. So, companies with higher multiples most likely have higher expected growth rates.”
But if the companies were very different, the link between expected cash flow growth and
valuation multiples would break down, and we would not be able to draw that conclusion.
There are few hard-and-fast rules for screening companies; if you can’t get enough companies
in your set, expand the screening criteria, and if you get too many, narrow it.
In large countries, such as the U.S., China, and India, there are so many domestic companies
that the geographic screen might be just that country.
But if your company is in a small European country, such as Estonia or Finland, you’ll probably
have to use a European-wide geographic screen to get enough companies in the set.
The same logic applies to the industry screen: Make it as specific as possible, but if you get a set
with only 1-2 companies, broaden the criteria.
For example, let’s say that you’re valuing a niche Software-as-a-Service (SaaS) company such as
Fleetmatics, which provides software for GPS tracking and vehicle fleet management.
You shouldn’t make the industry screen “SaaS companies providing transportation and logistics
software” because there might not be any other public companies doing that.
Even if there are 1-2 other companies, the screen is still too specific to be useful.
So, you’d probably expand it and use “Software-as-a-Service Companies” for the industry
screen, and then narrow the set based on financial criteria.
You can screen by financial metrics such as revenue, EBITDA, or FCF, but you should avoid
screening by both financial metrics and Equity Value or Enterprise Value.
For example, you should NOT use this screen: “Companies with revenue under $1 billion and
Enterprise Values above $2 billion.”
If you do that, you’re artificially constraining the multiples because EV / Revenue must be
above 2x for every company in the set.
Even screening by Equity Value or Enterprise Value alone is questionable because you constrain
the valuations by doing so. It’s best to screen based on simple metrics like revenue, EBITDA, or
FCF and leave it at that.
2) Determine the Metrics and Multiples You Want to Use
In most industries, you’ll look at 1 sales-based metric (and corresponding multiple) and 2
profitability-based metrics (and corresponding multiples).
For example, the following set of metrics and multiples is common in many industries:
• Revenue, EV / Revenue, and Revenue Growth

• EBITDA, EV / EBITDA, and EBITDA Growth and Margins
• Net Income, P / E, and Net Income Growth and Margins
There is no “best” metric or multiple. Each one has its strengths and weaknesses, and in a
valuation, you want to get the big picture by examining many metrics and multiples.
Sometimes, you’ll exclude Revenue-based metrics and multiples and focus on the profitability-
based ones, such as EBITDA, EBIT, and Net Income.
And if you’re in an industry with significantly different metrics and multiples, such as
commercial banks, you’ll use the metrics that are important there (P / BV, P / E, Total Assets,
ROE, etc.).
You also have to consider the time periods you use.
You can look at a company’s historical Revenue or EBITDA that it earned last year or in the past
12 months, but you can also look at its projected Revenue or EBITDA for the next 12 months or
next calendar year (or the year after next).
You almost always use a mix of historical and projected metrics. Often, you’ll use 1 historical
version and 2 projected versions of each metric.
For example, if the valuation date is June 30th, 2025, you might use these revenue figures for a
comparable company:
• Last Twelve Months (LTM) Revenue: This is the company’s revenue between June 30th,
2024, and June 30th, 2025; it’s based on what happened in real life.
• 2025 Projected Revenue: This is what the market expects the company to earn in
revenue for this entire current year. It’s based on the first half of this year, but also on
what’s expected to happen in the second half.
• 2026 Projected Revenue: This is what the market expects the company to earn in
revenue for the next year. This one is based 100% on expectations since the next year
hasn’t started yet.
Historical metrics are useful because they’re based on real events, but they can also be
deceptive if there were non-recurring items, acquisitions, or divestitures.
Projected metrics are useful because they assume that the company will operate in a “steady
state,” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable
because they’re predictions of the future.
3) Calculate the Metrics and Multiples for All the Companies
Since you use only public companies, the calculations are straightforward.
You calculate each company’s Current Equity Value and Current Enterprise Value based on its
current share price, shares outstanding, and most recent Balance Sheet.
Then, you retrieve the historical figures for revenue, EBITDA, Net Income, and any other metrics
by going through the company’s annual and quarterly reports and looking at the Income
Statements and Cash Flow Statements there.
To calculate the LTM figures, you take the previous fiscal year’s numbers, add the figures from
the most recent “partial period,” and subtract the figures from the same “partial period” in the
previous year.
Example: You want to calculate a company’s LTM revenue as of June 30th, 2025. If the
company’s fiscal year ends on December 31st, you would:
1. Start with the revenue on its Income Statement for the full year 2024, i.e., what the
company has earned between January 1st, 2024 and December 31st, 2024.
2. Then, add the revenue for the 6 months from January 1st, 2025 through June 30th, 2025.
3. Then, subtract the revenue for the 6 months between January 1st, 2024 and June 30th,
2024.
You calculate the LTM figures this way because no company discloses its “LTM revenue” –
companies only provide annual and quarterly figures.
If the company has non-recurring charges – Restructuring, Write-Downs, Legal Expenses,
Goodwill Impairment, etc. – then you’ll add back these charges in the calculations for the
financial metrics affected by these non-recurring items.
Use extreme caution when doing so because many of these charges are not, in fact, non-
recurring.
For example, many companies are always restructuring, but pretend that Restructuring
Expenses are unusual one-time events.
But if the expense occurs frequently (say, 2-3 years in the past 5 years), it should not count as
non-recurring.
Once you calculate the historical versions of these metrics, you have to find the projected
figures.
You do NOT make your own projections for each comparable company because the point of the
analysis is to use each company’s CURRENT Value and CURRENT valuation multiples.
So, you use what the market as a whole thinks about each company.
You can find these figures in equity research reports issued by banks, or you can look up
consensus estimates on Bloomberg, Capital IQ, and other financial news sources.
One issue with projected metrics is that comparable companies often have fiscal years that
end on different dates.
For example, one company’s fiscal year ends on June 30th but another company’s fiscal year
ends on September 30th.
If that happens, you “calendarize” the figures so that the metrics line up.
The full explanation for calendarization is beyond the scope of this guide, but at a high level,
you add and subtract quarters or half-year periods until you get matching figures or roughly-
matching figures.
For example, if it’s a June 30th vs. September 30th mismatch, you could make each projected
year for the June 30th company match up by:
• Taking the full fiscal-year projections (i.e., the numbers from July 1st to June 30th in a
future year).
• Adding the first quarter of the next fiscal year after that (June 30th to September 30th).
• And then subtracting that same period (June 30th to September 30th) from the prior
fiscal year.
Sometimes you can’t get an exact match – if one company’s fiscal year ends on April 30th and
another’s ends on June 30th, for example – so you might multiply the financial metrics by
fractions to make the projections match up.
Often, you calendarize to make the comparable companies’ fiscal years match the fiscal year of
the company you are valuing.
If the company’s fiscal year ends on December 31st, and other companies in the set have fiscal
years that end on June 30th and September 30th, you’ll change the other companies to use
calendar-year figures (i.e., the year ending December 31st).
But if every company in the set has a fiscal year ending on June 30th, and your company’s FY
ends on December 31st, then you might just change your company to match the rest.
One Final Note: For both historical and projected metrics, you ALWAYS use the company’s
Current Equity Value or Current Enterprise Value to calculate the valuation multiples.
In other words, you don’t “project” Equity Value or Enterprise Value.
If a company is growing, its multiples should decline into the future. For example, let’s assume
that a company’s LTM Revenue is $1,000, its Year 1 Projected Revenue is $1,200, and its Year 2
Projected Revenue is $1,500.
If its Current Enterprise Value is $2,000, then its EV / Revenue multiples are 2x for the LTM
period, 1.7x for Year 1, and 1.3x for Year 2.
You don’t project Equity Value or Enterprise Value because a company’s share price already
reflects its historical performance and expectations for future performance.
To project these items, you’d have to time travel to the future, see what expectations are at
that point in the future, and then time travel back to the present.
So, if you can break all known laws of physics, you can attempt to project Equity Value and
Enterprise Value; otherwise, though, always use the Current values for both.
Here’s our set of comparable public companies for Steel Dynamics:
4) Apply the Multiples to Your Company

This part is simple: You calculate the minimum, 25th percentile, median, 75th percentile, and
maximum for each version of each multiple (see the diagram above), and then you apply those
multiples to your company to value it.
Example: The median LTM EV / EBITDA multiple for the comparable companies is 12x. The LTM
EBITDA of the company you’re valuing is $500 million. Therefore, your company’s Implied
Enterprise Value based on the LTM EV / EBITDA of the public comps is 12 * $500 million, or $6
billion.
You repeat this same process for all the multiples, and then you back into the company’s
Implied Equity Value and Implied Share Price for each one:
You complete this process because you want to get a range of Implied Values for the company.
No one ever knows exactly how much a company is worth, so you can’t make a statement like:
“Steel Dynamics is worth exactly $23.51 per share!”
Instead, the goal is to say: “Steel Dynamics might be worth between $15.00 and $20.00 per
share according to revenue multiples, or between $17.00 and $23.00 per share according to
EBITDA multiples.”
Even though the mechanics are simple, the big idea may not be obvious.
With Public Comps, you are calculating the company’s Implied Value by using the Current
Values of other, similar companies.
Unlike in a DCF, where your views of the company’s revenue, expenses, and cash flow explain
the company’s Implied Value, the views of the market as a whole explain the company’s Implied
Value here.
That’s why Public Comps are a “relative valuation methodology” – you use market data, so the
company’s Implied Value is based on the values of other companies.
You should now understand one of the major downsides of Public Comps: What if the market is
completely wrong?
For this reason, you should consider relative valuation methodologies “supplemental.”
You’ll almost always use them, and they can help confirm or deny the results of your DCF
analysis, but the discounted cash flow analysis IS valuation.
Return to Top.
Key Rule #8: Precedent Transactions (M&A Comps)
Almost everything in the section above on Comparable Public Companies also applies to
Precedent Transactions.
The main difference is that with this methodology, you calculate valuation multiples based on
what acquirers have paid to acquire other companies, not what those companies’ shares are
currently trading at on the stock market.
Here are the key differences in this methodology:
• Screening Criteria: You still screen by industry, geography, and size, but each rule is
based on the seller. If the geographic screen is U.S.-based companies, it’s fine to use a
deal with a U.S.-based seller and a Japanese buyer.
One additional criterion is time. The M&A market changes greatly over time, so
multiples that were accurate 10 years ago might be ridiculous today. Often, you look at
transactions from only the past 2-3 years (sometimes up to 5 years). Going back 10
years is usually too far in the past to be useful.
For the financial criteria, you often use Transaction Value (Enterprise Value or Equity
Value based on the purchase price for the seller) rather than revenue, EBITDA, or Net
Income. Deals of very different sizes might not be comparable at all, so these screens
are common.
Finally, you often use broader screening criteria for M&A deals because there may not
be enough deals if you use narrow criteria.
• Metrics and Multiples: You still look at both sales-based and profitability-based metrics
and multiples, but you focus more on historical metrics and multiples – LTM Revenue
and LTM EBITDA are the most common ones.
You do that because it can be extremely difficult to find projections for acquired
companies as of the time they were acquired.
So, you use a shorter, simpler set of metrics and multiples: You might just list each
acquirer’s name, each target’s name, the purchase price, announcement date, LTM
Revenue and EBITDA, and LTM EV / Revenue and EV / EBITDA.
• Calculations of Metrics and Multiples: With Precedent Transactions, everything is based

on the purchase price as of the announcement date of the deal. The LTM figures are
based on the most recent data that was available at the time the deal was announced.
Example: A company has 100 shares outstanding, and its share price is $10.00. An
acquirer announces plans to buy the company for $15.00 / share. Therefore, you would
use 100 * $15.00, or $1,500, for the company’s Transaction Equity Value, and you
would calculate the Transaction Enterprise Value using the company’s most recent
Balance Sheet as of the time of the deal announcement.
If this transaction were announced on May 15th, the most recent financial figures would
be from the quarter ending March 31st, so you would use those and create LTM figures
based on that March 31st period.
If this transaction were announced on July 5th, the June 30th results would not be
available for another few weeks, so you would still use the March 31st results for the
LTM figures and Balance Sheet data.
You don’t need to worry about calendarization too much because you’ll almost always
focus on LTM metrics and multiples. If you do use forward numbers, you might base
them on “Next Twelve Months” (NTM) figures, which also means there is no need to
calendarize anything. The same points about non-recurring charges apply: Yes, add
them back if they affect figures like EBIT or EBITDA, but only if they are non-recurring.
• Output: You get the same output from Precedent Transactions that you do from Public
Comps: The minimum, 25th percentile, median, 75th percentile, and maximum for each
version of each multiple.
But the data tends to be less consistent because companies get acquired for very
different reasons. A “strategic acquirer” (i.e., a normal company) might pay a ridiculous
amount because the CEO is having an affair with the CEO of the target company, or
because the VP of Sales expects to realize significant synergies.
But a private equity acquirer might take a more scientific approach and pay based on
the company’s financial value, ignoring everything else.
Often, Precedent Transactions produce higher multiples than Public Comps because of
the control premium built into M&A deals.
To acquire 100% of another company, the buyer must offer a premium above the other
company’s Current Share Price. If the company’s shares are trading at $10.00, why
would it sell itself for only $10.00 per share? Investors could get that price by selling
their shares individually!
So, the acquirer might have to offer $12.00 per share or $15.00 per share to do the deal.
This “extra amount” above the seller’s Current Share Price is the control premium.
Control premiums vary based on industry and geography, but they’re often between
10% and 30%. As a result, multiples from Precedent Transactions are often higher than
multiples from Public Comps.
However, this rule doesn’t always apply because Precedent Transactions also include
acquisitions of private companies, the M&A market might be priced differently from the
public market, and control premiums might be unusually high or low.
• Transaction Structures and Other Points: Ideally, you will use real acquisitions – deals
where one company buys 100% of another company – in your set of Precedent
Transactions.
In many cases, however, there won’t be enough 100% acquisition deals, so you’ll also
have to use acquisitions for less than 100% of the other company.
It’s fine to use majority-stake deals, i.e., ones where the acquirer purchased at least
50% of the seller, but you should NOT include both minority and majority-stake deals.
The dynamics are very different when the buyer purchases 5% or 10% of the seller
rather than 70% or 90%.
M&A deals can be structured in different ways, which also creates issues with Precedent
Transactions.
For example, some deals include earn-outs where a portion of the purchase price is paid
out several years into the future, but only if the seller meets certain financial goals (e.g.,
the seller receives $200 million upfront and $100 million in 3 years if it reaches $50
million in EBITDA by then). With earn-outs, you often assume a 50% payout probability
and then add 50% of the earn-out amount to the Transaction Value.
The fact that some deals are cash purchases while others are stock purchases (i.e., the
acquirer issues shares to acquire the seller) also creates differences. Companies are
more likely to overpay in stock deals because the money seems “less real.”
Here’s our set of Precedent Transactions for Steel Dynamics:
The Bottom Line: Precedent Transactions are useful for valuing companies that lack good Public
Comps or that have difficult-to-forecast cash flows.
However, they are less reliable and consistent than the other methodologies because of the
issues described above.
If you look at the sets of Precedent Transactions throughout our modeling courses, they often
produce the most random output that spans the widest range of values.
You need to know about Precedent Transactions for interviews, and you’ll almost always use
them in valuations, but they are still less reliable and consistent than the other methodologies.
Return to Top.
Key Rule #9: Other Valuation Methodologies [OPTIONAL]
Besides the 3 main methodologies – the DCF analysis, Public Comps, and Precedent
Transactions – there are a few others.
You are unlikely to get questions on these methodologies in interviews, so consider this
section “Optional.”
Asset-Based Valuations
Remember the definitions of Equity Value and Enterprise Value: They’re both linked to a
company’s Balance Sheet because they relate to its core vs. non-core Assets and the Liability &
Equity items that represent other investor groups vs. those that don’t.
So, you could skip cash flows and multiples and simply estimate the market values of the
company’s Assets and Liabilities.
You could then subtract the market-valued Liabilities from the market-valued Assets to get the
company’s Implied Equity Value.
This method is called a Liquidation Valuation, but it also goes by other names, such as the “Net
Asset Value” (NAV) model.
It produces the company’s Implied Equity Value because you’re valuing all its Assets, not just its
core-business Assets, and you’re not distinguishing between Liabilities that represent other
investor groups and ones that don’t.
This methodology seems nice in theory, but there are a few problems with it:
1) It’s difficult to determine the market values of everything. There are some rules of
thumb – for example, Cash is almost always worth 100% of its book value, and Goodwill
is worth $0 – but to value an Asset like PP&E, you’d have to do a ton of research.
2) It tends to undervalue healthy, growing companies. If a company is distressed and

about to collapse, often it must sell its Assets and repay its Liabilities, so Liquidation
Valuation can be reasonably accurate. But healthy companies tend to be worth far more
than the Assets on their Balance Sheets because of their growth potential.
Here’s an example analysis:
The Dividend Discount Model (DDM)

The DDM is an alternative to the DCF analysis that is critical in some industries (commercial
banks and insurance), important in a few others (utilities and some energy companies), and
useless in most others (technology, healthcare, retail, etc.).
Instead of valuing a company by projecting its Unlevered Free Cash Flows and discounting them
with WACC, you use the company’s Dividends and Cost of Equity instead.
In a DDM, you project down to the company’s Net Income, make Dividends a % of Net Income,
and then calculate the Terminal Value based on a P / E multiple, just like in a Levered DCF.
But a DDM is only useful for companies that issue recurring, predictable Dividends, or for
companies where the traditional concept of “Free Cash Flow” doesn’t apply.
And Free Cash Flow applies to companies in almost every industry, except for commercial banks
and insurance firms.
The only firms outside those industries that tend to issue Dividends on a recurring, predictable
basis are utility companies and some trusts, partnerships, and MLPs (Master Limited
Partnerships), which are common in the midstream energy (pipelines) sector.
If you’re working in one of those industries, the DDM might be useful; if not, it’s not important.
Variations of Comparable Companies and Precedent Transactions
One variation of Precedent Transactions is the M&A Premiums Analysis, where you look at the
premium each acquirer paid over each seller’s share price and use those figures to value your
company.
For example, if you’re valuing Steel Dynamics, you might gather a set of 20-30 public
manufacturing companies that have been acquired over the past 5 years and calculate the
premium the buyer paid in each case.
If a seller’s share price was $20.00 before the acquisition, and the buyer paid $25.00 per share
for the company, that’s a 25% premium.
You collect that data for all the transactions and then apply the median figure (or some other
percentile) to your company’s current share price.
If the median figure is 25%, and your company’s share price is currently $28.00, then the
company is worth $28.00 * (1 + 25%), or $35.00, according to this methodology.
This method sounds simple, but a few points make it more complicated:
• Selection Criteria: You often use broader selection criteria than with Precedent
Transactions because you can include only acquisitions of public companies. So, instead
of screening based on U.S.-based steel companies worth at least $500 million, you might
reduce the threshold to $100 million.
• Which Premium? Often, rumors of an M&A deal break before the actual deal is
announced. So, the 1-day premium (i.e., Offer Price / Share Price One Day Prior – 1)
might be deceptive. As a result, some people use 30-day or 60-day premiums, or even
the premium to the average share price over the past 30, 60, 90, or 180 days.
• It Only Works for Public Companies: This methodology only works for standalone public
companies that might be acquired in full. It doesn’t apply to private companies or
acquisitions of less-than-100% stakes.
Here’s an example analysis for Jazz Pharmaceuticals that’s combined with normal Precedent
Transactions:
Based on these figures, we might conclude that a 25-35% premium for Jazz would be
reasonable if it wanted to sell.
A variation of Public Comps is the Future Share Price Analysis.
In this one, you take the median historical multiple from the Public Comps, usually the P / E
multiple, and multiply it by the projected metric of the company you’re valuing.
You “project” the company’s share price by assuming that in 1-2 years, the company will be
trading at the median multiple the comps are currently trading at.
Since money today is worth more than money tomorrow, you then discount this future share
price back to its Present Value by using Discount Rates linked to the company’s Cost of Equity.
If you’re using Enterprise Value-based multiples instead, you back into the Implied Equity Value
and Implied Share Price in the future year. And you still discount that share price to its Present
Value by using the Cost of Equity.
Here’s an example analysis:
We do NOT recommend this analysis unless someone specifically asks you for it.
There are dozens of problems with it, but let’s start with the biggest ones:
1) Why Would You Apply Historical Multiples to Projected Metrics? This idea is
questionable because multiples change over time. There’s no guarantee that the LTM
multiple of the Public Comps today will be the same in 1-2 years.
2) What Value Does This Add Over a Normal Public Comps Analysis? This method is
another way to use valuation multiples to value a company, but how is it better or more
useful than standard Public Comps?
3) You Shouldn’t Try to “Project” Share Prices. Finally, a company’s current share price
reflects past performance and future expectations. So, how could you possibly
“project” what it will be in the future? You’d have to jump into the future and assess
future expectations at that point – and then time travel back to the present.
Sum-of-the-Parts (SOTP) Valuation
This methodology makes some amount of sense, unlike the others listed above.
With Sum of the Parts, you value each division of a company separately, add up the Implied
Enterprise Value for each division, and then back into the Implied Equity Value and Implied
Share Price for the entire company at the end.
Sum of the Parts works best for companies with very different division: Firms like General
Electric or Samsung that operate in everything from aviation to healthcare to transportation.
It makes sense for these companies because the divisions have different Discount Rates, Cash
Flow Growth Rates, Comparable Public Companies, and Precedent Transactions.
Here’s a simple example:
Yahoo’s divisions at this time were a bit different, but not that different, so it’s a stretch to use
this methodology here.
Sum of the Parts makes no sense for a company like Steel Dynamics – it has different business
divisions, but they’re all related to steel manufacturing.
Other companies in the sector all have the same types of divisions as well, so you wouldn’t be
able to find Public Comps to value each division separately.
The main downsides to Sum of the Parts are:
1) It Takes A LOT More Time and Effort to Use – If the company has 10 divisions, you need
to find 10 different sets of Public Comps and Precedent Transactions, build 10 different
DCF analyses, and so on.
2) You May Not Have Enough Information to Use It – For example, many companies
disclose revenue by segment, but not operating income, taxes, Working Capital, or
CapEx by segment. It’s tough to build a separate DCF for each division without this
information.
All companies also have corporate overhead expenses that are not allocated to one
specific division. You need to factor these in when you calculate the Implied Value for
the entire company, but not all companies disclose these expenses.
Leveraged Buyout (LBO) Valuation
This one is a whole separate topic (see the LBO lessons/sections/guides), but you can also value
a company by assuming that a private equity firm buys it, runs it for several years, and sells it in
the future and that it targets a specific IRR or multiple with the investment.
For example, let’s say that a private equity firm plans to acquire a company, hold it, and sell it in
5 years.
They believe they can sell it for an EV / EBITDA multiple between 12x and 15x, and they want to
use 50% Debt and 50% Equity to purchase it. They are targeting a 20% IRR.
You could set up the LBO model and then use the “Goal Seek” function in Excel to determine
the maximum purchase price that would yield that 20% IRR.
That price would depend on the exit multiple, so you would show the maximum purchase price
at exit multiples ranging from 12x to 15x.
You use this methodology as more of a “sanity check” or “initial screen” – for example, a
private equity firm might run this analysis to decide if a deal makes sense before spending
time/money on it.
If the maximum amount the PE firm can pay to realize a 20% IRR is $1 billion, but the company’s
Current Enterprise Value is $1.5 billion, the deal cannot work.
But if the company’s Current Enterprise Value is only $800 million, then the deal might work.
Industry-Specific Valuation
This topic is beyond the scope of this guide, so take a look at the summary in the Equity Vale
and Enterprise Value Guide or our industry-specific guides and courses.
In short, there are also industry-specific valuation methodologies in industries such as
commercial banking, insurance, real estate investment trusts (REITs), and oil & gas.
But these methodologies aren’t “new”: They’re primarily variations of the DCF Analysis.
For example, the Net Asset Value (NAV) Model for oil & gas is a DCF with no Terminal Value.
After an initial exploration/growth period, you assume that the company stops exploring for
more oil and gas and that it produces everything until its reserves are depleted.
As a result, its Cash Flow eventually drops to $0 in the future.
You discount and sum up all the cash flows, as you do in any DCF, but you skip the Terminal
Value because it makes no sense here.
For life insurance, the embedded value methodology is a similar, far-in-the-future DCF analysis
where a company’s Implied Value is linked to its Balance Sheet (Assets minus Liabilities) plus
the Present Value of Future Cash Profits from its policies.
Since life insurance policies can last for 20-30 years, you might create projections for decades
into the future with this one.
For most other industries, the standard metrics, multiples, and methodologies described in this
guide apply.
Return to Top.
Key Rule #10: How to Put Together and Use a Full Valuation
When you’ve finished the DCF, Public Comps, and Precedent Transactions, you can see how all
the methodologies stack up.
You do this by showing the range of multiples from each methodology on the same page.
Here’s our summary page for Steel Dynamics:
Then, you calculate the Implied Enterprise Value or Implied Equity Value based on each
multiple in this set and the company’s applicable figure.
For example, if the minimum LTM EV / Revenue multiple is 2.0x, and the company’s LTM
revenue is $1,000, then its Implied Enterprise Value is $2,000 based on that multiple.
For private companies, you often stop there.
But if you’re valuing a public company, you then back into the Implied Equity Value by adding
non-core-business Assets and subtracting Liability and Equity items that represent other
investor groups.
And then you divide by the company’s share count to get its Implied Share Price.
You repeat this process for all the multiples to calculate ranges of Implied Share Prices:
You don’t use this process for the DCF because the DCF should calculate the Implied Share Price
directly. So, you simply link to a range of values around the center of the sensitivity table:
Once you have this, you then create a “Football Field” chart that shows the ranges of Implied
Share Prices using bar charts:
Our conclusions here might be:

1) Implied Value – Steel Dynamics is likely worth between $15.00 and $20.00 per share
because the DCF output is in that range, as are some of the median Implied Share Prices
from the Public Comps.
The company’s share price was $24.97 at the time of this analysis, making it overvalued
by 25-35%.
2) Useless Methodologies and Multiples – The P / E multiples seem so far off from
everything else that we shouldn’t pay much attention to them. The Precedent
Transactions also produce odd values, though the Implied Value from the median EV /
Revenue multiple seems plausible.
Your next steps depend on where you’re working and the purpose of this analysis.
For example, if you’re working at an investment bank and you advise companies on deals, you
might tell the Steel Dynamics management team the following based on this analysis:
• Company Value – If the team wants to know what the company is “really worth,” you’d
likely tell them, “Between $15.00 and $20.00 per share.”
• It’s Probably Not a Good Time to Sell – The company trades at a premium to its intrinsic
value, and an acquirer would have to pay even more to acquire the company. A
standard 30% premium would make the company even more overvalued, meaning that
an acquirer would need to realize massive synergies to make the math work.
• But It Might Be a Good Time to Raise Equity – Companies benefit from raising Equity
when they trade at higher multiples and premiums to their intrinsic values; Equity
produces less dilution in those cases because the company can issue fewer shares to
raise the same amount of capital.
On the other hand, if you’re working in a buy-side role, such as at a hedge fund or private
equity firm, your interpretation would be different.
In those roles, the key question is whether or not you should invest in a company.
Buying a company, or buying a small stake in a company, makes the most sense when it
appears to be undervalued and when specific events (“catalysts”) might cause the share price
to change in the next 6-12 months.
A private equity firm might conclude that since Steel Dynamics trades at a premium to its
intrinsic value, it is not a great investment right now.
The firm might still build a leveraged buyout model and see if it can achieve its targeted IRRs,
but the valuation alone would make a deal less likely.
A hedge fund might conclude that the company is overvalued and that its share price could
decline in the next 6-12 months.
That makes it, potentially, a good “Short” candidate. You would sell the company’s shares and
then buy them back at a lower level to profit from the company’s share-price decline.
If you’re wrong, you could lose an unlimited amount of money, which is why you would need to
hedge yourself and limit your potential losses in this scenario.
Steel Dynamics isn’t overvalued by that much, so many hedge funds would stay away.
Funds often seek companies that are mispriced by much greater percentages (e.g., 50%+) so
that they have a higher margin of safety.
Return to Top.
Key Rule #11: The Trade-Offs of Different Methodologies
We’ve covered a lot in this guide, so this last section provides a summary of the trade-offs of
different methodologies:
Advantages and Disadvantages of the Main Valuation Methodologies:
Methodology Public Comps Precedent Transactions Discounted Cash Flow

Name: Analysis
Advantages: • Based on real market data. • Based on what real • Not as subject to market
companies have actually fluctuations/conditions.
• Less dependent on future paid for other
assumptions. companies. • Most “correct”
methodology according
• Quick to calculate and easy • May show industry to finance theory.
to understand/explain. trends more effectively
than Public Comps. • Better reflects company-
specific factors and
scenarios/stages.
Disadvantages: • There may not be truly • Data can be limited and • Very dependent on far-
comparable companies. misleading. in-the-future
assumptions.
• Less accurate for thinly • There may not be truly
traded stocks or volatile comparable transactions. • Bankers are notoriously
companies. bad at making reasonable
• Multiples don’t capture assumptions.
• May undervalue all the aspects of a deal.
companies’ long-term • Widespread
potential. • Specific market disagreement on how to
conditions can greatly calculate figures like Cost
• The market might be impact output. of Equity and WACC.
wrong!
And then for the more “exotic” methodologies:
• Liquidation Valuation – It's difficult to determine the market values of everything on the
Balance Sheet, and it undervalues healthy, growing companies; it’s more appropriate for
distressed companies.
• Dividend Discount Model – Useful for companies that issue predictable Dividends or for
industries in which Free Cash Flow is meaningless, but it's not useful for non-Dividend-
paying companies.
• M&A Premiums Analysis – It’s helpful for assessing what an acquirer might have to pay
for an entire public company, but it's not useful for valuing private companies or non-
100% acquisitions.
• Future Share Price Analysis – There are no real positives. The methodology itself –
applying historical multiples to projected metrics – is questionable, and it doesn't fix or
improve anything from normal Public Comps. Even if you apply future multiples to
future metrics, it doesn’t add much over Public Comps.
• Sum of the Parts – It’s useful for valuing conglomerates and companies with very
different divisions, but it takes a lot more time and effort to use, and the company may
not disclose all the information you need.
• Leveraged Buyout Valuation – It's helpful for PE firms thinking about the maximum
amount they could pay for a company to achieve a certain IRR, but it's more of an initial
screening tool or sanity check than a strict valuation methodology.
Comparing Expected Values from Different Methodologies
Since all the methodologies depend on your assumptions, it’s difficult to make universal
statements about which one, if any, produces the “highest” values.
But here’s what we can say:
• Precedent Transactions vs. Public Comps: Transactions tend to produce higher Implied
Values due to the control premium. But this rule doesn’t always hold up, especially if
market conditions have suddenly changed.
• M&A Premiums Analysis vs. Public Comps: Like the Precedent Transactions, the M&A
Premiums Analysis tends to produce higher Implied Values because of the control
premium.
• Discounted Cash Flow Analysis: This one often produces the most variable output since
it’s the most dependent on far-in-the-future assumptions. But if you use reasonable
assumptions, you should get reasonable results, as we did for Steel Dynamics.
• Liquidation Valuation: This one will produce the lowest Implied Values for healthy
companies because they’re worth significantly more than what their Balance Sheets
suggest.
• Sum of the Parts: If a company truly is worth more in “parts,” then this one will produce
higher Implied Values than if you valued the entire company using one DCF, one set of
comparable companies, and so on.
• LBO Valuation: This one tends to produce values on the lower end of the range because
it tells you the maximum price a PE firm could pay to achieve a minimum IRR. Unlike the
other methodologies, it sets a “ceiling” on valuation.
There are so many exceptions to these rules that we suggest avoiding this topic in interviews.
It’s best to turn the conversation back to the trade-offs of the different methodologies and
explain why they differ rather than claiming that one specific approach will always produce the
highest or lowest values.
Return to Top.
Interview Questions
Interview questions on valuation are extremely common, but we’ve already covered many of
them in the Equity Value, Enterprise Value, and Valuation Multiples guide.
As a result, we’re going to focus on the DCF analysis here, as well as how to use methodologies
like Public Comps and Precedent Transactions in real life.
Interviews have evolved to the point where simple questions with easily-memorized answers
(e.g., “What are the 3 valuation methodologies?”) are no longer common.
Instead, interviewers are more likely to test your conceptual understanding by asking you to
walk through analyses, explain the trade-offs, and apply the methodologies to advise clients
and make investment recommendations.
The Purpose of Valuation
These questions are quite high-level, but many candidates don’t understand the point of
valuation.
You can’t answer the more detailed questions without knowing that, so don’t dismiss this
category as “too basic” – even if you have significant work experience.
1. What’s the point of valuation? WHY do you value a company?

You value a company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company’s Current Value, you might be able to
invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell management the price
that it might receive if the company sells, which is often different from its Current Value.
2. But public companies already have Market Caps and Share Prices. Why bother valuing
them?
Because a company’s Market Cap and Share Price reflect its Current Value according to “the
market as a whole” – but the market might be wrong!
You value companies to see if the market’s views are correct or incorrect.
3. What are the advantages and disadvantages of the 3 main valuation methodologies?
Public Comps are useful because they’re based on real market data, are quick to calculate and
explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for
volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies
have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable
transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to
market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement
over the proper calculations for key figures like the Cost of Equity and WACC.
4. Which of the 3 main methodologies will produce the highest Implied Values?
This is a trick question because almost any methodology could produce the highest Implied
Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps because of
the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF stacks up because it’s far more dependent on your assumptions.
The best answer is: “A DCF tends to produce the most variable output since it’s so dependent
on your assumptions, and Precedent Transactions tend to produce higher values than the
Public Comps because of the control premium.”
5. When is a DCF more useful than Public Comps or Precedent Transactions?

You should pretty much always build a DCF since it IS valuation – the other methodologies are
supplemental.
But it’s especially useful when the company you’re valuing is mature and has stable, predictable
cash flows, or when you lack good Public Comps or Precedent Transactions.
6. When are Public Comps or Precedent Transactions more useful than the DCF?
If the company you’re valuing is early-stage, and it is impossible to estimate its future cash
flows, or if the company has no path to positive cash flows, you have to rely on the other
methodologies.
These other methodologies can also be more useful when you run into problems in the DCF,
such as an inability to estimate the Discount Rate or extremely volatile cash flows.
7. Which one should be worth more: A $500 million EBITDA healthcare company or a $500
million EBITDA industrials company?
Assume the growth rates, margins, and all other financial stats are the same.
In all likelihood, the healthcare company will be worth more because healthcare is a less asset-
intensive industry. That means the company’s CapEx and Working Capital requirements will be
lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA) as a result.
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than
industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset
intensity and higher expected growth rates would likely make up for that.
However, this answer is an extreme generalization, so you would need more information to
make a real decision.
8. How do you value an apple tree?

The same way you value a company: Comparables and a DCF. You’d look at what similar apple
trees have sold for, and then calculate the expected future cash flows from this tree.
You would then discount these cash flows to Present Value, discount the Terminal Value to PV,
and add up everything to determine the apple tree’s Implied Value.
The Discount Rate would be based on your opportunity cost – what you might be able to earn
each year by investing in other, similar apple trees.
9. People say that the DCF is an intrinsic valuation methodology, while Public Comps and
Precedent Transactions are relative valuation.
Is that correct?
No, not exactly. The DCF is based on the company’s expected future cash flows, so in that
sense, it is “intrinsic valuation.”
But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use
the Multiples Method to calculate Terminal Value, the multiples are also linked to peer
companies.
The DCF depends less on the market than the other methodologies, but there is still some
dependency.
It’s more accurate to say that the DCF is more of an intrinsic valuation methodology than the
others.
Return to Top.
DCF Analysis – Walking Through and Explaining It
Questions on how to set up a DCF are the most common ones in interviews. Even if you don’t
understand the advanced items that go into the analysis, you must be able to walk through it.
You must also understand the relationship between a DCF and other methodologies, and, in
particular, why valuation multiples are shorthand for real valuation.
1. Why do you build a DCF analysis to value a company?

You build a DCF analysis because a company is worth the Present Value of its expected future
cash flows:
But you can’t just use that single formula because a company’s Cash Flow Growth Rate and
Discount Rate change over time.
So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where
those assumptions change (the explicit forecast period) and one where they stay the same (the
Terminal Period).
You then project the company’s cash flows in both periods and discount them to their Present
Values based on the appropriate Discount Rate(s).
Then, you compare this sum – the company’s Implied Value – to the company’s Current Value
or “Asking Price” to see if it’s valued appropriately.
2. Walk me through a DCF analysis.

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast
period plus the Present Value of its Terminal Value.
You start by projecting the company’s Free Cash Flows over the next 5-10 years by making
assumptions for revenue growth, margins, Working Capital, and CapEx.
Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost
of Capital, and sum up everything.
Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon
Growth Method; it represents the company’s value after those first 5-10 years into perpetuity.
You then discount the Terminal Value to Present Value using the Discount Rate and add it to
the sum of the company’s discounted cash flows.
Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise
Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to
the Current Share Price.
3. How do you move from Revenue to Free Cash Flow in a DCF?

First, confirm that the interviewer is asking for Unlevered Free Cash Flow (AKA Free Cash Flow
to Firm). If so:
Subtract COGS and Operating Expenses from Revenue to reach Operating Income (EBIT).
Then, multiply Operating Income by (1 – Tax Rate), add back Depreciation & Amortization, and
factor in the Change in Working Capital.
If the company spends extra cash as it grows, the Change in Working Capital will be negative; if
it generates extra cash flow as a result of its growth, it will be positive.
Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow.
Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest
Expense before multiplying by (1 – Tax Rate), and you also factor in changes in Debt principal.
4. What does the Discount Rate mean?

The Discount Rate represents the opportunity cost for the investors – what they could earn by
investing in other, similar companies in this industry.
A higher Discount Rate means the risk and potential returns are both higher; a lower Discount
Rate means lower risk and lower potential returns.
A higher Discount Rate makes a company less valuable because it means the investors have
better options elsewhere; a lower Discount Rate makes a company more valuable.
5. How do you calculate Terminal Value in a DCF, and which method is best?
You can use the Multiples Method or the Gordon Growth Method (AKA Long-Term Growth
Method, Perpetuity Growth Method, etc.).
With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF
in the final year of the forecast period. For example, if you apply a 10x EV / EBITDA multiple to
the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000.
With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free
Cash Flows in the Terminal Period and assume they’ll grow at that rate forever.
Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate –
Terminal Growth Rate)
The Gordon Growth Method is better because growth always slows down over time; all
companies’ cash flows eventually grow more slowly than GDP.
If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense
because it implies a growth rate that’s too high.
However, many bankers still use and prefer the Multiples Method because it’s “easier” or
because they don’t understand the need to cross-check the output.
6. What are some signs that you might be using the incorrect assumptions in a DCF?
The most common signs of trouble are:
1. Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of
the company’s total Implied Value, but it shouldn’t account for, say, 95% of its value.
2. Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you
pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the
country’s long-term GDP growth rate is 3%, something is wrong.
3. You’re Double-Counting Items – If an income or expense line item is included in FCF,

you should not count the corresponding Asset or Liability in the Implied Enterprise
Value  Implied Equity Value “bridge” at the end. And if a line item is excluded from
FCF, you should count the corresponding Asset or Liability in the “bridge” at the end.
4. Mismatched Final Year FCF Growth Rate and Terminal Growth Rate – If the company’s
Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal
Growth Rate, something is wrong. FCF growth should decline over time and approach
the Terminal Growth Rate by the end of the explicit forecast period.
7. If your DCF seems off, what are the easiest ways to fix it?
The simplest method is to extend the explicit forecast period so that the company’s Free Cash
Flow contributes more value, and so that there’s more time for FCF growth to slow down and
approach the Terminal Growth Rate.
So, if you’re using a 5-year forecast period, extend it to 10-15 years and reduce the company’s
FCF growth in those extra years as it approaches maturity.
To avoid double-counting items… look at what you’re doing and don’t double count!
Finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower
Terminal Multiple. Terminal Value tends to be overstated in financial models because people
don’t understand the theory behind it.
8. How do you interpret the results of a DCF?

You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current
Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic.
For example, if you believe that the company’s Implied Share Price is between $15.00 and
$20.00, but its Current Share Price is $8.00, then that is good evidence that the company may
be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.
9. Does a DCF ever make sense for a company with negative cash flows?
Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company
is cash flow-negative right now, the analysis could work if it starts generating positive cash
flows in the future.
If the company has no path to positive cash flows, or you can’t reasonably forecast its cash
flows, then the analysis doesn’t make sense.
10. How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from
the Unlevered DCF?
In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount
Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E.
You don’t back into Implied Equity Value at the end because the analysis produces the Implied
Equity Value directly.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest
Tax Shield separately and add the Present Value of this Tax Shield at the end.
You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered
Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median
Unlevered Beta from Public Comps).
You then project the Interest Tax Shield each year, discount it at that same Discount Rate,
calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.
11. Will you get the same results from an Unlevered DCF and a Levered DCF?
No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on
the company’s Debt, while the Levered DCF does.
That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes
in Debt principal) will also contribute; it’s very difficult to pick “equivalent assumptions” in both
analyses.
12. Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?
The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more
consistent results than the other methods.
With the other methods, you have to project the company’s Cash and Debt balances, Net
Interest Expense, and changes in Debt principal, all of which require more time and effort.
The Levered DCF sometimes produces odd results because Debt principal repayments can spike
the Levered FCF up or down in individual years.
The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: Increased
chances of bankruptcy. You can try to reflect this risk, but no one agrees on how to estimate it
numerically.
The Unlevered DCF solves this issue because WACC decreases with additional Debt, at first, but
then starts increasing past a certain level, which reflects both the advantages and
disadvantages of Debt.
Return to Top.
DCF Analysis – Calculating Free Cash Flow
Calculating Unlevered FCF is simple if you remember the key rule: Include only recurring items
that are related to the company’s core business and that are available to all the investor groups.
There are some trickier topics, but you can answer 90% of interview questions by
understanding that rule.
1. Why do you calculate Unlevered Free Cash Flow by including and excluding various items
on the financial statements?
Unlevered FCF must capture the company’s core, recurring line items that are available to ALL
investor groups.
That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value
of the company’s core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to
all investor groups, you leave it out.
This rule explains why you exclude all of the following items:
• Net Interest Expense – Only available to Debt investors.

• Other Income / (Expense) – Corresponds to non-core-business Assets.
• Most non-cash adjustments besides D&A – They’re non-recurring.
• All Items in Cash Flow from Financing – They’re only available to certain investors.
• Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.
2. How does the Change in Working Capital affect Free Cash Flow, and what does it tell you
about a company’s business model?
The Change in Working Capital tells you whether the company generates more cash than
expected as it grows, or whether it requires more cash to fuel that growth.
It’s related to whether a company records expenses and revenue before or after paying or
collecting them in cash.
For example, retailers tend to have negative values for the Change in Working Capital because
they must pay for Inventory upfront before they can sell products.
But subscription-based software companies often have positive values for the Change in
Working Capital because they collect cash from long-term subscriptions upfront and recognize
it as revenue over time.
The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a
major value driver because it’s fairly small for most companies.
3. Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a non-
cash add-back on the Cash Flow Statement.
No! You should consider SBC a cash expense in the context of valuation because it creates
additional shares and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: The company paid for a
capital asset earlier on but recognizes that payment over many years.
Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context
is different: Accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back,
you should reflect the additional shares by increasing the company’s diluted share count, which
will reduce the Implied Share Price.
Most DCFs get this completely wrong because they use neither approach: They pretend that
SBC is a normal non-cash charge that makes no impact on the share count (wrong!).
4. What’s the proper tax rate to use when calculating FCF – the effective tax rate, the
statutory tax rate, or the cash tax rate?
The company’s Free Cash Flows should reflect the cash taxes it pays.
So, it doesn’t matter which rate you use as long as the cash taxes are correct.
For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax
Income), and then include Deferred Taxes within the non-cash adjustments.
Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax
adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes and other
items to arrive at the company’s real cash taxes.
It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on
historical trends.
5. How should CapEx and Depreciation change within the explicit forecast period?
Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast
period, the company’s CapEx and Depreciation should also decline.
High-growth companies tend to spend more on Capital Expenditures to support their growth,
but this spending declines over time as the companies move from “growth” to “maintenance.”
If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be
less of a difference by the end.
Also, if the company’s FCF is growing, CapEx should not equal Depreciation – even in the
Terminal Period.
That’s partially due to inflation (capital assets purchased 5-10 years ago cost less), and partially
because Net PP&E must keep growing to support FCF Growth in the Terminal Period.
If you’re assuming that the company’s FCF stagnates or declines, then you might use different
assumptions.
6. Should you reflect inflation in the FCF projections?

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for
prices and salaries tend to be based on nominal figures.
If you reflect inflation, then you also need to forecast inflation far into the future and adjust all
figures in your analysis.
That’s rarely worthwhile because of the uncertainty, extra work, and extra explanations
required.
7. If the company’s capital structure is expected to change, how do you reflect it in FCF?
You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt
principal will change over time. You’ll also change the Cost of Equity over time to reflect this.
The changing capital structure won’t show up explicitly in Unlevered FCF, but you will still
reflect it in the analysis with the Discount Rate – WACC will change as the company’s Debt and
Equity levels change.
8. What’s the relationship between including an income or expense line item in FCF and the
Implied Equity Value calculation at the end of the DCF?
If you include an income or expense line item in Free Cash Flow, then you should exclude the
corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity
Value at the end (and vice versa for items you exclude).
For example, if you capitalize the company’s operating leases and count them as a Debt-like
item at the end, then you should exclude the rental expense from FCF, making it higher.
This rule also explains why you factor in Cash and Debt when moving to the Implied Equity
Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement
(Interest Income and Interest Expense).
9. How do Net Operating Losses (NOLs) factor into Free Cash Flow?
You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also
factoring in NOL accruals if the company earns negative Pre-Tax Income.
If you do this, then you don’t need to count the NOLs in the Implied Enterprise Value  Implied
Equity Value calculation at the end.
However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business
Asset in this calculation at the end.
Beyond the extra work, one problem with the first approach is that the company may not use
all of its NOLs by the end of the explicit forecast period!
10. How does the Pension Expense factor into Free Cash Flow?
There are different components of the Pension Expense, including the Service Cost, the Interest
Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and
Other Adjustments.
The Service Cost is an operating expense and should always be included in the company’s Free
Cash Flow.
In an Unlevered DCF, you exclude the Interest Expense, Expected Return on Plan Assets, and
Amortization of Net Losses or Gains, and then subtract the Unfunded portion of the Pension
Obligation when moving from Implied Enterprise Value to Implied Equity Value.
Some companies embed these items within Operating Expenses on the Income Statement, so
you may have to review the filings to calculate EBIT properly.
If company contributions into the pension plan are tax-deductible (varies by country), you have
to multiply the Unfunded Pension by (1 – Tax Rate) as well.
11. Should you ever include items such as asset sales, impairments, or acquisitions in FCF?
For the most part, no. You certainly shouldn’t make speculative projections for these items –
they are all non-recurring.
If a company has announced plans to sell an asset, make an acquisition, or record a write-down
in the near future, then you might factor it into FCF for that year.
And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or
received, and you’ll have to change the company’s cash flow after the deal takes place.
Return to Top.
DCF Analysis – Discount Rates and WACC
Questions related to the Discount Rate and WACC in a DCF are surprisingly tricky because it’s
not always easy to explain how the assumptions are linked.
You don’t need to know every single detail of these calculations, but you should know the
intuition behind everything.
If you know that the Discount Rate represents the opportunity cost and that the Debt and
Equity levels affect all investors, you can answer many of these questions.
1. What does the Cost of Equity mean intuitively?
It tells you the average percentage a company’s stock “should” return each year, over the very
long term, factoring in both stock-price appreciation and dividends.
In a valuation, it represents the percentage an Equity investor might earn each year (averaged
over decades).
To a company, the Cost of Equity represents the cost of funding its operations by issuing
additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting
existing investors (thereby giving up stock-price appreciation potential).
2. What does WACC mean intuitively?

WACC is similar to Cost of Equity, but it’s the expected annual return if you invest
proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock,
and anything else it has.
To a company, WACC represents the cost of funding its operations by using all its sources of
capital and keeping its capital structure percentages the same over time.
Investors might invest in a company if their expected IRR exceeds WACC, and a company might
decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.
3. How do you calculate Cost of Equity?

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
The Risk-Free Rate represents what you would earn on "risk-free" government bonds
denominated in the same currency as the company’s cash flows. You usually use 10-year or 20-
year bonds to match the explicit forecast period of the DCF.
Levered Beta represents how volatile this stock is relative to the market as a whole, factoring in
both intrinsic business risk and risk from leverage.
And the Equity Risk Premium represents how much the stock market in the company’s country
will return above the “risk-free” government bond in the long term.
Stocks are riskier and have higher potential returns than government bonds, so you take the
rate of return on those government bonds, add the extra returns you could get from the stock
market, and then adjust for this company’s specific risk and potential returns.
4. If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?
You should use the rate on the government bonds denominated in the currency of the
company’s cash flows.
So, if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if
it reports them in EUR or GBP, you might use the rate on 10-year bonds issued by the European
Central Bank or the Bank of England.
5. What should you use for the Risk-Free Rate if government bonds in the country are NOT
risk-free (e.g., Greece)?
One option is to take the Risk-Free Rate in a country that is “risk-free,” like the U.S. or U.K., and
then add a default spread based on your country’s credit rating.
For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a
spread of 11.2% for Greece based on its current credit rating.
That rate of 13.7% represents how yields are much higher in Greece due to the significant
chance of government default.
6. How do you calculate the Equity Risk Premium?

Stock-market returns differ based on the period and whether you use an arithmetic mean, a
geometric mean, or other approaches, so there’s no universal method.
Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for
companies of different sizes in different industries each year; some academic sources also track
and report this data.
You could also take the historical data for the U.S. stock market and add a premium based on
the default spread of your country/market.
For example, if the historical U.S. premium is 7%, you might add 3% to it if your country’s credit
rating is Ba2, and that rating corresponds to a 3% spread.
Finally, some groups use a “standard number” for each market, such as 5-6% in developed
countries.
7. How do you calculate the Equity Risk Premium for a multinational company that operates
in many different geographies?
You might take the percentage revenue earned in each country, multiply it by the ERP in that
market, and then add up everything to get the weighted average ERP.
To calculate the ERP in each market, you might use one of the methods described in the
previous question. The “Historical U.S. stock market returns + default spread” approach is
common here.
8. What does Beta mean intuitively?

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a
whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt).
If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so
it’s always less than or equal to Levered Beta.
9. Could Beta ever be negative?

Yes, it’s possible. The company’s stock price must move in the opposite direction of the entire
market for Beta to be negative.
Gold is commonly cited as an Asset that has a negative Beta because it often performs better
when the stock market declines, and it acts as a “hedge” against disastrous macroeconomic
events.
However, negative Betas for companies are quite rare and usually revert to positive figures,
even if they’re negative for short periods.
10. Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?
You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical
Beta, i.e., its own Levered Beta, and skip this step.
But in a valuation, you’re estimating the company’s Implied Value – what it should be worth.
The historical Beta corresponds more closely to the company’s Current Value – what the
market says it’s worth today.
By un-levering Beta for each comparable company, you isolate each company’s inherent
business risk.
Each company might have a different capital structure, so it’s important to remove the risk
from leverage and isolate just the inherent business risk.
You then take the median Unlevered Beta from these companies and re-lever it based on the
capital structure (targeted or actual) of the company you’re valuing.
You do this because there will always be business risk and risk from leverage, so you need to
reflect both for the company you’re valuing.
You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock
price, relative to the market as a whole, should be, based on the median business risk of its peer
companies and this company’s capital structure.”
11. What are the formulas for un-levering and re-levering Beta, and what do they mean?
Assuming the company has only Equity and Debt:
Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 – Tax Rate))
Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 – Tax Rate))
If the company has Preferred Stock, you add another term for the Preferred / Equity Ratio.
You use a “1 +” in front of Debt / Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is
always less than or equal to Levered Beta.
And you multiply the Debt / Equity Ratio by (1 – Tax Rate) because the tax-deductibility of
interest reduces the risk of Debt.
The formulas reduce Levered Beta to represent the removal of risk from leverage, but they
increase Unlevered Beta to represent the addition of risk from leverage.
12. In those formulas, you’re not factoring in the interest rate on Debt. Isn’t that wrong?
More expensive Debt should be riskier.
Yes, this is one drawback. However:

1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with
high Debt / Equity ratios tend to pay higher interest rates as well.
2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result
in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as
simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.”
An interest rate that’s 4x higher might barely change a large company’s financial profile, but it
might make a much bigger difference for a small company.
13. Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?
Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF.
A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and re-
lever Beta regardless of the type of Free Cash Flow you’re using.
14. What are some different ways to calculate Beta in the Cost of Equity calculation?
Some people argue that you should use the Predicted Beta instead of the Historical Beta
because the Cost of Equity relates to expected future returns.
If you do use historical data, you could use the company’s Historical Beta or the re-levered Beta
based on comparable companies.
And if you re-lever Beta, you could do it based on the company’s current capital structure, its
targeted or “optimal” structure, or the capital structure of the comparable companies.
Most of these methods produce similar results, and you always use a range of values when
calculating Cost of Equity and WACC.
15. How would you estimate the Cost of Equity for a U.S.-based technology company?
This question tests your ability to make a guesstimate based on common sense and your
knowledge of current market rates.
You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company
like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So, if you
assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.”
The numbers will change based on market conditions, but that’s the idea.
16. How do you calculate WACC, and what makes it tricky?

The formula for WACC is simple:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred
But it’s tricky to calculate because of the ambiguity with many of these items:
1. Cost of Debt: Do you use the weighted average coupon rate on the company’s bonds?
Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies?
2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company’s current
capital structure, “optimal” structure, or targeted structure? Or do you use the median
percentages from the comparable public companies?
3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the
Equity Risk Premium.
17. WACC reflects the company’s entire capital structure, so why do you pair it with
Unlevered FCF? It’s not capital structure-neutral!
Think of Unlevered FCF as “Free Cash Flow to Firm,” or FCFF, instead.
And think of this relationship as: “Unlevered FCF, or FCFF, is available to ALL investors, and
WACC represents ALL investors. Therefore, you pair WACC with Unlevered FCF.”
No Discount Rate can be “capital structure-neutral” since each part of a company’s capital
structure affects the other parts.
“Capital-structure neutrality” is a property of Free Cash Flow, not the Discount Rate.
18. Should you use the company’s current capital structure or optimal capital structure to
calculate WACC?
A company’s “optimal” capital structure is the one that minimizes its WACC. But there’s no way
to calculate it because you can’t tell in advance how the Costs of Equity, Debt, and Preferred
will change as the capital structure changes.
So, in practice, you’ll often use the median capital structure percentages from the comparable
public companies as a proxy for the “optimal” capital structure.
It’s the same as the logic for un-levering and re-levering Beta: You want to capture what this
company’s capital structure should be, not what it is right now.
It’s better to use this expected capital structure because the company’s Implied Value in a DCF
is based on its expected, future cash flows.
19. Should you use Total Debt or Net Debt to determine the capital structure percentages in
the WACC calculation?
Some textbooks claim that you should use Equity Value + Debt + Preferred Stock – Cash, rather
than Equity Value + Debt + Preferred Stock, for the denominator of the capital structure
percentages.
However, we disagree with this approach for several reasons:
1) Cash Does Not “Offset” Debt – For example, many forms of Debt do not allow for early
repayment or penalize the company for early repayment. So, a high Cash balance
doesn’t necessarily reduce the risk of Debt on a 1:1 basis.
2) You May Get Nonsensical Results with High Cash Balances – For example, if the
company’s Cash exceeds its Debt, Debt as a Percentage of Total Capital will be far too
low. This will artificially inflate the Discount Rate since Equity is more expensive than
Debt for most companies.
20. Why is Equity more expensive than Debt?

Because it offers higher risk and higher potential returns.
Expected stock market returns (plus dividends) exceed the interest rates on Debt in most cases,
which already makes the Cost of Equity higher. But the interest on Debt is also tax-deductible,
which further reduces its cost.
In developed markets like the U.S., the average annualized stock market return is around 10-
11%. So, a company with a Beta of 1.0 will have a Cost of Equity in that range.
For the Cost of Debt to be higher, the Pre-Tax Cost would have to be ~17-18% at a 40% tax rate.
Hardly any Debt has interest rates that high.
21. How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?
Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers
higher risk and potential returns than Debt, but lower risk and potential returns than Equity.
That’s because the coupon rates on Preferred Stock tend to be higher than the rates on Debt,
and Preferred Dividends are not tax-deductible.
But these rates are still lower than expected stock market returns. The risk is also lower since
Preferred Stock investors have a higher claim on the company’s Assets than Equity investors.
22. How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC
calculation, and what do they mean?
These Costs represent the rates a company would pay if it issued additional Debt or additional
Preferred Stock.
There is no way to observe these rates directly, but you can estimate them.
For example, you could calculate the weighted average coupon rate on the company’s existing
Debt or Preferred Stock or the median coupon rate on the outstanding issuances of comparable
public companies.
You could also use the Yield to Maturity (YTM), which reflects the market prices of the bonds (a
bond with a coupon rate of 5% that’s trading at a discount to par value will have a YTM higher
than 5%).
Finally, you could also take the Risk-Free Rate and add a default spread based on the
company’s expected credit rating if it issues more Debt or Preferred Stock. If you think its credit

rating will fall from BB+ to BB after issuing Debt, you’d look up the average spread for BB-rated
companies and add it to the Risk-Free Rate.
23. How do convertible bonds factor into the WACC calculation?

If the company’s current share price exceeds the conversion price of the bonds, you count the
bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher
Equity Value for the company and a greater Equity weighting in the WACC formula.
But if the bonds are not currently convertible, you count them as Debt and use the coupon rate
(or YTM, or another method) to calculate their Cost.
Convertible bonds offer lower coupon rates than standard corporate bonds, so you should use
the rate on equivalent, non-convertible bonds.
Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt
is lower than the Cost of Equity.
24. How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more
Debt?
The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of
bankruptcy, which affects all investors.
As a company goes from no Debt to some Debt, WACC decreases at first because Debt is
cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy
starts to outweigh the lower Cost of Debt.
However, the exact impact depends on where you are on that curve. If the company already
has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt,
WACC is more likely to decrease with more Debt.
25. How do those figures change as the company uses less Debt?
The Cost of Equity and Cost of Debt decrease for the reasons stated above: Less Debt means a
lower risk of bankruptcy and, therefore, less risk for all investors.

WACC could go either way depending on where you are on the curve. If the company already
has a very high level of Debt, WACC will likely decrease with less Debt; if its Debt level is much
lower, WACC will likely increase with less Debt.
26. If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt,
how does that affect its WACC?
It depends on how you’re calculating WACC. If you’re using the company’s current capital
structure, WACC will most likely increase because 20% Debt is a fairly low level. At that low
level, the benefits of Debt still outweigh its risks, so less Debt will increase WACC.
But if you’re using the targeted, optimal, or median capital structure from the comparable
companies, this change won’t affect WACC because you’re not using the company’s current
capital structure at all.
27. Should you ever use *different* Discount Rates for different years in a DCF?
Yes, sometimes it makes sense to use different Discount Rates.
For example, if a company is growing quickly right now, but is expected to grow more slowly in
the future, you might decrease the Discount Rate each year until the company reaches
maturity.
So, if the company’s current WACC is between 11% and 13%, and WACC for mature companies
in the industry is between 8% and 9%, you might start it at 12% and then reduce it by 0.4% in
each year of the explicit forecast period until it reaches 8.4% by the end.
It makes less sense to do this if the company is already mature and is not expected to change
much over time.
Return to Top.
DCF Analysis – Calculating the Terminal Value
Many guides and textbooks tend to focus on the basics of Terminal Value, such as the different
ways to calculate it.
But it’s more important to understand the trade-offs of the methods and how to use them to
cross-check your work, which is why most of the questions here go beyond the basics.

1. What is the difference between the explicit forecast period and the Terminal Period in a
DCF?
The company’s Free Cash Flow Growth Rate, and possibly its Discount Rate, change over time in
the explicit forecast period since the company is still growing and changing.
But in the Terminal Period, you assume that the company remains in a “steady state” forever:
Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.
2. What’s the intuition behind the Gordon Growth formula for Terminal Value?
The typical formula is:
Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal
FCF Growth Rate)
But it’s more intuitive to think of it as:
Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate)
A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF
Growth Rate is higher.
For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has
$100 in FCF in the first year of the Terminal Period.
You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the
Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay
$100 / 20%, or $500.
The company is worth more when you have worse investment options elsewhere, and worth
less when you have better investment options elsewhere.
Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay
$100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d
be willing to pay $100 / (10% – 5%), or $2,000, for it.
Higher growth lets you achieve the same targeted return even when you pay more.

3. If you use the Multiples Method to calculate Terminal Value, do you use the multiples from
the Public Comps or Precedent Transactions?
Neither one – you just use them as starting points in the analysis, and then you adjust once
you’ve calculated the Terminal FCF Growth Rates implied by the selected multiples.
It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years
into the future, because you don’t want to reflect the control premium inherent in Precedent
Transactions, at least not if you’re completing a standalone valuation of the company.
Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your
initial guess; if not, adjust it up or down as necessary.
4. How do you pick the Terminal Growth Rate when you calculate the Terminal Value using
the Gordon Growth Method?
This growth rate should be below the country’s long-term GDP growth rate and in-line with
other macroeconomic variables like the rate of inflation.
For example, if you’re in a developed country where the expected long-term GDP growth rate is
3.0%, you might use numbers ranging from 1.5% to 2.5% for the range of Terminal Growth
Rates.
You should NOT pick a rate above the country’s long-term GDP growth rate because the
company will become bigger than the economy as a whole after a certain point!
You can then check your work by calculating the Terminal Multiples implied by these growth
rates.
5. Why do you need to discount the Terminal Value back to its Present Value?
Because the Terminal Value represents the Present Value of the company’s cash flows from the
very end of the explicit forecast period into perpetuity. In other words, it represents the
company’s value IN a future period AT a point in the future.
Valuation tells you what a company is worth TODAY, so any “future value” must always be
discounted back to its Present Value.
If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Value
because you’d be acting as if its Year 6, 11, or 16 cash flows arrived next year.

6. When you discount the Terminal Value, why do you use the number of the last year in the
forecast period for the discount period (for example, 10 for a 10-year forecast)?
Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting
in Year 11?
No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but
it’s the Present Value as of the very end of Year 10.
You would use 11 for the discount period only if your explicit forecast period went to Year 11
and the Terminal Period started in Year 12.
7. What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?
If you’re building a Levered DCF analysis, you’re almost done because this summation gives you
the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity
Value by its diluted share count to get its Implied Share Price (if the company is public).
In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows equals the company’s
Implied Enterprise Value, so you have to “back into” the Implied Equity Value and then
calculate its Implied Share Price.
You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting
Liability and Equity items that represent other investor groups (Debt, Preferred Stock,
Noncontrolling Interests, etc.).
Then, you divide by the company’s diluted share count to get its Implied Share Price.
8. The diluted share count includes dilution from the company’s in-the-money options.
But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?
In theory, yes. Some professors, such as Damodaran, use Black-Scholes to value these out-of-
the-money options and then subtract them to determine the company’s Implied Equity Value.
In practice, banks rarely include out-of-the-money options in a DCF. These options tend to
make a small impact on most companies, and options valuation is tricky and requires inputs
that you may or may not have. So, it is usually not worth the time and effort.

9. How can you check whether or not your Terminal Value estimate is reasonable?
It’s an iterative process: You start by entering a range of assumptions for the Terminal Multiple
or Terminal FCF Growth Rate, and then you cross-check your assumptions by calculating the
Growth Rates or Multiples they imply.
If it seems wrong, then you adjust the range of Terminal Multiples or Terminal FCF Growth
Rates until you get more reasonable results.
Example: You start by picking 10x EV / EBITDA for the Terminal Multiple. At a Discount Rate of
12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high.
So, you reduce it to 6x EV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to
1%, which is too low.
So, you guess 8x EV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more
reasonable since it’s below the expected long-term GDP growth rate, but it’s also slightly above
the inflation rate.
This 8x figure might be your “Baseline Terminal Multiple,” so you would start there and go
slightly above and below it in the sensitivity tables.
10. What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?
The biggest issue is that EBITDA ignores CapEx. Two companies with similar EV / EBITDA
multiples might have very different Free Cash Flow and FCF growth figures. As a result, their
Implied Values might differ significantly even if they have similar EV / EBITDA multiples.
You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those
multiples create other issues, such as less comparability across peer companies.
This problem is one reason why the Gordon Growth Method is still the “real” way to calculate
Terminal Value.
11. Would it ever make sense to use a negative Terminal FCF Growth Rate?
Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its
key drug expires within the explicit forecast period, you might assume that the company’s cash
flows eventually decline to $0.

A negative Terminal FCF Growth Rate represents your expectation that the company will stop
generating cash flow eventually.
It doesn’t make the company “worthless”; it just means that the company will be worth less.
12. How can you determine which assumptions to analyze in sensitivity tables for a DCF?
The same assumptions make a big impact in any DCF: The Discount Rate, the Terminal FCF
Growth Rate or Terminal Multiple, and the revenue growth and margin figures.
It doesn’t make sense to sensitize much else – the assumptions for CapEx and Working Capital,
for example, tend to make a small difference.
There may also be industry-specific assumptions that are worth sensitizing, such as the patent
expiration dates for drugs in the biotech/pharmaceutical industry.
Return to Top.
DCF Analysis – More Advanced Features
You’re unlikely to get questions on these topics unless you have significant valuation-related
work experience.
The most important questions here relate to the mid-year convention and stub periods; the
math can be a bit tricky, so it helps to complete a few examples yourself.
1. Why do you use the mid-year convention in a DCF analysis?

You use it because a company’s cash flows do not arrive 100% at the end of each year – the
company generates cash flow throughout each year.
Using 1, 2, 3, 4 for the discount periods implies that the first year’s cash flow arrives after one
entire year has passed.
If you use 0.5, 1.5, 2.5, 3.5 instead, you assume that only half a year passes before the first cash
flow is generated, which is a better approximation of real life.
2. What impact does the mid-year convention make?

A DCF that uses the mid-year convention will produce higher Implied Values because the
discount periods are lower. A formula like this:
Present Value = $100 / ((1 + 10%) ^ Year#)
Will produce higher values because the Year # of the first period would be 1.0 without the mid-
year convention, but 0.5 with the mid-year convention.
3. Why might you include a “stub period” in a DCF, and what does it mean?
You might include a “stub period” if you’re valuing a company midway through the year, and it
has already reported some of its financial results for the year.
A DCF is based on expected future cash flow, so you should exclude these previously reported
results and adjust the discount periods as well.
For example, maybe it’s September 30th, and the company’s fiscal year ends on December 31st.
The company’s future cash flow for this year will be generated between September 30th and
December 31st.
Therefore, you should exclude the cash flow from January 1st to September 30th in your
projections since that part of the year has already passed.
So, for the first year in the analysis, you would include only the projected FCF from September
30th to December 31st. To discount the FCF in that 3-month period, you would use 0.25 for the
discount period because 3 months is 25% of the year.
You would then use 1.25 for the discount period of the next year, 2.25 for the year after that,
and so on.
4. You’re valuing a company on April 30th, and you want to include both the stub period and
the mid-year convention in your analysis.
How would you change the company’s Free Cash Flow, and which discount periods would you
use?
For the FCF, you would exclude everything generated between January 1st and April 30th and
include only the projected FCF to be generated between April 30th and December 31st.

Since most companies report only quarterly results, you would most likely exclude the first
quarter, not exactly the first 4 months.
To reflect both the stub period and the mid-year convention, you would divide the stub period
of the first year by 2. And then in each year after that, you would subtract 0.5 from the
“normal” discount period.
In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the “normal”
stub discount period is 0.67.
You would divide that by 2 to get 0.34. You would then use that 0.34 period to discount the
company’s FCF from April 30th to December 31st.
The “normal” discount period of the next year would be 0.67 + 1.00, or 1.67. So, you would take
the 1.67 and subtract 0.50 to get 1.17.
For the next year after that, the “normal” discount period is 0.67 + 2.00, or 2.67, so you would
subtract 0.50 to get 2.17. You would continue that for the rest of the years in the forecast.
5. Continuing with the same example, how would the Terminal Value and PV of Terminal
Value change with this April 30th valuation?
It depends on how you calculate the Terminal Value. With the Multiples Method, the Terminal
Value calculation stays the same since it’s based on the company’s EBITDA (or another metric)
in the final projected year times an appropriate multiple.
When you discount the Terminal Value, the stub period affects the discount period, but the
mid-year convention does not because the Terminal Value is as of the END of the last
projected year.
So, if the valuation date is April 30th, and there are 10 years in the projection period, you would
use 9.67 for the discount period to calculate the PV of the Terminal Value.
With the Gordon Growth Method, if you’re using the mid-year convention, you must adjust the
Terminal Value by multiplying it by (1 + Discount Rate) ^ 0.5.
You do this because the normal formula – FCF in Year 1 of Terminal Period / (Discount Rate –
Terminal Growth Rate) – gives you the Present Value at Year 10.5 if you’re using the mid-year
convention.
When you multiply by (1 + Discount Rate) ^ 0.5, you “move back the Terminal Value” to Year
10.0 instead.

Discounting the Terminal Value works the same way as it does with the Multiples Method: Only
the stub period affects it. So, you would also use 9.67 for the discount period.
6. Why do you need to adjust the Terminal Value when you use the mid-year convention?
Can’t you just discount it to Present Value using a different discount period?
Yes, you could discount the Terminal Value to its Present Value by using a different discount
period instead.
However, the Terminal Values calculated via both methods should be directly comparable.
In other words, BOTH Terminal Values should be as of the end of Year 10 in a 10-year analysis.
If you do not adjust the Terminal Value produced by the Gordon Growth Method, and you’re
using the mid-year convention, you cannot compare it to the Terminal Value produced by the
Multiples Method because one TV is as of Year 10.0, and the other is as of Year 10.5.
7. Why might you create a “Normalized Terminal Year” in a DCF?

You might create a Normalized Terminal Year if something about the company’s revenue
growth, margins, Working Capital, or CapEx is expected to change in a major way in the
Terminal Period.
As a result of this change, multiplying Final Year FCF by (1 + Terminal FCF Growth Rate) won’t
produce accurate results in the Terminal Value formula.
For example, a key drug patent might expire in Year 9 or 10, or the company might have a huge
Intangibles balance that gets completely amortized in Year 10.
The first scenario would make a huge impact on the company’s revenue, growth rates, and
margins, and the second would affect the company’s margins and non-cash add-backs.
You use the FCF in this Normalized Year for the numerator in the Terminal Value calculation
rather than multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).
8. What impact does the Normalized Terminal Year make?

Technically, it could go either way, but in most cases, the Normalized Terminal Year will reduce
a company’s Implied Value because you often adjust down the company’s growth rates and

margins in this year (and remove non-cash adjustments that might have benefited the company
in previous periods).
Return to Top.
Factors That Affect a DCF Analysis
This section is short because much of it has been covered in the previous sections.
Interviewers like to ask these questions because they test whether or not you understand the
big picture.
Anyone can memorize a DCF walkthrough, but you can answer these questions only if you
understand the underlying concepts.
1. Which assumptions make the biggest impact on a DCF?

The Discount Rate and Terminal Value make the biggest impact on the DCF.
That’s because the Discount Rate affects the PV of everything and because the PV of the
Terminal Value often represents 50%+ of the company’s Implied Value.
The assumptions for revenue growth and operating margins also make a significant impact, but
less than the ones above. Other items, such as CapEx, Working Capital, and non-cash
adjustments, make a smaller impact.
2. Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value
company?
Assuming that both companies have the same capital structure percentages, Cost of Equity and
WACC should both be higher for the $500 million company.
All else being equal, smaller companies tend to offer higher potential returns and higher risk
than larger companies, which explains why Cost of Equity will be higher.
Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt
(and Preferred) also tends to be higher.
And since all the Costs tend to be higher for smaller companies, WACC must be higher,
assuming the same capital structure percentages.

3. Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from
9% to 10% make a bigger impact on a DCF?
The Discount Rate increase will make a bigger impact. Increasing revenue growth from 9% to
10% will barely impact FCF and Terminal Value, but the Discount Rate will affect the Present
Value of everything, and 9% vs. 10% is a significant difference.
4. Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase
the Discount Rate from 9% to 10%?
It’s harder to tell here. Doubling a company’s revenue growth could make a bigger impact than
changing the Discount Rate by 1%, but when the changes are this different, you’d have to run
the numbers to tell.
These operational changes make a bigger impact in longer projection periods than they do in
shorter ones, so you would see more of a difference in a 10-year DCF than a 5-year one.
5. Two companies produce identical total Free Cash Flows over a 10-year period, but
Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining
9 years. Company B generates the same amount of Free Cash Flow in every year.
Which company will have the higher Implied Value in a DCF?
This is a trick question because it depends on what you count toward the Implied Value. If it’s
just this series of cash flows, Company A will have the higher Implied Value because of the time
value of money: The cash flows arrive earlier, so they’re worth more.
However, Company B will almost certainly have a much higher Terminal Value because it has a
much higher FCF in Year 10.
So, if you count the PV of Terminal Value in the analysis, it’s a good bet that Company B will
have the higher Implied Value.
6. How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value
from a DCF?

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If
the company does not have Debt, or its targeted/optimal capital structure does not include
Debt, the tax rate doesn’t matter because there’s no tax benefit to interest paid on Debt.
If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt,
and WACC.
It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher
rate always reduces the after-tax cost.
But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is
less risky even to Equity investors. And if both of these are lower, WACC will also be lower.
However, the Implied Value from a DCF will also be lower because the higher tax rate reduces
FCF and the company’s Terminal Value. Those changes outweigh a lower WACC.
The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and WACC are all
higher, and the Implied Value is also higher.
Return to Top.
Public Comps and Precedent Transactions
This section is short because we covered many of these questions in the guide to Equity Value,
Enterprise Value, and Valuation Multiples.
Public Comps and Precedent Transactions relate to how you use valuation multiples in real life.
If you already understand what multiples mean and how to calculate them, you just need to
understand the execution to answer these questions.
1. Can you walk me through how you use Public Comps and Precedent Transactions in a
valuation?
First, you select the companies and transactions based on criteria such as industry, size, and
geography (and time for the transactions).
Then, you determine the appropriate metrics and multiples for each set – for example,
revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples – and
you calculate them for all the companies and transactions.

Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for
each valuation multiple in the set.
Finally, you apply these numbers to the financial metrics of the company you’re analyzing to
estimate its Implied Value.
For example, if the company you’re valuing has $100 million in LTM EBITDA, and the median
LTM EV / EBITDA multiple in a set of comparable companies is 7x, then the company’s implied
Enterprise Value is $700 million.
You then calculate its Implied Value for all the other multiples to get a range of possible values.
2. Why is it important to select Public Comps and Precedent Transactions that are similar?
Because the comparable companies and transactions should have similar Discount Rates and
Free Cash Flow figures.
Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate,
and Expected FCF Growth Rate.
If the companies in your set all have similar Discount Rates and Free Cash Flows, it’s easier to
conclude that one company trades at higher multiples because its expected growth rate is
higher.
If the companies do not have similar Discount Rates and Free Cash Flows, it’s harder to draw
meaningful conclusions.
3. How do you select Comparable Companies and Precedent Transactions?

You screen based on geography, industry, and size, and also time for Precedent Transactions.
Here are a few example screens:
• Comparable Company Screen: U.S.-based steel manufacturing companies with over

$500 million in revenue.
• Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA.
• Precedent Transaction Screen: Latin American M&A transactions over the past 3 years
involving consumer/retail sellers with over $1 billion USD in revenue.

• Precedent Transaction Screen: Australian M&A transactions over the past 2 years
involving infrastructure sellers with over $200 million AUD in revenue.
4. Are there any screens you should AVOID when selecting Comparable Companies and
Precedent Transactions?
You should avoid screening by both financial metrics and Equity Value or Enterprise Value.
For example, you should NOT use this screen: “Companies with revenue below $1 billion and
Enterprise Values above $2 billion.”
If you use that screen, you’re artificially constraining the multiples because EV / Revenue must
be above 2x for every company in the set.
5. Public Comps and Precedent Transactions seem similar. What are the main differences?
The idea is similar – you use Current valuation multiples from similar companies or deals to
value a company – but the execution is different.
Here are the differences for Precedent Transactions:
• Screening Criteria: In addition to industry, size, and geography, you also use time
because you only want transactions from the past few years. You might also use
Transaction Size, and you might use broader screening criteria in general.
• Metrics and Multiples: You focus on historical metrics and multiples, especially LTM
revenue and EBITDA as of the announcement date.
• Calculations: All the multiples are based on the purchase price as of the announcement
date of the deal.
• Output: The multiples produced tend to be higher than the multiples from Public Comps
because of the control premium. But the multiples also tend to span wider ranges
because deals can be done for many different reasons.

6. Can you walk me through the process of finding market and financial information for the
Public Comps?
You start by finding each company’s most recent annual and interim (quarterly or half-year)
filings. You calculate its diluted share count and Current Equity Value and Current Enterprise
Value based on the information there and its most recent Balance Sheet.
Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent
annual results, adding the results from the most recent partial period, and subtracting the
results from the same partial period the last year.
For the projected figures, you look in equity research or find consensus figures on Bloomberg.
And then you calculate all the multiples by dividing Current Equity Value or Current Enterprise
Value by the appropriate metric.
7. Can you walk me through the process of finding market and financial information for the
Precedent Transactions?
You find the acquired company’s filings from just before the deal was announced, and you
calculate the LTM financial metrics using those.
To calculate the company’s Transaction Equity Value and Enterprise Value, you use the
purchase price the acquirer paid, and you move from Equity Value to Enterprise Value in the
same way you usually do, using the company’s most recent Balance Sheet as of the
announcement date.
You calculate all the valuation multiples in the same way, using Transaction Equity Value or
Transaction Enterprise Value as appropriate.
8. How do you decide which metrics and multiples to use in these methodologies?
You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability-
based metrics and multiples. For example, you might use Revenue, EBITDA, and Net Income,
and the corresponding multiples: EV / Revenue, EV / EBITDA, and P / E.
You do this because you want to value a company in relation to how much it sells and to how
much it keeps of those sales.
Sometimes, you’ll drop the sales-based multiples and focus on profitability or cash flow-based
ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

9. Why do you look at BOTH historical and projected metrics and multiples in these
methodologies?
Historical metrics are useful because they’re based on what actually happened, but they can
also be deceptive if there were non-recurring items or if the company made acquisitions or
divestitures.
Projected metrics are useful because they assume the company will operate in a “steady state,”
without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because
they’re based on predictions of the future.
10. When you calculate forward multiples for the comparable companies, should you use
each company’s Current Equity Value or Current Enterprise Value, or should you project them
to get the Year 1 or Year 2 values?
No, you always use the Current Equity Value or Current Enterprise Value. NEVER “project”
either one.
A company’s share price, and, therefore, both of these metrics, is based on past performance
and future expectations.
So, to “project” these metrics, you’d have to jump into the future and see what future
expectations are at that point, which doesn’t make sense.
11. What should you do if some companies in your set of Public Comps have fiscal years that
end on June 30th and others have fiscal years that end on December 31st?
You have to “calendarize” by adjusting the companies’ fiscal years so that they match up.
For example, to make everything match a December 31st year-end date, you take each
company with a June 30th fiscal-year end and do the following:
• Start with the company’s full June 30th fiscal-year results.

• Add the June 30th – December 31st results from this year.
• Subtract the June 30th – December 31st results from the previous year.
Normally, you calendarize to match the fiscal year of the company you’re valuing.

But you might pick another date if, for example, all the comparable companies have December
31st fiscal years but your company’s ends on June 30th.
12. How do you interpret the Public Comps? What does it mean if the median multiples are
above or below the ones of the company you’re valuing?
The interpretation depends on how the growth rates and margins of your company compare to
those of the comparable companies.
Public Comps are most meaningful when the growth rates and margins are similar, but the
multiples are different. This could mean that the company you’re valuing is mispriced and that
there’s an opportunity to invest and make money.
For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15-
20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these
ranges.
However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable
companies all trade at multiples of 10x to 12x.
That could indicate that your company is undervalued since its multiples are lower, but its
growth rates, margins, industry, and size are all comparable.
If the growth rates and margins are very different, it’s harder to draw conclusions.
13. Is it valid to include both announced and closed deals in your set of Precedent
Transactions?
Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed
yet, the simple announcement of the deal reflects what one company believes another is worth.
Note that you base all the metrics and multiples on the financial information as of the
announcement dates.
14. Why do Precedent Transactions often result in more “random” data than Public Comps?
The problem is that the circumstances surrounding each deal might be very different.

For example, one company might have sold itself because it was distressed and about to enter
bankruptcy.
But another company might have sold itself because the acquirer desperately needed it and
was willing to pay a high price.
Some deals are competitive and include multiple acquirers bidding against each other, while
others are more targeted and do not involve competitive bidding.
All these factors mean that the multiples tend to vary widely, more so than the multiples for
Public Comps.
15. How do you factor in earn-outs and expected synergies in Precedent Transactions?
You generally don’t factor in expected synergies because they’re so speculative. If you do
include them, you might increase the sellers’ projected revenue or EBITDA figures so that the
valuation multiples end up being lower.
Opinions differ on earn-outs, but you could assume that they have a 50% chance of being paid
out, multiply the earn-out amounts by 50%, and add them to the purchase prices.
Other people ignore earn-outs or add the full earn-out amounts to the purchase prices.
16. Are there any rules about filtering out deals for less than 100% of companies or about
stock vs. cash deals in Precedent Transactions?
Ideally, your set of Precedent Transactions will include only 100% acquisition deals.
However, you may need to go beyond that and also include majority-stake deals (ones where
the acquirer buys more than 50% but less than 100% of the seller).
You can include those because the dynamics are similar, but you should not include minority-
stake deals because acquiring 10% or 20% of a company is quite different.
Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically
include all deals regardless of the form of consideration.
You may note whether each deal was cash, stock, or a mix of both.

17. If there’s a Precedent Transaction where the buyer acquired 80% of the seller, how do you
calculate the valuation multiples?
The multiples are always based on 100% of the seller’s value.
So, if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value
would be $500 million / 80% = $625 million. And then you would calculate the Purchase
Enterprise Value based on that figure plus the usual adjustments.
You would then calculate the valuation multiples based on those figures and the financial stats
for 100% of the seller.
18. Why do you use median multiples rather than average multiples or other percentiles?
Median multiples are better than average multiples because of outliers.
If there are 5 companies in your set, and the multiples are 8x, 10x, 9x, 8x, and 25x, you don’t
want the 25x multiple to push up the average when it’s clearly an outlier.
However, there’s no “rule” that you have to use the median rather than other percentiles, so
you could make an argument for using the 25th percentile or 75th percentile.
For example, you could argue that your company’s growth rates and margins are in-line with
those of companies in the 75th percentile of your set and that the 75th percentile multiples are,
therefore, most applicable to your company.
Return to Top.
Other Valuation Methodologies
These questions are unlikely to come up unless you have significant finance experience.
If they do come up, they’ll most likely be in the form of straightforward questions on how to set
up different analyses and the advantages and disadvantages of each one.
1. What is a Liquidation Valuation, and when is it useful and not so useful?

In a Liquidation Valuation, you value a company by determining the fair market values of all its
Assets, adding them up, and subtracting the fair market values of all its Liabilities.

It gives you the company’s Implied Equity Value because you’re valuing all the company’s
Assets rather than just its core-business Assets.
This methodology is useful for distressed companies because it tells you how much they might
be worth if they have to liquidate and shut down.
It’s less useful for healthy, growing companies because it tends to undervalue them greatly. A
growing company is worth a lot more than what’s on its Balance Sheet because of its future
growth potential.
2. How does a Dividend Discount Model (DDM) differ from a DCF?

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually
based on a percentage of Net Income. You then discount the Dividends to their Present Value
using the Cost of Equity and add them up.
To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E (or the
Gordon Growth Method), and then you discount it to its Present Value using the Cost of Equity.
You calculate the company’s Implied Equity Value at the end rather than its Implied Enterprise
Value, and you divide it by the diluted share count to get the company’s Implied Share Price.
The DDM is essential in some industries, such as commercial banks and insurance, useful for
other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so
useful for most others.
3. Why might you use an M&A Premiums analysis to value a company?

The M&A Premiums analysis applies only to public companies because you look at acquisitions
of similar public companies and calculate the “premium” each buyer paid for each seller.
For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00
per share, that represents a 25% premium.
You take the median for a set of transactions and then use that percentage to value your
company. If the median premium is 20%, and your company’s share price is $10.00, it’s worth
$12.00 per share.
This analysis is useful when Precedent Transactions give nonsensical results, and you want to
use something other than traditional multiples to value your company.

For example, if the Precedent Transactions were all done at EV / EBITDA multiples between 6x
and 8x, and your company is currently at trading at 10x EV / EBITDA, the results don’t make
sense: A public company can’t sell for less than its current multiples.
So, you could look at the M&A premiums instead. If the median premium is 25%, you might
apply that to your company’s share price and say that a buyer might have to pay that much to
do the deal.
4. How do you build a Future Share Price Analysis?

You take the median historical multiple from the Public Comps, often the P / E multiple, and
apply it to the future metric of the company you’re valuing (Net Income or EPS with the P / E
multiple).
You assume that in 1-2 years, the company will be trading at the median multiple the
comparable companies are currently trading at.
For example, if the median P / E is 15x, and the company’s Year 1 projected EPS is $1.00, you
could say the company’s expected “future share price” is 15 * $1.00 = $15.00.
Then, you discount this future share price to its Present Value by using a range of values for the
company’s Cost of Equity.
For Enterprise Value-based multiples, you back into the Implied Equity Value and Implied Share
Price in future years and then discount that share price to its Present Value.
5. What are the advantages and disadvantages of a Sum-of-the-Parts Valuation?

The Sum-of-the-Parts methodology, where you value each division of a company separately and
add them up to determine the company’s Implied Value, works well for conglomerates like
General Electric that have very different divisions.
The divisions operate in such different industries that it would be meaningless to value the
company as a whole – no other company would be truly comparable.
But Sum of the Parts also takes far more time and effort to set up because you have to find
comparable companies and transactions for each division, build a separate DCF for each
division, and so on.

Also, you may not have enough information to use it – companies sometimes don’t disclose
EBIT or CapEx by division, and they may not disclose the corporate overhead expenses that you
must factor in at the end of the analysis.
6. How do you set up an LBO valuation, and when is it useful?

You set up the LBO valuation by creating a leveraged buyout model where a private equity firm
acquires a company using Debt and Equity, holds it for several years, and then sells it for a
certain multiple of EBITDA.
Since most private equity firms target an internal rate of return (IRR) in a specific range, you
work backward and determine the maximum purchase price the PE firm can pay to achieve a
minimum IRR.
You use the “Goal Seek” function in Excel to do this, and you solve for the purchase price based
on constraints for the IRR, exit multiple, and Debt / Equity split.
This methodology is useful for setting a floor on the company’s valuation – you’re constraining
the price because of the IRR requirement.
It’s also useful for estimating what a private equity firm, rather than a normal company, might
be willing to pay for a company.
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Access the Rest of the IB Interview Guide

IB Interview Guide, Module 4: Valuation and DCF Analysis

Overview & Key Rules of Thumb

We’ve continually referenced this formula:

Key Rule #2: DCF – How to Project Free Cash Flow

And then on the Cash Flow Statement:

How to Make the Projections

2) Assume an Operating (EBIT) Margin or Project COGS and OpEx.

3) Calculate NOPAT (Net Operating Profit After Taxes).

4) Project Depreciation & Amortization and Possibly Other Non-Cash Adjustments.

5) Project the Change in Working Capital.

6) Project Capital Expenditures.

Capital Expenditures must be linked to the company’s sales growth.

7) Calculate Unlevered FCF.

You should also check:

Key Rule #3: DCF – Discount Rates and WACC

• WACC: It equals 10% * 80% + 20% * 6% * (1 – 40%) = 8.7%.

• Do you use the arithmetic or geometric mean?

2) Other mature companies in this industry have WACCs in a similar range.

Key Rule #4: DCF – Terminal Value

The Most Important Point: Cross-Check Your Work!

Based on these results, our assumptions seem reasonable.

Key Rule #5: How Different Factors Affect the DCF

• Will Cost of Equity be higher for a $500 million or $5 billion company?

• Will a 1% difference in revenue or a 1% difference in the Discount Rate make a greater

• How does a company’s WACC change as it uses more Debt?

And here’s the same annotated diagram we looked at previously:

Key Rule #6: DCF – More Advanced Points [OPTIONAL]

• What if a key patent expires for a pharmaceutical company in Year 9 or 10?

• In an Unlevered analysis, you’d have to reverse the partially-owned companies’ taxes,

• And most companies don’t disclose nearly enough information to do that.

3) Terminal Value with P / E or Equity Value-Based Multiples – You’re only considering

Key Rule #7: Comparable Public Companies (Public Comps)

“Valuation” refers to the discounted cash flow (DCF) analysis.

• Revenue, EV / Revenue, and Revenue Growth

4) Apply the Multiples to Your Company

Key Rule #8: Precedent Transactions (M&A Comps)

• Calculations of Metrics and Multiples: With Precedent Transactions, everything is based

Key Rule #9: Other Valuation Methodologies [OPTIONAL]

2) It tends to undervalue healthy, growing companies. If a company is distressed and

Here’s an example analysis:

The Dividend Discount Model (DDM)

Our conclusions here might be:

Key Rule #11: The Trade-Offs of Different Methodologies

Methodology Public Comps Precedent Transactions Discounted Cash Flow

And then for the more “exotic” methodologies:

The Purpose of Valuation

1. What’s the point of valuation? WHY do you value a company?

5. When is a DCF more useful than Public Comps or Precedent Transactions?

8. How do you value an apple tree?

DCF Analysis – Walking Through and Explaining It

1. Why do you build a DCF analysis to value a company?

2. Walk me through a DCF analysis.

3. How do you move from Revenue to Free Cash Flow in a DCF?

4. What does the Discount Rate mean?

3. You’re Double-Counting Items – If an income or expense line item is included in FCF,

8. How do you interpret the results of a DCF?

DCF Analysis – Calculating Free Cash Flow

• Net Interest Expense – Only available to Debt investors.