Walk me through a DCF? (NEW) | Interview Answer

in almost every single investment banking interview you will get asked walk me through a DCF or tell me about the DCF now the good thing is most people do get this right but they give an incomplete answer so in this video I'm going to show you how to fully answer this question and give an answer that will impress your interviewer hi I'm NASA I started in MSN banking in 2013 and I've recruited and interviewed over a dozen candidates in investment banking there are two valuation approaches there is intrinsic valuation which is the DCF and then there is a relative valuation which is comparables analysis and precedent transactions which we've already gone through where the value of the company which you're valuing is dependent on either what similar companies are being valued at or what similar companies has already been valued at now you can think of it as the value of your house is dependent on the value of your neighbor's house now whereas intrinsic valuation the value of the company which you're valuing is dependent purely on its own ability to generate cash flow so think of it as the value of your house is purely dependent on its ability to generate or rent and we're going to encapsulate the future rent in one figure and that's the value which we're going to place only your house so simply put a DCF is discounting the future cash flow of a company and that's how we value a company and you can pretty much do a DCF in three steps step number one is projecting the free cash flows and you can have a projected out five years ten years ideally you want to stay as short as possible because then your formal accurate and how you project this out is by getting a bit EBIT is earnings before interest and tax once you have a bit you then tax adjusted because we live in a world where we have to pay taxes so a bit times one minus the tax rate you'll then take away capex because you have to pay in order to maintain the business you will then add back depreciation and because those are non-cash expenses and then you'll take away net changes to working capital once you have that you then project it out five years or ten years into the future and the rate at which you're going to grow this is going to be dependent on your growth revenue growth assumptions step number two we've already projected out five years of cash flows but we are going to assume that our company is going to be operating longer than five years and in fact it's going to operate forever so we have to encapsulate the cash flow of year six to infinity in one number and there are two approaches to this and this is known as a terminal value there is the multiples approach this is more widely used in investment banking this is where we're going to use an exit multiple multiplied by the EBIT de or ef5 so we get the FIV beta or EBIT or revenue and then we'll multiply it by an exit multiple this exam multiple we're going to get from equity of research reports so other investment bankers that I've already done this analysis for our company or a very similar company and once we multiply this X are multiple with the EBIT da that's going to be our terminal value now that's the first approach the second approach is going to be the golden growth method now here we're going to assume that our company is going to be growing forever and it's going to be growing at a very low single-digit either GDP rate or inflation rate of the company which operates any so we will get the free cash flow of year five and then we'll multiply by 1 plus at the birth rate and we'll divide that by the weighted average cost of capital - at the growth rate and that's the Gordon growth method as a quick side note in reality most investment bankers will just depend on the multiples method because one is quicker to calculate and second the Gordon growth method assumes that companies are going to be growing forever now there hasn't been a single company in human history that has gone on for longer than a couple hundred years so it's irrational to assume that a company is going to forever be growing now we still calculate both methods but we use the Gordon growth method as a sanity check as a of actually using in our analysis step 3 now that we've calculated the future cash flows of our company and the terminal value we now need to discount those back into present terms and we're going to use the weighted average cost of capital as our discounting rate so once we've calculated our weighted average cost of capital are you work were then going to use a simple formula of free cash flow over 1 plus the weighted average cost of capital ^ the period you're in so if you're in your 1 1 year to power of 2 and once we've calculated that will then do all of them and add them up and that's going to be the value of your DCF ie the enterprise value of this company and that's pretty much it now remember in the beginning I said most candidates give a correct answer but they give an incomplete answer and the reason is because they just stop here and they completely ignore two problems facing the DCF you're assuming that you're in January and when you discount the future cash flows you're going to be collecting it throughout the year so for example in year 1 when we calculated our first year cash flow and discounting it we're assuming we're currently in January and we have to the end of December to collect all of this money but what if it's July the 1st what if half of the year has already gone then can you still discount a full year's cash flow well no you can't so in that case you have to use a stub period a stub period is going to adjust for of the calendar ization or the time period of this cash flow so it's only going to be discounting half of this cash flow so instead of using ^ 1 we're going to be using the power of Northpoint 5 and then we're going to adjust for subsequent yes problem number 2 we're also assuming that we're going to be collecting this cash flow at the end of the year so we're going to be collecting this cash flow on December 31st of every single year but we know that businesses generate cash throughout the year so we have to use the mid yet discounting period so we're going to be incrementing our discounting period by 0.5 and if we use the stub period and the midea discounting period your DCF analysis is completely wrong because you're going to be inflating the value of the cash flows and now you're going to be getting a higher number than what you should be getting or low number some cases so it's really important that you understand how this works now every single investment banker has to do this in practice in the real world so when you're answering this question during your interviews and if you include the stub period and the mid-year discounting period you are going to impress your interviewer because 90% of candidates do not include this in their answer now how do you combine a stub period and a mid-year discounting period now that's far more easily explained by doing a large demonstration or an Excel model and if you like to see a real-life DCF module as well as other valuation methodologies in Excel then consider looking at our financial modeling course where we'll show you step by step what investment banking analyst an associate to do when they do these financial modeling processes and more importantly how do they interpret the results after you get asked what is a DCF or walk me through a DCF there are twenty to thirty very common follow-up questions which analysts and associates would typically get and if you're an intern from a finance background you can also get them some of these follow-up questions would be in a DCF do you use unlevered free cash flow or levered free cash flow and why what proportion of the DCF is attributable to terminal value typically in a DCF are you trying to find the enterprise value or the equity value why do we use the weighted average cost of capital and what is the formula behind it how do you unlevered beta and real elevator now there are around 20 to 30 of these very common DCF follow-up questions and if you ask you know more then have a look at our Investor mock interview guys for a full list of all of the questions you can get ask as well as the ideal answers and also be sure to check out our other videos where we go through other investment banking interview questions and break down how to answer it okay so if this video has helped you better understand how to walk DCF then be sure to like it and share it and as well as leave us a comment if there are any other questions which you have I always check and read the comment section so I'll be sure to apply to you if I don't apply to you in the comment section then our probably answers in the next video so be sure to check that out and as usual subscribe and press the Bell button to get notified for our future videos

Channel: High Finance Graduate

Views: 126,672

Rating: 4.9273763 out of 5

Keywords: Investment banking interviews, Investment banking interview questions, investment banking, investment banking answers, how to get into investment banking, what is a DCF, DCF, Walk me through a DCF, discounted cashflow analysis, tell me about the DCF, DCF interview question, DCF investment banking, investment banker, mergers and inquisitions, banking, breaking into wall street, interview questions, mergers and inquisitions interview, discounted cash flow analysis, dcf analysis

Id: 7o-1DcsT7xA

Length: 9min 18sec (558 seconds)

Published: Sun Jan 20 2019