1.What is DCF model. Explain in detail.

A discounted cash flow model ("DCF model") is a type of financial model that values a
company by forecasting its' cash flows and discounting the cash flows to arrive at a
current, present value. The DCF has the distinction of being both widely used in
academia and in practice. Valuing companies using the DCF is considered a core
skill for investment bankers, private equity, equity research and "buy side" investors.

STEPS TO BUILDING A DCF

The premise of the DCF model is that the value of a business is purely a function of its
future cash flows. Thus, the first challenge in building a DCF model is to define and
calculate the cash flows that a business generates. There are two common approaches
to calculating the cash flows that a business generates.
1. Unlevered DCF approach
Forecast and discount the operating cash flows. Then, when you have a present value,
just add any non-operating assets such as cash and subtract any financing related
liabilities such as debt.
2. Levered DCF approach
Forecast and discount the cash flows that remain available to equity shareholders
after cash flows to all non-equity claims (i.e. debt) have been removed.
Both should theoretically lead to the same value at the end (though in practice it's
actually pretty hard to get them to exactly equal). The unlevered DCF approach is the
most common and is thus the focus of this guide. This approach involves 6 steps:

1. Forecasting unlevered free cash flows

Step 1 is to forecast the cash flows a company generates from its core operations after
accounting for all operating expenses and investments. These cash flows are called
"unlevered free cash flows."

2. Calculating terminal value

You can't keep forecasting cash flows forever. At some point, you must make some high
level assumptions about cash flows beyond the final explicit forecast year by estimating a
lump-sum value of the business past its explicit forecast period. That lump sum is called
the "terminal value."
3. Discounting the cash flows to the present at the weighted average cost
of capital
The discount rate that reflects the riskiness of the unlevered free cash flows is called
the weighted average cost of capital. Because unlevered free cash flows represent all
operating cash flows, these cash flows “belong” to both the company’s lenders and
owners. As such, the risks of both providers of capital need to be accounted for using
appropriate capital structure weights (hence the term “weighted average” cost of capital).
Once discounted, the present value of all unlevered free cash flows is called the
enterprise value.

4. Add the value of non-operating assets to the present value of unlevered

free cash flows
If a company has any non-operating assets such as cash or has some investments just
sitting on the balance sheet, we must add them to the present value of unlevered free cash
flows. For example, if we calculate that the present value of Apple’s unlevered free cash
flows is $700 billion, but then we discover that Apple also has $200 billion in cash just
sitting around, we should add this cash.

5. Subtract debt and other non-equity claims

The ultimate goal of the DCF is to get at what belongs to the equity owners (equity
value). Therefore if a company has any lenders (or any other non-equity claims against
the business), we need to subtract this from the present value. What’s left over belongs to
the equity owners.

In our example, if Apple had $50 million in debt obligations at the valuation date, the
equity value would be calculated as:

$700 billion (enterprise value) + $200 billion (non-operating assets) - $50 (debt) = $850
billion

6. Divide the equity value by the shares outstanding

The equity value tells us what the total value to owners is. But what is the value of each
share? In order to calculate this, we divide the equity value by the company’s diluted
shares outstanding.
Now let’s break down each step into more detail.
Calculating the unlevered free cash flows (FCF)
Here is the unlevered free cash flow formula:

FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures

 EBIT = Earnings before interest and taxes. This represents a company’s GAAP-
based operating profit.
 Tax rate = The tax rate the company is expected to face. When forecasting taxes, we
usually use a company’s historical effective tax rate.
 D&A = depreciation and amortization.
  NWC = Annual changes in net working capital. Increases in NWC are cash outflows
while decreases are cash inflows.
 Capital expenditures represent cash investments the company must make in order
to sustain the forecast growth of the business. If you don’t factor in the cost of required
reinvestment into the business, you will overstate the value of the company by giving it
credit for EBIT growth without accounting for the investments required to achieve it.
Exhibit A – Advantages and Disadvantages

Advantages Disadvantages

 Theoretically, the DCF is arguably the soundest  The accuracy of the valuation determined using
method of valuation. the DCF method is highly dependent on the
The DCF method is forward-looking and quality of the assumptions regarding FCF, TV,
depends more future expectations rather than and discount rate. As a result, DCF valuations
historical results. are usually expressed as a range of values
 The DCF method is more inward-looking, rather than a single value by using a range of
relying on the fundamental expectations of the values for key inputs. It is also common to run
business or asset, and is influenced to a lesser the DCF analysis for different scenarios, such
extent by volatile external factors. as a base case, an optimistic case, and a
 The DCF analysis is focused on cash flow pessimistic case to gauge the sensitivity of the
generation and is less affected by accounting valuation to various operating assumptions.
practices and assumptions. While the inputs come from a variety of
 The DCF method allows expected (and different) sources, they must be viewed objectively in the
operating strategies to be factored into the aggregate before finalizing the DCF valuation.
valuation.  The TV often represents a large percentage of
 The DCF analysis also allows different the total DCF valuation. Valuation, in such
components of a business or synergies to be cases, is largely dependent on TV assumptions
valued separately. rather than operating assumptions for the
business or the asset.

2. What is Precedent Transaction Analysis. Explain.

Precedent transaction analysis is a valuation method in which the price paid for
similar companies in the past is considered an indicator of a company’s value.
Precedent transaction analysis creates an estimate of what a share of stock would be
worth in the case of an acquisition.
Also known as "M&A comps."

Limitations of Precedent Transaction Analysis

While this type of analysis benefits from using publicly available information, the
amount and quality of the information relating to transactions can sometimes be
limited. This can make drawing conclusions difficult. This difficulty can be
compounded when trying to account for differences in the market conditions during
previous transactions compared to the current market. For example, the number of
competitors may have changed or the previous market could have been in a different
part of the business cycle.

Steps to perform precedent transaction analysis:

1. Search for relevant transactions

The process begins by looking for other transactions that have happened in (ideally)
recent history and are in the same industry.

The screening process requires setting criteria such as:

● Industry classification
● Type of company (public, private, etc.)
● Financial metrics (revenue, EBITDA, net income)
● Geography (headquarters, revenue mix, customer mix, employees)
● Company size (revenue, employees, locations)
● Product mix (the more similar to the company in question the better)
● Type of buyer (private equity, strategic / competitor, public/private)
● Deal size (value)
● Valuation (multiple paid i.e. EV/Revenue, EV/EBITDA etc)
The above criteria can be set in a financial database such as Bloomberg or CapIQ and
exported to Excel for further analysis
2. Analyze and refine the available transactions

Once the initial screen has been performed and the data is transferred into Excel then
it’s time to start filtering out the transactions that don’t fit the current situation.

In order to sort and filter the transactions, an Analyst has to careful “scrub” the
transactions by carefully reading the business descriptions of the companies on the list
and removing any that aren’t a close enough fit.

3. Determine a range of valuation multiples

When a short list is prepared (following steps 1 and 2) the average (or selected range)
of valuation multiples can be calculated.

The most common multiples for precedent transaction analysis are EV/EBITDA and
EV/Revenue.

An Analyst may exclude any extreme outliers such as transactions that had
EV/EBITDA multiples much lower or much higher than the average (assuming there
is a good justification for doing so).

4. Apply the valuation multiples to the company in question

After a range of valuation multiples from past transaction has been determined, those
ratios can be applied to the financial metrics of the company in question.

For example, if the valuation range was:

 ● 5x EV/EBITDA (low)

● 0x EV/EBITDA (high)

And the company in question has

EBITDA of $150 million, The

valuation ranges for the business

would be:

● $675 million (low)

● $900 million (high)

5. Graph the results (with other methods) in a football field

Once a valuation range has been determined for the business that’s being valued it’s
important to graph the results so they can be easily understood and compared to other
methods.

The Football field chart is the best way to illustrate the various methods on one

page in a simple way. The main valuation methods included in the chart are:
● Comparable company analysis
● Precedent transactions analysis
● DCF analysis
● Ability-to-pay analysis
● 52-week hi/lo (if a public company)

3. Explain in detail the company comparable analysis.

Comparable company analysis is a valuation methodology that looks at ratios of similar

public companies and uses them to derive the value of another business. Comps is a relative
form of valuation, unlike a discounted cash flow (DCF) analysis, which is an intrinsic form of
valuation.

Steps in Performing Comparable Company Analysis

1. Find the right comparable companies
This is the first and probably the hardest (or most subjective) step in performing a ratio
analysis of public companies. The very first thing an analyst should do is look up the
company you are trying to value on CapIQ or Bloomberg so you can get a detailed
description and industry classification of the business.

The next step is to search either of those databases for companies that operate in the same
industry and that have similar characteristics. The closer the match, the better.

The analyst will run a screen based on criteria that include:

 1. Industry classification
2. Geography
3. Size (revenue, assets, employees)
4. Growth rate
5. Margins and profitability
2. Gather financial information
Once you’ve found the list of companies that you feel are most relevant to the company
you’re trying to value it’s time to gather their financial information.

Once again, you will probably be working with Bloomberg Terminal or Capital IQ and you
can easily use either of them to import financial information directly into Excel.

The information you need will vary widely by industry and the company’s stage in the
business lifecycle. For mature businesses, you will look at metrics like EBITDA and EPS, but
for earlier stage companies you may look at Gross Profit or Revenue.

If you don’t have access to an expensive tool like Bloomberg or Capital IQ you can manually
gather this information from annual and quarterly reports, but it will be much more time-
consuming.

3. Set up the comps table

In Excel, you now need to create a table that lists all the relevant information about the
companies you’re going to analyze.

The main information in comparable company analysis includes:

 Company name
 Share price
 Market capitalization
 Net debt
 Enterprise value
 Revenue
 EBITDA
 EPS
 Analyst estimates
4. Calculate the comparable ratios

With a combination of historical financials and analyst estimates populated in the comps
table, it’s time to start calculating the various ratios that will be used to value the company
in question.

The main ratios included in a comparable company analysis are:

 EV/Revenue
 EV/Gross Profit
 EV/EBITDA
  P/E
 P/NAV
 P/B
5. Use the multiples from the comparable companies to value the company in question

Analysts will typically take the average or median of the comparable companies’ multiples
and then apply them to the revenue, gross profit, EBITDA, net income, or whatever metrics
they included in the comps table.

In order to come up with a meaningful average, they often remove or exclude outliers and
continually massage the numbers until they seem relevant and realistic.

For example, if the average P/E ratio of the group of comparable companies is 12.5 times,
then the analyst will multiply the earnings of the company they are trying to value by 12.5
times to arrive at their equity value.

Formatting the Table

For a good financial analyst, formatting matters a lot! In the tables shown above, you can
see what type of formatting is recommended.

It’s important to clearly separate market data, financial data, and the multiples into
separate sections, so the reader can easily follow the information.

Multiples should have an “x” next to them (which we explain how to do in our free Excel
Crash Course) and should be to one decimal place.

The average or median section should be clearly separated at the bottom of the table and
indicate if any adjustments have been made.

Applications of Comparable Company Analysis

There are many uses for comps (or comparable companies analysis, or market multiples, or
whatever name you use for them). Typically performed by financial analysts and associates,
the most common uses include:

 Initial Public Offerings (IPOs)

 Follow-on offerings
 M&A advisory
 Fairness opinions
 Restructuring
 Share buybacks
 Terminal Value in a DCF model

Explain all the metrics that are used in Precedent Transaction Analysis & company comparable
analysis to value the business.
Metrics for Precedent Transaction Analysis (PTA) and Company Comparable
Analysis (CCA):

Both PTA and CCA are relative valuation methods, relying on comparisons to other
companies to estimate a target company's value. However, they look at different
data points:

1. PTA Metrics:

 Acquisition Multiples: These are ratios that reflect the price paid for a comparable
company relative to a key financial metric like revenue, EBITDA, or EBIT. Common
examples include:

o Enterprise Value (EV)/Revenue: Measures how much an acquirer paid for each
dollar of the target's revenue.
o EV/EBITDA: Reflects the price paid for each dollar of the target's operating cash
flow.
o EV/EBIT: Shows the price paid for each dollar of the target's operating profit.

 Transaction Premiums: The percentage amount an acquirer paid above the target's
pre-announcement stock price. This signifies the additional value recognized during
the acquisition.
 Deal Characteristics: Details like deal type (merger, acquisition, tender
offer), financing structure (cash, stock, or mix), and strategic rationale for the
acquisition can influence valuation.

2. CCA Metrics:

 Trading Multiples: Similar to acquisition multiples, but calculated using publicly traded
comparable companies' current market data.

o Price-to-Earnings Ratio (P/E): Compares the company's stock price to its earnings
per share.
o Price-to-Book Ratio (P/B): Compares the stock price to the company's net asset
value per share.

 Financial Ratios: Measures of profitability, solvency, and efficiency like EBITDA

margin, return on equity (ROE), and debt-to-equity ratio provide insights into the
company's financial health and performance.
 Growth Rates: Historical and projected growth in revenue, earnings, or other key
metrics can significantly impact the company's valuation.
What is sensitivity analysis and how it is used in financial modeling. Give one example.
What is Sensitivity Analysis?
Technically, Sensitivity Analysis is the practice that is used to depict the way changes in
certain independent variables impact the dependent variables of the financial model, under a
fixed set of assumptions. Sensitivity analysis is performed with the help of Data table in
excel. There are other options also such as Goal Seek and Scenario Manager, however for
this post we will limit our discussion to Data Table.

Let us take a small example and see how we perform Sensitivity Analysis on a two-variable
Data table. For two-variable data table we require two possible ranges of input for analyzing
a given output.

Example:

Let us take example of a company ABC, for which we have done a simple calculation for
Gross Profit. In this case, we will study the impact of annual revenue growth and COGS as a
% of revenue on the Gross-Profit. Which means we will judge the sensitivity of the Gross-
Profit based on the other two variables.

1. For a two-variable data table, we need to copy of the original formula of the gross
profit value at the intersection of the row and column input values.
2. Select the table range from G9:L15 and click on Data—–What if Analysis—-Data
Table
3. Click on E5 as the Row input cell ($E$5) and Click on E3 ($E$3) as Column input
cell. Then click OK.
4. The table gets populated with all the possible Gross Profit under any given
combination of y/y revenue growth and COGS as a % of revenue.

So, we see that through Sensitivity Analysis, we judge the impact of two independent
variables on a dependent variable. Conclusion of this analysis is that more the variation an
output value shows for a particular combination of variables, the more is its dependency on
those variables which means its sensitivity quotient is high at that level.

Importance of sensitivity analysis

1. Credibility– Future cannot be predicted; hence testing the financial model across a
given set of possibilities lends more credibility to the output. Moreover it also enhances
confidence amongst the users of the financial model.
 2. Flexibility-The premises on which a financial model is based are assumptions at
the end of the day. A sensitivity analysis shows a range of outputs which lends more
flexibility to the model.
3. Insights– A financial model can never be static. There has to be an element of
dynamism associated with it. Studying the interdependence of the independent variables
with few dependent variables helps one to draw insights on various scenarios. A
financial model is not just aimed at deriving an output, but empowering analysts to
scrutinize the circumstances and sharpen predictability skills.
4. Risk assessment-Analyzing the dependency of one variable on the other also helps
in assessing the underlying risk element. A significant change in the value of output, or
an increased degree of dependency indicates various levels of risk. A sensitivity analysis
can help the analyst to identify prospective risk factors and take steps to mitigate it.
5. Decision Making– A sensitivity analysis helps one to make informed choices. The
decision-makers use the model in understanding how responsive the output is to changes
in certain variables. This relation can help the analyst in deriving tangible conclusions
and be instrumental in taking optimal decisions.

Difference between Sensitivity Analysis and Scenario Analysis

Many a times, sensitivity analysis is confused with scenario analysis. While both of these
terms have similar connotation, there are basic difference at the principle level. While
sensitivity analysis studies responsiveness between two or more variables, scenario analysis,
on the other hand, studies changes due to a certain scenario. The scenarios in question can be
changes in industry regulations, fluctuations in the interest rate, economic boom and bust
phase etc. Under most of these circumstances, the outcome is measured under three possible
scenarios: Optimistic, Pessimistic and Realistic. The situation can also be judged by assigning
probabilities and drawing correlations.

A financial model is incomplete without Sensitivity Analysis

Sound analysis is one which focuses on the holistic picture rather than an isolated case. It
should not just depend on an output. Sensitivity analysis ensures that a model is stress-tested
against most of the possibilities. In fact it won’t be wrong to say that a financial model is
absolutely incomplete without a Sensitivity Analysis.

Explain different ratios used in financial modeling.

Ratio Analysis
Over the years, investors and analysts have developed numerous analytical tools, concepts
and techniques to compare the relative strengths and weaknesses of companies. These tools,
concepts and techniques form the basis of fundamental analysis.

Ratio analysis is a tool that was developed to perform quantitative analysis on numbers found
on financial statements. Ratios help link the three financial statements together and offer
figures that are comparable between companies and across industries and sectors. Ratio
analysis is one of the most widely used fundamental analysis techniques.
However, financial ratios vary across different industries and sectors and comparisons
between completely different types of companies are often not valid. In addition, it is
important to analyze trends in company ratios instead of solely emphasizing a single period’s
figures.

What is a ratio? It’s a mathematical expression relating one number to another, often
providing a relative comparison. Financial ratios are no different—they form a basis of
comparison between figures found on financial statements. As with all types of fundamental
analysis, it is often most useful to compare the financial ratios of a firm to those of other
companies.

Financial ratios fall into several categories. For the purpose of this analysis, the commonly
used ratios are grouped into four categories: activity, liquidity, solvency and profitability.
Also, for the sake of consistency, the data in the financial statements created for the prior
instalments of the Financial Statement Analysis series will be used to illustrate the
ratios. Table 1 shows the formulas with examples for each of the ratios discussed.

Activity Ratios
Activity ratios are used to measure how efficiently a company utilizes its assets. The ratios
provide investors with an idea of the overall operational performance of a firm.

1. Inventory turnover
Inventory turnover is calculated by dividing cost of goods sold by average inventory. A
higher turnover than the industry average means that inventory is sold at a faster rate,
signalling inventory management effectiveness. Additionally, a high inventory turnover rate
means less company resources are tied up in inventory.

2. Receivables turnover
The receivables turnover ratio is calculated by dividing net revenue by average receivables.
This ratio is a measure of how quickly and efficiently a company collects on its outstanding
bills. The receivables turnover indicates how many times per period the company collects and
turns into cash its customers’ accounts receivable.

3. Payables turnover
Payables turnover measures how quickly a company pays off the money owed to suppliers.
The ratio is calculated by dividing purchases (on credit) by average payables.

4. Asset turnover
Asset turnover measures how efficiently a company uses its total assets to generate revenues.
The formula to calculate this ratio is simply net revenues divided by average total assets.
A low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it
is operating in a capital-intensive environment. Additionally, it may point to a strategic
choice by management to use a more capital-intensive (as opposed to a more labor-intensive)
approach.
Liquidity Ratios
Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios.
They are especially important to creditors. These ratios measure a firm’s ability to meet its
short-term obligations.

The level of liquidity needed varies from industry to industry. Certain industries are more
cash-intensive than others. For example, grocery stores will need more cash to buy inventory
constantly than software firms, so the liquidity ratios of companies in these two industries are
not comparable to each other.

1. Current ratio
The current ratio measures a company’s current assets against its current liabilities. The
current ratio indicates if the company can pay off its short-term liabilities in an emergency by
liquidating its current assets. Current assets are found at the top of the balance sheet and
include line items such as cash and cash equivalents, accounts receivable and inventory,
among others.
2. Quick ratio
The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio
compares the cash, short-term marketable securities and accounts receivable to current
liabilities.

3. Cash ratio
The most conservative liquidity ratio is the cash ratio, which is calculated as simply cash and
short-term marketable securities divided by current liabilities. Cash and short-term
marketable securities represent the most liquid assets of a firm. Short-term marketable
securities include short-term highly liquid assets such as publicly traded stocks, bonds and
options held for less than one year.

Solvency Ratios
Solvency ratios measure a company’s ability to meet its longer-term obligations. Analysis of
solvency ratios provides insight on a company’s capital structure as well as the level of
financial leverage a firm is using.
Some solvency ratios allow investors to see whether a firm has adequate cash flows to
consistently pay interest payments and other fixed charges. If a company does not have
enough cash flows, the firm is most likely overburdened with debt and bondholders may
force the company into default.

1. Debt-to-assets ratio
The debt-to-assets ratio is the most basic solvency ratio, measuring the percentage of a
company’s total assets that is financed by debt. The ratio is calculated by dividing total
liabilities by total assets. A high number means the firm is using a larger amount of financial
leverage, which increases its financial risk in the form of fixed interest payments. In our
example in Table 1, total liabilities accounts for 72% of total assets.
2. Debt-to-capital ratio
The debt-to-capital ratio is very similar, measuring the amount of a company’s total capital
(liabilities plus equity) that is provided by debt (interesting bearing notes and short- and long-
term debt). Once again, a high ratio means high financial leverage and risk. Although
financial leverage creates additional financial risk by increased fixed interest payments, the
main benefit to using debt is that it does not dilute ownership.

3. Debt-to-equity ratio
The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the
amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses the same amount
of debt as equity and means that creditors have claim to all assets, leaving nothing for
shareholders in the event of a theoretical liquidation.

For our example, total debt used in the numerator includes short- and long-term interest-
bearing debt. This ratio can also be calculated using only long-term debt in the numerator.

4. Interest coverage ratio

The interest coverage ratio, also known as times interest earned, measures a company’s cash
flows generated compared to its interest payments. The ratio is calculated by dividing EBIT
(earnings before interest and taxes) by interest payments.

Profitability Ratios
Profitability ratios are arguably the most widely used ratios in investment analysis. These
ratios include the ubiquitous “margin” ratios, such as gross, operating and net profit margins.
These ratios measure the firm’s ability to earn an adequate return. When analyzing a
company’s margins, it is always prudent to compare them against those of the industry and its
close competitors.

1. Gross profit margin

Gross profit margin is simply gross income (revenue less cost of goods sold) divided by net
revenue. The ratio reflects pricing decisions and product costs. The 50% gross margin for the
company in our example shows that 50% of revenues generated by the firm are used to pay
for the cost of goods sold.

2. Operating profit margin

Operating profit margin is calculated by dividing operating income (gross income less
operating expenses) by net revenue. Operating expenses include costs such as administrative
overhead and other costs that cannot be attributed to single product units.
Operating margin examines the relationship between sales and management-controlled costs.
Increasing operating margin is generally seen as a good sign, but investors should simply be
looking for strong, consistent operating margins.

3. Net profit margin

Net profit margin compares a company’s net income to its net revenue. This ratio is
calculated by dividing net income, or a company’s bottom line, by net revenue. It measures a
firm’s ability to translate sales into earnings for shareholders. Once again, investors should
look for companies with strong and consistent net profit margins.
4. ROA and ROE
Two other profitability ratios are also widely used—return on assets (ROA) and return on
equity (ROE).
Return on assets is calculated as net income divided by total assets. It is a measure of how
efficiently a firm utilizes its assets. A high ratio means that the company is able to efficiently
generate earnings using its assets. As a variation, some analysts like to calculate return on
assets from pretax and pre-interest earnings using EBIT divided by total assets.