DCF Valuation Practice Exam Questions
and Correct Answers
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.
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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.
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:
Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash
Flow
Growth Rate < Discount Rate
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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
