Interview Question

Associate Analyst III Interview(Student Candidate)

Where do you get your assumptions from for DCF? Describe

  the process
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Interview Answer

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I was not ready for that question

Interview Candidate on Mar 6, 2013
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I would start out by understanding through due diligence process what the revenue/earnings drivers are for the business. I would then understand what kind of growth I'm expecting out of this company, depending on several industry and firm specific factors that would influence this growth, including market/product position/penetration, growth relative to industry, competitive advantage, stage of business cycle of product lines, core compentencies, competition, customers, bargaining power, etc.. Of course by this point I already know whether the company is a price taker/setter, and I would base the revenue growth on different economic scenarios that the price/volumes might undergo. I would assume historical pattern continuation in items that I cannot find in the company's own public documents (assuming I have no access to internal management) such as cap ex growth, days in in rec/pay/ inv turnover, etc in my forecasting of future cash flows. In calculating a discoutn rate I can take two approaches; the first approach would involve me using the WACC, which means I have to assume an unlevered equity Beta based on public data (if public company) or based on comparables (if private). Inherent in this method is the assumption that the capital structure of the firm will not change throughout my projection period because I will be using the same d/A, e/A ratios for my constant WACC which I used to discount my FCFs. Other assumptions in WACC include treasury/libor rate for risk free rate, S&P 500 past 5/10/30 year returns for market risk premium, Beta of Debt based on company's average debt rates. Another method would be to implement the stochastic DCF process by which I would use the Risk free rate to discount my FCFs to account for the time value of money, and I would accoutn for the company risks by discounting the revenue and cost line items (depending on business) using Monte Carlo simulation scenario analysis and probablities of each scenario taking place. The second process has the advantage of being a dynamic process and more rigorous process, while the first is easier to implement, and is less subject to subjectivity, so to speak.

Michael on Dec 21, 2013

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