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Why even seasoned bankers get their DCF valuations wrong? We continue our series of how to answer DCF valuation questions in investment banking interviews. Caveat before we kick off - This technical post is meant for seasoned bankers or students who have taken our 8-week course only. In my 12 years of experience working with some of the leading investment banks such as Goldman Sachs and Barclays, I would probably be a billionaire by now if I got a nickel every time I saw a mistake in a financial model. A bit of an exaggeration but you get the point. So what are the most oft-repeated mistakes, I have seen bankers and analyst make when it comes to valuing businesses using DCF? Terminal Value (TV) Calculating FCFF Computing FCFF growth rates Not using SOTP when a straight out DCF is not enough Cost of debt calculations The focus of this post is to discuss common errors found in Terminal Value calculation. To learn more on other mistakes made by bankers, make sure you follow me and subscribe to our valuation newsletter by sending your CV to firstname.lastname@example.org with subject "Valuations Newsletter" There are primarily two avenues to calculate TV in a DCF. Gordon growth method and Multiple approach using EV/FCFF. Almost everyone in the banking world tends to use the Gordon growth method which makes the model unstable - Why? Because all the underlying numbers from cost to debt to cost for equity leans on statistical numbers such as beta and historical risk premium over risk free rate. These numbers are second layer deductions from historical market data and fails to draw from direct valuations multiples. The smarter way to calculate TV is to use the current EV to FCFF multiple and slap it on the final year (end of the modelling period) FCFF. Obviously the analyst has the wiggle room to slap a 1x to 4x premium/discount on current multiples driven by a clear justification. Case in point being Microsoft. An analyst could suggest that he sees Microsoft taking market share from Google in the roughly $150bn search engine market space driven by the advent and nascent success of ChatGpt. More on that for a later post. So the key takeaway is ... The reason why EV To FCFF is more stable than Gordon growth method is that it uses current market multiples derived from real life market valuations rather than second layer statistical inferences.
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