0.1) Core Concepts - IBC

Question 1

What are the three financial statements, why do we need them?

Answer 1

The three main financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.

The Income Statement shows the company’s revenue, expenses, and taxes over a period and ends with Net Income, which represents the company’s after-tax profits.

The Balance Sheet shows the company’s Assets – its resources – as well as how it paid for those resources – its Liabilities and Equity – at a specific point in time. A key thing in the Balance Sheet is that Assets must equal Liabilities plus Equity.

The Cash Flow Statement shows how a company’s cash position changes over a given period. It begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and then shows the company’s Cash Flow from Investing and Financing activities; the last lines show the net change in cash and the company’s ending cash balance.

You need the financial statements because there’s always a difference between the company’s Net Income and the real cash flow it generates, and the statements let you estimate the cash flow more accurately.

Question 2

How do the three financial statements link together?

Answer 2

To link the statements, you make Net Income from the Income Statement the top line of the Cash Flow Statement.

Then, you (i) adjust this Net Income number for non-cash items such as Depreciation & Amortization, and (ii) reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or reduce the company’s cash flow. This gets you to Cash Flow from Operations.

Next, include investing and financing activities, which may increase or reduce cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.

Cash at the bottom of the Cash Flow Statement becomes Cash on the Balance Sheet, and Net Income, Stock Issuances, Stock Repurchases, Stock-Based Compensation, and Dividends link into Common Shareholders’ Equity.

Next, link the separate line items on the Cash Flow Statement to their corresponding Balance Sheet line items; for example, CapEx and Depreciation link into Net PP&E.

When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow Statement, subtract Cash Flow Statement links; add them on the Liability and Equity side.
Finally, check that Assets equals Liabilities plus Equity at the end.

Question 3

Walk me from revenue to net income on the income statement

Answer 3

Sure! You start at the top with Revenue, which represents the total amount of sales generated by the company’s core business activities—basically, all the money brought in before any expenses are deducted.

Then, you subtract Cost of Goods Sold (COGS). COGS includes the direct costs of producing the products or services sold by the company, such as raw materials and labor costs. Once you subtract these direct costs from revenue, you’re left with Gross Profit, which shows how efficiently the company is producing and selling its goods.

Next, you have to account for Operating Expenses, which include things like Selling, General & Administrative (SG&A) expenses and Research & Development (R&D). These are the costs that keep the business running day-to-day, like employee salaries, marketing, and product development. After subtracting these, you get to EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a good measure of the company’s core profitability before accounting for non-operating factors.

Then, you subtract Depreciation & Amortization (D&A). This represents the reduction in value of the company’s long-term assets over time. It’s worth noting that D&A is often hidden within COGS or SG&A and not always shown separately, but it’s important because it reflects the cost of using the company’s assets. Subtracting D&A brings you to EBIT, or Operating Income, which shows how much profit the company is making from its operations before considering any financing costs.

Next, you subtract Interest Expense, which is the cost the company pays on any debt it has. After subtracting interest, you’re left with Pre-Tax Income (EBT), or what the company earns before taxes.

Finally, you subtract Taxes to get to the bottom line—Net Income. This is the company’s profit after all expenses, interest, and taxes have been accounted for. It’s the amount of money available to shareholders, representing the company’s true profitability

Question 4

How is the Balance Sheet structured?

Answer 4

The Balance Sheet is structured to show a snapshot of a company’s financial position at a specific point in time. It highlights what the company owns and how it has financed those resources. Specifically, it shows the company’s Assets, and how they’re financed through Liabilities and Equity. One key rule is that Assets must always equal Liabilities plus Equity.

First, let’s break down Assets. These are the company’s resources that are expected to provide future benefits, like generating additional cash flow. For example, Accounts Receivable would be considered an asset because it represents money owed to the company that will be collected in the future. Assets are split into two categories: Current Assets, which are expected to be converted into cash or used up within a year (such as cash, inventory, and receivables), and Non-Current Assets, which are longer-term, like property, equipment, or long-term investments.

Next, we have Liabilities, which represent the company’s obligations—essentially, what it owes. A common example is Accounts Payable, which refers to payments the company needs to make to suppliers. Similar to assets, liabilities are also split into Current Liabilities (those due within a year, like short-term debt or bills) and Non-Current Liabilities (those due in more than a year, such as long-term debt).

Finally, there’s Equity, which represents the residual interest in the company after liabilities are subtracted from assets. It reflects the owners’ or shareholders’ stake in the company. Equity line items could include common stock and retained earnings. It’s essentially what’s left over for shareholders if all liabilities were paid off.

In summary, the Balance Sheet always balances because the company’s assets must have been financed by either liabilities (borrowing) or equity (ownership).

Question 5

How is the Cash Flow Statement (CFS) structured?

Answer 5

The Cash Flow Statement (CFS) is designed to show how a company’s cash position changes over a given period. It’s divided into three main sections, each representing a different aspect of the company’s cash flow:

1. Cash Flow from Operations (CFO): This section starts with Net Income and adjusts for non-cash items like Depreciation and Amortization, as well as changes in operational balance sheet items such as Accounts Receivable or Accounts Payable. It essentially reflects the cash flow generated or consumed by the company’s core business operations during the period. This is a key section because it shows whether the company’s core operations are cash-generating or consuming.
2. Cash Flow from Investing (CFI): The second section covers cash flows related to investments in long-term assets. This includes items like purchases or sales of property, plant, and equipment (PP&E), as well as investments or acquisitions. Purchases show up as negative amounts because they represent an outflow of cash, while sales are positive as they bring in cash. This section tells you how much the company is investing in its long-term growth.
3. Cash Flow from Financing (CFF): The final section looks at cash flows related to the company’s financing activities. This includes issuing or repurchasing debt, paying dividends, or issuing or repurchasing shares. Financing activities are crucial because they show how the company is funding its operations, either by borrowing money or returning cash to shareholders.

In the end, the CFS combines these three sections to show the net change in cash during the period. It helps you understand how cash is flowing in and out of the business across different activities.

Question 6

What is Free Cash Flow (FCF)? What does it mean if Free Cash Flow is positive and increasing? What does it mean if Free Cash Flow is negative or decreasing?

Answer 6

There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations (CFO) minus CapEx. FCF represents a company’s “discretionary cash flow” – how much cash flow it generates from its core business after also paying for the cost of its funding sources, such as interest on Debt.

It’s defined this way because most items in CFO are required to run the business, while most of the CFI and CFF sections are optional or non-recurring (except for CapEx).

It’s generally a good sign if FCF is positive and increasing, as long as it’s driven by the company’s sales, market share, and margins growing (rather than creative cost-cutting or reduced reinvestment into the business). Positive and growing FCF means the company doesn’t need outside funding sources to stay afloat, and it could spend its cash flow in different ways: hiring more employees, re-investing in the business, acquiring other companies, or returning money to the shareholders with Dividends or Stock Repurchases.

You have to find out why FCF is negative or decreasing first. For example, if FCF is negative because CapEx in one year was unusually high, but it’s expected to return to normal levels in the future, negative FCF in one year doesn’t mean much. On the other hand, if FCF is negative because the company’s sales and operating income have been declining each year, then the business is in trouble. If FCF decreases to the point where the company runs low on Cash, it will have to raise Equity or Debt funding ASAP and restructure to continue operating. Short periods of negative FCF, such as for early-stage startups, are acceptable, but if a company continues to generate negative cash flow for years or decades, stay away!

Question 7

What are unlevered and levered free cash flows?

Answer 7

First, it’s important to understand that Free Cash Flow (FCF) is not the same as the change in cash from the Cash Flow Statement. In valuation, and during interviews, when we talk about free cash flow, we’re really referring to a company’s discretionary cash flow—that is, the cash flow left over after the company has paid what it needs to run its business and avoid being shut down by external parties like suppliers, lenders, and the government.

Companies are valued based on their free cash flow because it represents what’s available to reinvest, pay shareholders, or pay off debt. The typical valuation formula for this is:

Valuation = Free Cash Flow / (Discount Rate – Free Cash Flow Growth Rate).

Now, there are two main types of free cash flow: Unlevered and Levered.

1. Unlevered Free Cash Flow (UFCF): This represents the discretionary cash flow available to all investors in the company, including debtholders, preferred shareholders, and common shareholders. It’s calculated before any debt-related payments, so it gives a broader picture of the company’s ability to generate cash regardless of how it’s financed. UFCF is often used in valuation models (like DCF) because it shows the company’s cash-generating potential without considering capital structure.
2. Levered Free Cash Flow (LFCF): This is the discretionary cash flow available only to equity shareholders, after the company has paid its debts and met all financial obligations. It’s what’s left after interest payments and other required debt payments have been made. Therefore, it’s a narrower view of free cash flow, focusing on what’s available to shareholders after creditors have been paid

Question 8

How would you get to unlevered free cash flows from EBIT / EBITDA / Revenue?

Answer 8

[Unlevered FCF = NOPAT + D&A - Change in NWC – Capex
Abbreviations:

“NOPAT”: Net operating profit after tax

“NWC”: Net working capital

These are synonymous: NOPAT = EBIT * (1-tax rate) = “tax-effected EBIT”

Thus…

Unlevered FCF = EBIT * (1- tax rate) + D&A - Change in NWC - Capex

Unlevered FCF = (EBITDA - D&A) * (1-tax rate) + D&A - Change in NWC - Capex

Conceptually: Unlevered free cash flows are cash flows available to all investor groups]

To get to Unlevered Free Cash Flow (UFCF) from EBIT, EBITDA, or Revenue, you need to make a series of adjustments that reflect the cash flow available to all investors, before accounting for any debt payments.

Let’s break it down:

From EBIT:

EBIT stands for Earnings Before Interest and Taxes, so you’ll start by adjusting for taxes and non-cash expenses:

1. Tax Effected EBIT (NOPAT):
   First, you need to calculate Net Operating Profit After Tax (NOPAT). You do this by multiplying EBIT by (1 - tax rate).

NOPAT = EBIT * (1 - tax rate)

2. Add back Depreciation & Amortization (D&A):
   Since D&A is a non-cash expense, you add it back to NOPAT.
3. Adjust for Changes in Net Working Capital (NWC):
   If the company’s working capital (current assets minus current liabilities) changes, it affects cash flow. For example, if accounts receivable increases, cash flow decreases, so you need to subtract the change in NWC.
4. Subtract Capital Expenditures (CapEx):
   CapEx represents the company’s investments in long-term assets, so you subtract this amount.

Thus, the formula becomes:
Unlevered FCF = EBIT * (1 - tax rate) + D&A - Change in NWC - CapEx

From EBITDA:

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. To get to unlevered free cash flow from EBITDA, the process is similar, but you must adjust for D&A since it’s already included in EBITDA:

1. Subtract D&A:
   EBITDA includes D&A, so to calculate UFCF correctly, you need to subtract D&A.
2. Tax Effected (EBITDA - D&A):
   Once you have subtracted D&A, you apply the tax rate to get to NOPAT.
   NOPAT = (EBITDA - D&A) * (1 - tax rate)
3. Adjust for Changes in NWC and Subtract CapEx as you did with EBIT.

So, the formula becomes:
Unlevered FCF = (EBITDA - D&A) * (1 - tax rate) + D&A - Change in NWC - CapEx

From Revenue:

To get to unlevered free cash flow from Revenue, you need to move through the entire income statement and apply the same principles:

1. Start with Revenue and subtract Cost of Goods Sold (COGS) to get Gross Profit.
2. Subtract Operating Expenses (SG&A, R&D) to get EBITDA.
3. Follow the same process as outlined above for EBITDA:
   Unlevered FCF = (EBITDA - D&A) * (1 - tax rate) + D&A - Change in NWC - CapEx.

Conceptually, unlevered free cash flow represents the cash available to all investor groups, including debtholders, preferred shareholders, and equity holders, before accounting for interest payments and other debt-related items.

Question 9

How would you get from unlevered to levered free cash flows?

Answer 9

To get from Unlevered Free Cash Flow (UFCF) to Levered Free Cash Flow (LFCF), you need to account for the company’s financial obligations—specifically, the impact of debt. Levered Free Cash Flow represents the cash flow available to equity shareholders after the company has met all of its debt-related payments.

Here’s how you move from UFCF to LFCF:

1. Start with Unlevered Free Cash Flow (UFCF): UFCF represents the cash flow available to all investors, including both debtholders and shareholders, before debt payments.
2. Subtract Interest Expense: Since levered free cash flow is after debt payments, you need to subtract interest expense from the UFCF. Interest represents the cost of the company’s debt and needs to be paid before any cash flow is available to equity holders.
3. Subtract Mandatory Debt Repayments: If the company has mandatory principal debt repayments, those also need to be deducted from UFCF. These payments represent the amount the company is obligated to pay on its debt, which reduces the cash flow available to equity holders.

Thus, the formula becomes:

Levered FCF = Unlevered FCF - Interest Expense - Debt Repayments

In summary, Levered Free Cash Flow represents the cash that’s left over after the company has paid all of its financial obligations related to debt. This is the cash flow available to common shareholders, and it’s often used to evaluate equity value in valuation models. Levered FCF will be smaller than unlevered FCF because it reflects the company’s ability to generate cash flow after accounting for the burden of its debt.

Question 10

How would you get from Levered Free Cash Flow (LFCF) to Unlevered Free Cash Flow (UFCF)?

Answer 10

To get from Levered Free Cash Flow (LFCF) to Unlevered Free Cash Flow (UFCF), you essentially need to “add back” the effects of debt-related payments (interest and debt repayments) to account for the cash flow available to all investors, not just equity holders.

Here’s the process to go from Levered to Unlevered Free Cash Flow:

1. Start with Levered Free Cash Flow (LFCF): LFCF is the cash flow available to equity holders after all debt-related obligations (interest payments and debt repayments) have been made.
2. Add Back Interest Expense (after-tax): Since Unlevered Free Cash Flow is calculated before debt payments, you need to add back the interest expense, but in its after-tax form. This is because interest is tax-deductible, and its effect on free cash flow is reduced by the tax shield.

The formula for after-tax interest expense is:

Interest Expense * (1 - tax rate)

3. Add Back Principal Debt Repayments: Next, add back any mandatory principal debt repayments. These payments reduce levered free cash flow but are not subtracted when calculating unlevered free cash flow.

Thus, the formula becomes:

Unlevered FCF = Levered FCF + Interest Expense * (1 - tax rate) + Principal Debt Repayments

In summary, moving from Levered Free Cash Flow to Unlevered Free Cash Flow requires reversing the effects of the company’s debt payments. By adding back both interest and debt repayments, you arrive at the unlevered cash flow, which represents the cash flow available to all investors, not just equity holders.

Question 11

What do Equity Value and Enterprise Value MEAN? Why do you use both Equity Value and Enterprise Value? Isn’t Enterprise Value more accurate?

Answer 11

Equity Value (Eq. Val. or MEV) represents the value of EVERYTHING a company has (its Net Assets) but only to EQUITY INVESTORS (i.e., common shareholders).

Enterprise Value (EV or TEV) represents the value of the company’s CORE BUSINESS OPERATIONS (its Net Operating Assets) but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

Neither one is “better” or “more accurate” – they represent different concepts, and they’re important to different types of investors.

Enterprise Value and TEV-based multiples have some advantages because they are not affected by changes in the company’s capital structure as much as Equity Value and Eq Val-based multiples are affected.

However, in valuation, one methodology might produce Implied Enterprise Value, while another might produce Implied Equity Value, so you will need to move between them to analyze a company.

Finally, you use both of them because actions taken by one investor group affect all the other groups. If a company raises Debt, that also affects the risk and potential returns for common shareholders

Question 12

You’re about to buy a house using a $600K mortgage and a $200K down payment. What are the real-world analogies for Equity Value and Enterprise Value in this case?

Answer 12

The “Enterprise Value” here is the $800K total price of the house, and the “Equity Value” is the $200K down payment you’re making.

Question 13

Walk me from equity value to enterprise value.

Answer 13

Moving from equity value to enterprise value involves adjusting for all sources of financing and obligations, both debt and non-equity claims, to arrive at the true value of the company’s operations, independent of its capital structure.

The basic formula for Enterprise Value (EV) is:

Enterprise Value = Equity Value + Debt – Cash

Alternatively, you might see it expressed as:

Enterprise Value = Equity Value + Net Debt (where Net Debt = Debt – Cash)

Anything else?

There are additional components that need to be added. Besides net debt, you also add:

Enterprise Value = Equity Value + Net Debt + Preferred Stock + Non-Controlling Interest

• Preferred Stock is added because it represents another form of financing that is similar to debt in how it’s treated for valuation purposes.
• Non-Controlling Interest (or Minority Interest) is added because, when you consolidate financial statements, you have to reflect the value of a subsidiary that is not entirely owned by the parent company.

Anything else?

To further refine the calculation, you may also need to include adjustments for:

Enterprise Value = Equity Value + Net Debt + Preferred Stock + Non-Controlling Interest + Capital Leases - Equity Investments

o Capital Leases are considered similar to debt and need to be added because they are financial obligations.

o Equity Investments are subtracted because they represent investments in other companies, which do not directly contribute to the core operations of the company you’re valuing.

Question 14

What are some financial metrics and their most common multiples?

Answer 14

When we talk about valuation multiples, we’re essentially using a quick way to compare a company’s value to its financial performance. These multiples typically involve Enterprise Value (EV) or Equity Value in the numerator, divided by a financial metric in the denominator. Let’s go through some common financial metrics and their typical multiples.

1. Revenue:

One of the simplest multiples is Enterprise Value / Revenue. This is often used for companies that may not yet be profitable but are growing their top line. It compares the total value of the company to its sales.

2. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):

A more common multiple you’ll see is Enterprise Value / EBITDA. EBITDA is used because it strips out non-cash expenses like depreciation and amortization, and it focuses on core operational profitability. Since EBITDA is before interest, we use Enterprise Value here, as it captures the value available to all investors, including both debt and equity holders.

3. EBIT (Earnings Before Interest and Taxes):

Another multiple is Enterprise Value / EBIT. This one is similar to EBITDA, but EBIT includes depreciation and amortization, so it gives a more complete picture of the company’s operating performance after accounting for asset wear and tear. Again, this multiple is based on Enterprise Value since EBIT is before interest.

4. Net Income:

When it comes to Net Income, we shift to using the Price / Earnings (P/E) ratio. This multiple is based on Equity Value, meaning the share price, and tells you how much investors are willing to pay for each dollar of earnings. It’s commonly used for evaluating a company’s profitability from the perspective of shareholders.

Key Point:

• The dividing line between Enterprise Value multiples and Equity Value multiples is interest expense. Metrics above interest expense, like Revenue, EBITDA, and EBIT, use Enterprise Value multiples because they reflect the cash available to all investors—debt and equity holders.
• Metrics below interest expense, like Net Income, use Equity Value multiples, since they only represent the cash flow available to equity holders, i.e., the shareholders.

Question 15

What are the four major valuation methodologies?

Answer 15

Sure! The four major valuation methodologies are:

1. Discounted Cash Flow (DCF) Analysis:

DCF is an intrinsic valuation method. It values a company based on the present value of its future cash flows. You project the company’s free cash flows, then discount them back to today’s value using the company’s weighted average cost of capital (WACC). This method is very detailed and focuses on the company’s ability to generate cash in the future.

2. Trading Comparables (also called “Comps”):

This is a relative valuation method. Here, you compare the company to other similar publicly traded companies. You use valuation multiples, like EV/EBITDA or P/E, from those companies to value your company. For example, if comparable companies are trading at 10x EV/EBITDA, and your company has an EBITDA of $10, the relative valuation would be $100.

3. Precedent Transactions:

Similar to trading comparables, but instead of using current market values, you look at what acquirers have paid for similar companies in past transactions. For example, if previous deals in the same industry had buyers paying 15x EV/EBITDA, and your company has an EBITDA of $10, its value based on precedent transactions would be $150. This method helps to understand what buyers might be willing to pay.

4. Leveraged Buyout (LBO) Analysis:

This method is primarily used by financial sponsors, like private equity firms. In an LBO, the buyer purchases the company using a mix of debt and equity. The goal is to use the company’s cash flows to pay down the debt over time and eventually sell the company at a higher valuation to achieve a target internal rate of return (IRR). LBOs focus on the company’s ability to generate cash and pay off debt, typically over a 3-5 year period.

These are the four main approaches, each with its own use case. DCF focuses on the company’s cash-generating potential, while comps and precedent transactions look at how similar companies are valued in the market. LBO is more specific to leveraged transactions and focuses on how debt can be used to enhance returns.

Question 16

How would you order these valuation methods from highest to lowest?

Answer 16

While there’s no fixed ranking that always holds, we can generally make some assumptions about how these valuation methods stack up in terms of their results:

1. Precedent Transactions typically give the highest valuation because they often include a control premium. This premium reflects the fact that buyers are willing to pay extra for controlling interest in a company. A typical control premium might range from 20-30%, but in some industries like biotech, it can be much higher.
2. Trading Comparables come next. These depend heavily on current market conditions and reflect how similar companies are being valued right now. Since there’s no control premium involved, it tends to result in a lower valuation than precedent transactions.
3. DCF can vary significantly because it’s highly dependent on the assumptions you make—such as growth rates, discount rates, and future cash flow projections. Depending on those assumptions, the valuation could land higher or lower, but typically, DCF falls somewhere in the middle.
4. LBO Valuation usually provides the lowest valuation. This is because private equity firms look to acquire companies at a lower price to generate high returns. In an LBO, the valuation sets a floor since the sponsor doesn’t benefit from synergies the way a strategic buyer might. The focus is on using the company’s cash flows to pay down debt and eventually sell at a higher price, so the valuation starts conservatively.

This order isn’t set in stone—it can change depending on market conditions and the specific company being valued. But generally, Precedent Transactions will be at the top, and LBO valuations set the floor.

One key point to remember is that the timing of the analysis plays a crucial role in determining the order of these methods. Market conditions, industry trends, and specific transaction circumstances can all affect the results.

Question 17

What is a DCF / What are the key components of a DCF?

Answer 17

A Discounted Cash Flow (DCF) is an intrinsic valuation method that values a company based on its future cash flows. The idea is to forecast the company’s cash flows for a specific period (typically 5-10 years) and then discount them back to the present value using a discount rate, which reflects the company’s cost of capital.
There are three key components of a DCF:

1. Free Cash Flow Projections:
   You forecast the company’s free cash flows over the explicit period, usually 5 to 10 years. This represents the cash the company generates from its operations after accounting for necessary investments like CapEx.
2. Terminal Value:
   After the explicit forecast period, you calculate the company’s terminal value, which estimates the value of the company beyond the forecast period.
3. Discount Rate:
   Once you have the cash flows and terminal value, you discount them back to the present using the Weighted Average Cost of Capital (WACC). WACC represents the company’s cost of equity and debt, weighted based on its capital structure, and serves as the required rate of return for investors.

In the end, the DCF gives you the Enterprise Value of the company by summing the present value of the projected free cash flows and terminal value. To get to Equity Value, you subtract net debt from the enterprise value.

Question 18

What are the main methods used to project a company’s terminal value?

Answer 18

Projecting a company’s terminal value can be done using either the Gordon Growth Model (assuming perpetual growth at a constant rate, and discount it back to today’s value using WACC):

Terminal Value = FCF in the final year × (1 + growth rate), divided by (discount rate – growth rate).

or the Exit Multiple Method (applying a valuation multiple, like EV/EBITDA, to the final year of cash flows. Here, instead of assuming a perpetual growth rate, you base the company’s long-term value on how similar companies are valued in the market).

Terminal Value = EBITDA in the final year × the valuation multiple.

Question 19

What is the WACC of a company and what does it represent?

Answer 19

WACC, or Weighted Average Cost of Capital, is a formula used to calculate the overall cost of a company’s financing. It represents the return that investors expect when they invest proportionally in a company’s debt and equity. In other words, it’s the average rate the company has to pay to finance its operations, whether it’s through borrowing (debt) or raising money from shareholders (equity).

So the formula looks like this:

WACC = (after-tax cost of debt × % of debt) + (cost of equity × % of equity)

WACC is critical because it serves as the discount rate in a DCF analysis. It reflects the company’s risk and the returns required by both its debt and equity investors. The higher the WACC, the riskier the company is considered, and the higher the return investors will demand.

In short, WACC represents the company’s blended cost of capital and is used to evaluate whether investments or projects are likely to generate returns that exceed this cost.

Question 20

What is the CAPM formula and what does it represent?

Answer 20

CAPM, or the Capital Asset Pricing Model, is a formula used to calculate a company’s cost of equity. In other words, it tells you the return that shareholders expect to compensate for the risk of investing in the company.

The formula is:

CAPM = Risk-free rate + (Beta × Market Risk Premium)
Let’s break that down:

1. Risk-free rate:
   This is the return you could expect from an investment with zero risk. It’s typically based on the yield of a government bond, such as U.S. Treasuries or SOFR (Secured Overnight Financing Rate).
2. Beta:
   Beta measures the company’s systematic risk, or how much its stock moves relative to the broader market. If a company’s Beta is 1, it moves in line with the market. A Beta greater than 1 means the company’s stock is more volatile than the market, and less than 1 means it’s less volatile.
3. Market Risk Premium:
   This is the extra return that investors demand for taking on the risk of investing in equities over risk-free assets. It’s generally between 3-7% but can vary depending on the market conditions.

In theory, CAPM gives you the return that a company must generate to make investing in its equity worthwhile for shareholders, based on both the risk-free return and the additional risk of investing in the market.

In summary, CAPM captures the cost of equity by combining a risk-free return, the company’s risk relative to the market, and the premium investors expect for taking on market risk. It’s a key input in determining a company’s WACC in a DCF model.

Question 21

What does Beta represent?

Answer 21

Beta represents the volatility of a company’s stock or asset relative to the broader market. It’s essentially a measure of non-diversifiable, systematic risk—the kind of risk that can’t be eliminated by simply diversifying your investments.

A Beta of 1 means that the company’s stock moves exactly in line with the broader market. For example, if the market (like the S&P 500) goes up or down by 10%, a stock with a Beta of 1 would also move up or down by 10%.

If Beta is greater than 1, it indicates that the stock is more volatile than the market. So if the market moves by 10%, a stock with a Beta of 1.5 might move by 15%—in both directions, meaning more risk and potentially more reward.

On the other hand, a Beta less than 1 means the stock is less volatile than the market. So, a stock with a Beta of 0.8 would only move 8% for every 10% move in the market.

In summary, Beta tells you how sensitive a stock is to market movements, with higher Betas indicating more risk (and potentially more reward) and lower Betas indicating more stability.

Question 22

What are examples of assets/securities that might have a Beta of…?

Answer 22

Let’s look at examples of assets or securities based on their Beta values:

1. Exactly 1:

If an asset has a Beta of 1, it moves exactly in line with the broader market. A good example would be the S&P 500 itself, or an ETF that tracks the S&P 500. So, if the market goes up or down by 10%, this asset will move up or down by the same amount.

2. More than 1:

A Beta greater than 1 means the asset is more volatile than the market. High-growth tech stocks like NVIDIA (NVDA), Tesla (TSLA), or Wayfair (W) are examples. These stocks tend to swing more than the market—both up and down—because they carry more risk.

3. Less than 1 but greater than 0:

If an asset has a Beta between 0 and 1, it’s less volatile than the market but still moves in the same direction. Examples include consumer staples like Procter & Gamble (PG), utilities like AT&T (T), or food and beverage companies like Coca-Cola (KO). These companies tend to be stable and aren’t as affected by market swings since they produce “essentials.”

4. Exactly 0:

A Beta of 0 means the asset is completely uncorrelated with the market—its value isn’t impacted by market movements at all. Things like lottery tickets, art, or collectibles could fall into this category because their value depends on factors entirely outside of market trends.

5. Less than 0:

A Beta less than 0 indicates that the asset moves inversely to the market. Safe-haven assets like Treasuries or gold are typical examples. These assets often rise when the market is falling, as investors flock to them during times of uncertainty or market downturns.