05. Valuation Flashcards

Question

What are three pit falls of the WACC method?

Answer 1

(1) Assumes a constant capital structure (2) Difficult to estimate an appropriate growth rate when calculating the TY value (3) In theory, DCF analysis is for valuing a firm’s projects. It is a stretch to argue that all the projects of the firm (i.e. the whole firm) should be valued the same way.

Answer 2

(1) Discount projected UFCF using the discount rate for an all-equity firm (rU or the unlevered equity discount rate as derived using CAPM) (2) Discount the debt tax shield separately. DTS = (T) (rD) (Total Debt for that Year) OR APV approximation = (APV w/o DTS) (T) (D/V) (3) Add the present value of the cash flows and the debt tax shield *Note: debt tax shield is the amount of money a company saves by not having to pay taxes on its debt

Answer 3

WACC incorporates the effects of interest tax shields into the discount rate. Typically calculated from actual data from the balance sheet and used for a company with a consistent capital structure over the period of the valuation. APV adds present value of financing effects to NPV assuming all-equity firm. Useful where costs of financing are complex and capital structure is changing. Use APV for LBOs. The primary shorting coming is that it is difficult to project the cost of financial distress

Answer 4

Basic shares represent the number of common shares that are outstanding today (or as of the reporting date). Fully diluted shares equals basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt. In calculating a company’s market value of equity (MVE) we always want to use diluted shares. Implicitly the market also uses diluted shares to value a company’s stock.

Answer 5

In some sense we don’t subtract cash. We are netting it against debt to get net debt. (1) Cash is considered a non-operating asset (2) Cash is already implicitly accounted for in the market cap (3) You can use that cash to pay off some of the debt, or pay yourself a dividend, effectively reducing the purchase price of a company * In an acquisition, the buyer absorbs the cash of the seller, so it effectively pays less for the company based on how large its cash balance is This method is not always accurate because when we subtract cash, to be precise, we should specify excess cash. However, we will typically make the assumption that a company’s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash.

Answer 6

When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books. In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial statements. But since the parent company does not own 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting the portion of the sub’s net income that the parent is not entitled to (the percentage that it does not own). The parent company’s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub’s book value of equity that the parent does NOT own. It is the balance sheet minority interest figure that we add in the Enterprise Value formula. Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDA from the parent company’s financial statements, these figures due to the accounting consolidation, will contain 100% of the sub’s sales or EBITDA, even though the parent does not own 100%. In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest). By doing this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric. One might ask, instead of adding minority interest to Enterprise Value, why don’t we just subtract the portion of sales or EBITDA that the parent does NOT own. In theory, this would indeed work and may in fact be more accurate. However, typically we do not have enough information about the sub to do such an adjustment (minority owned subs are rarely, if ever, public companies). Moreover, even if we had the financial information of the sub, this method is clearly more time consuming.

Answer 7

(1) Project free cash flow for a period of time (e.g. five years) UFCF = EBIT(1 – T) + D&A – Capex – Change in NWC *Note that this measure of free cash flow is unlevered or debt-free. This is because it does not include interest and is thus independent of debt and capital structure (2) Calculate appropriate discount rate, WACC WACC = (E/V)rE + (P/V)rP + (1 – T)(D/V)rD (3) Calculate TY Value – predict the value of the company/assets for the years beyond the projection period (e.g. 5 years) - Terminal Multiple method – more common; take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple; select appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a LTM basis - Gordon Growth (Perpetuity Growth) method – must choose a modest growth rate around average long-term GDP or inflation growth rate (~3%). TY Value = UFCF5(1 + g) / (r – g) (4) Discount cash flows and TY value back to year 0 using WACC – sum up the present value of the projected cash flows and the present value of the TY value to give us the NPV = DCF value = Enterprise Value * Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of Enterprise Value, not Equity Value.

Answer 8

It is the discount rate used in a DCF analysis to present value projected free cash flows and TY value. Conceptually, WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile. It reflects the risk of the whole company WACC reflects the cost of each type of capital (debt, equity and preferred stock) weighted by the respective percentage of each type of capital assumed for the company’s optimal capital structure. WACC = (E/V)rE + (1 – T)(D/V)rD + (P/V)rP * To estimate the cost of equity, we will typically use CAPM * To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies * To estimate the cost of preferred, we can analyze the dividend yields on preferred stock issued by similar companies

Answer 9

(1) Unstable or unpredictable cash flows (e.g. tech start-ups) (2) Debt and WC serve fundamentally different role (e.g. banks do not reinvest debt and working capital is a huge part of their balance sheets)

Answer 10

To calculate a company’s cost of equity, we typically use the Capital Asset Pricing Model. The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium. - rF (for a U.S. company) is generally considered to be yield on 10 or 20 year US Treasury Bond. - Beta should be levered and represents the riskiness (equivalently, expected return) of the company’s equity relative to the overall equity markets - Equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term (6-7%)

Answer 11

Beta is a measure of the riskiness or volatility of a stock relative to the market as a whole (e.g. S&P500, Wilshire 5000, etc). Beta is used in the capital asset pricing model (CAPM) for the purpose of calculating a company’s cost of equity. By definition the “market” has a Beta of one (1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky. Beta < 1: consumer staples, healthcare, utilities, tobacco, petroleum production Beta > 1: wireless networking, bio-tech, computer software, e-commerce, entertainment *Note that beta is calculated as the covariance between a stock’s return and the market return divided by the variance of the market return.

Answer 12

Stocks that have debt are somewhat riskier than stocks without debt because (1) Increases risk of bankruptcy (2) Ties up funds that could be used to grow the business (3) Reduces flexibility of management

Answer 13

Earnings before interest, taxes, depreciation and amortization. It is used as a proxy for a company’s cash flows. Although it is not useful for equity investing, EBITDA is the most important financial metric in debt investing. It is a good metric for comparing the performance of different firms because it strips out the effects of financing and accounting decisions.

Answer 14

In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate Beta. We typically get the appropriate Beta from our comparable companies (often the mean or median Beta). However before we can use this “industry” Beta we must first unlever the Beta of each of our comps. The Beta that we will get (say from Bloomberg or Barra) will be a levered Beta. Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other things being equal, stocks of companies that have debt are somewhat more risky that stocks of companies without debt (or that have less debt). This is because even a small amount of debt increases the risk of bankruptcy and also because any obligation to pay interest represents funds that cannot be used for running and growing the business. In other words, debt reduces the flexibility of management which makes owning equity in the company more risky. Now, in order to use the Betas of the comps to conclude an appropriate Beta for the company we are valuing, we must first strip out the impact of debt from the comps’ Betas (i.e. remove the financial effects of leverage). This is known as unlevering Beta. Unlevered beta shows you how much risk a firm’s equity has compared to the market. Comparing unlevered betas allows an investor to see how much risk he will be taking on by investing in a company’s equity. After unlevering the Betas, we can now use the appropriate “industry” Beta (e.g. the mean of the comps’ unlevered Betas) and relever it for the appropriate capital structure of the company being valued. After relevering, we can use the levered Beta in the CAPM formula to calculate cost of equity. *Example: when you have Company A that does not have a beta, you can find comparable Company B, take their levered beta, unlever it, and then relever it using Company A’s capital structure to find its beta

Answer 15

Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Debt/Equity))) Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Debt/Equity)))

Answer 16

In order to calculate an equity beta, you must perform a regression of the return of the stock vs the return of the market as a whole (e.g. S&P 500). Slope of the regression line is the equity beta.

Answer 17

EBIT(1 – T) + D&A – Capex – Change in NWC

Answer 18

(1) Terminal multiple method: assign a valuation multiple (e.g. TEV/EBITDA) to the final year’s projection (point at which company is stable) and use that as the TY value * Note that we typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months (LTM) basis (2) Perpetuity growth method: choose modest growth rate, usually around the long-term average inflation rate or GDP growth rate, in order to assume that the firm can grow at this rate infinitely. Use the perpetuity formula in order to come up with the value in that year. TY Value = FCF(1 + g) / (WACC – g) Other methods: stable perpetuity w/o growth (UFCF / WACC) liquidation value (i.e. fire-sale)

Answer 19

Almost always use terminal multiple method in banking because it is much easier to get appropriate data for exit multiples since they are based on comparable companies. Picking a long-term growth rate is sort of a shot in the dark. Might use Gordon growth method if you have no good comps or if you have reason to believe the multiples will change significantly in the industry several years down the road (e.g. industry is cyclical)

Answer 20

Public company will be priced higher due to the liquidity premium one would pay to be able to quickly and easily buy/sell the shares in the public markets. Another reason the public company would be priced higher would be the transparency the firm is required to have in order to be listed on a public exchange.

Answer 21

One example is gold. When the stock market goes up in value, the price of gold drops as people flee from the safe haven of gold. The opposite occurs when the stock market declines. Thus, there is a negative correlation.

Answer 22

Return that investors require for investing in stocks over investing in risk free securities such as a 10 year Treasury note. Premium = average market return (~12%) – RFR (~3.5%) = 8.5%

Answer 23

Debt is less expensive for two main reasons. First, interest on debt is tax deductible (i.e. the tax shield). Second, debt is senior to equity in a firm’s capital structure. That is, in a liquidation or bankruptcy, the debt holders get paid first before the equity holders receive anything. Note, debt being less expensive capital is the equivalent to saying the cost of debt is lower than the cost of equity.

Answer 24

By "money left on the table," bankers mean that the company could have successfully completed the offering at a higher price, and that the difference in valuation thus goes to initial investors rather than the company. Why this happens and when it will happen is not easy to predict from responses received from investors during roadshows. Moreover, if the stock rises a lot the first day it is good publicity for the firm. But in many ways it is money left on the table because the company could have sold the same stock in its initial public offering at a higher price. However, bankers must honestly value a company and its stock over the long-term, rather than simply trying to guess what the market will do. Even if a stock trades up significantly initially, a banker looking at the long-term would expect the stock to come down, as long as the market eventually correctly values it. Inventory: Assets: % of Sales Liabilities: % of COGS

Answer 25

NPV = Cash Flow * (1/(1+r))^N

Answer 26

CAGR = (Ending/Beginning)^(1/(Periods - 1) - 1

Answer 27

``` WACC = CE*E% + CD*(1-T)*D% CAPM = RFR + B*(Market Risk Premium) ```

Answer 28

CAPM was developed for US markets; however, it is presently the best known tool for calculating discount rates. While CAPM is not exact, it is a good framework for thinking about and analyzing discount rates outside of the US as markets are based on similar principles.

Answer 29

(1) Use local companies to value local companies (2) With cross border comparisons, consider different accounting rules, different interest rates (e.g. lower interest rates mean higher valuations and higher P/E), and different risk (e.g. emerging markets vs US) (3) Use local currency and translate at the end

Answer 30

Look at comparable apple trees and their values (relative valuation) Discount the apple tree’s cash flows (intrinsic valuation)

Answer 31

(1) Industry classification (2) Financial criteria (revenue, EBITDA, etc) (3) Geography * Precedent transactions are limited to last 3-4 years

Answer 32

First, you must ask what the cost of capital is. Assuming 10% cost of capital for simplicity, your return is (2.00 – 1.50) / 1.50 = 33% and in three year you would earn a return of (1.00 + 0.10)^3 = 33%. Thus, you would buy three years’ worth of tokens.

Answer 33

The inverse of TEV / EBITDA is a proxy for your return.

Answer 34

Restructuring – negotiate debt on more favorable terms (i.e. debt with lower interest rates) M&A – combined income and possible synergies Debt issuance – negative income from interest expense but positive income from interest revenue or organic growth Equity – positive income from interest revenue or organic growth

Answer 35

It is a measure of both a company's operational efficiency and its short-term financial health. The working capital ratio is calculated as: NWC = Current Assets – Current Liabilities Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory) If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. *Note: when considering an acquisition, we subtract cash because we assume it will be used to pay down debt and we subtract short-term debt because it is purchased as reflected in the transaction price

Answer 36

FCF decreases because you subtract the change in NWC in the calculation of FCF. Working capital is the net dollars that are tied up to run the business. Thus, as more cash is tied up (either in accounts receivable, inventory, etc), there will be less FCF generated

Answer 37

Make reasonable assumptions about the company’s projected cash flows for future years (~10 years) and then construct a DCF model of those cash flows using an appropriate rate. Alternatively, you could use other operating metrics to value the company. If you took a start-up with 50,000 subscribers, but no revenue, you could look at a similar website’s value per subscriber and apply that multiple to the website you are valuing

Answer 38

To value this company, you must use multiples or a precedent transaction analysis

Answer 39

Use CAPM to calculate the discount rate. rU = rF + bU(rM – rF)

Answer 40

It is a framework used to calculate the required / expected return on an investment or the cost of equity of a company. The formula is: rE = rF + bE (rM – rF) The equity beta is a measure of how volatile the stock is in relation to the market (which refers to a well-diversified index such as the S&P 500) *Note: CAPM takes into account the sensitivity to non-diversifiable risk, which is represented by beta and the expected market excess return

Answer 41

Levered free cash flows leads to equity value rather than enterprise value since the cash flow is only available to equity investors. (Debt investors have already been paid with interest payments). You must use the cost of equity rather than WACC because we are no concerned with debt or preferred stock.

Answer 42

Investors are anticipating extremely high future earnings due to their reach and growth trajectory and are less focused on presents revenues and margins. Investors believe that these companies will be able to tap into the earnings power of their millions of users in some way that they are not currently doing. Additionally, other companies are willing to pay astronomical premiums for a small equity stake

Answer 43

(1) Banks use debt differently than other companies and do not reinvest it into the business. Instead, they use it to create financial instruments. (2) Interest is a critical part of a bank’s business model and working capital takes up a huge part of its balance sheet so a DCF does not make much sense * More common valuation methodology is dividend discount model. Value of stock = dividend per share / (discount rate – dividend g)

Answer 44

“Does management think that the tooth fairy pays for capex?” He dislikes EBITDA because it excludes the often sizeable capex companies make and hides how much cash they are actually using to finance their operations. He argues that there is a big disparity between EBIT and EBITDA in capital-intensive industries.

Answer 45

A comparable set lists financial data, valuation metrics and ratio analyses on a set of comparable companies in an industry. It is used to value private companies or better understand how the market values a particular industry. Identify comparable companies using buiness and financial characteristics and then rank according to relevance (Tier I: Pure-play, Tier II: Relevant) * Business characteristics: industry, products, customers, geography * Financial characteristics: size, profitability, leverage

Answer 46

Process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis and comparison (1) Pros: good estimate for companies in the same sector (2) Cons: not taking company capital structure into account (debt vs. equity) * Most relevant multiple depends on the industry

Answer 47

(1) Earnings beat expectations. Company may have recently reported earnings well above wall street estimates, and its stock price subsequently rose (2) Competitive advantage. Company may have some sort of competitive advantage not reflected in its financials, such as a key patent or IP (3) Lawsuit. Company may have received a favorable ruling in a lawsuit (4) Market leader. Company may have greater market share than its competitors

Answer 48

PE multiples can be different in two countries even if all other factors are constant because of the difference in the way earnings are recorded. Additionally, market valuations in American markets tend to be higher than those in the UK.

Answer 49

It is rare. Sometimes large financial institutions with big cash balances have negative enterprise values. May also use for comparability of financial and non-financial institutes.

Answer 50

Use comparable companies and precedent transactions. Look at more creative multiples such as TEV / Unique Visitors Would NOT use far in the future DCF because cannot reasonably predict cash flows for a company that is not even making money. *Note: when you cannot reasonably predict cash flows, use other metrics

Answer 51

Because preferred stock holders provide capital to the firm and therefore, they have a claim to the company’s value. Preferred stock pays a fixed dividend and preferred stockholders have a higher claim to the company’s assets than equity holders. Preferred stock is more similar to debt than to common stock.

Answer 52

Significant mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.

Answer 53

It is hard to generalize. Both are highly dependent on the underlying assumptions. Generally, the multiple method will be more variable because exit multiples tend to span a wider range than possible long-term growth rates.

Answer 54

This is highly unusual. However, it could happen if a company had substantial hard assets, but the market was severely undervaluing it for a specific reason (e.g. earnings miss of cyclicality). In this case, a company’s comparable and precedent transactions would be low. If the assets were valued high enough, liquidation value might yield a higher value

Answer 55

For unlevered free cash flow, use enterprise value *Unlevered FCF excludes interest and thus represents money available to all shareholders and lenders For levered free cash flow, use equity value *Levered FCF already includes interest and the money is therefore only available to equity holders (i.e. debt investors have already been paid with the interest payments they received

Answer 56

Amount of money that a company saves by not having to pay taxes on its debt. DTS = (T)(rD)(D) - Main reason for the emergence of LBO shops; KKR borrowed money to buy RJR Nabisco at a price well above the market price - Since the company had no debt before the takeover and has historically had highly reliable cash flows, KKR was able to increase the company’s value through a financial restructuring and save on taxes through the use of interest payments on debt and its accompanying write-offs - Discount rate for DTS depends on which captures the risk associated with the DTS (reU or rD)

Answer 57

Discount as if an all-equity firm. rU = rF + bU (rM – rF)

Answer 58

There several different methods to value a company. Even if you use the most thorough and popular DCF method, WACC and APV make different assumptions about interest tax shields, which can lead to different valuations. This is the main reason why market valuations fluctuate

Answer 59

(1) Create your own projections and construct a separate case in your model (2) Modify projections downward to make them more conservative (3) Show sensitivity tables based on different growth rates and margins and show the values under the different assumptions

Answer 60

It is not possible to have a negative market value of equity because neither share price nor share count can be negative.

Answer 61

Cost of equity should be higher for the $500 million company because smaller companies are considered to be more risky and expected to outperform large companies in the stock market. WACC depends on the capital structure of each company. All else equal, the $500 million company will have a higher WACC.

Answer 62

If significantly more than 50% of the company’s enterprise value comes from its TY value, then your DCF model is probably too dependent on future assumptions.

Answer 63

A company with a large cash balance (e.g. financial institutes) or low market cap (e.g. company on brink of bankruptcy)

Answer 64

FCF is the amount of actual cash that could hypothetically be paid out to lenders and investors from the earnings of a company.

Answer 65

It depends. PE ratios are relative measurements. In order to know whether a PE ratio is high or low, we need to know the general PE ratios of comparable companies. Higher growth firms have higher PE ratios because their earnings will be low relative to their price, with the idea that the earnings will eventually grow more rapidly than the stock price

Answer 66

Basic Equity Value = $10 x 100 = $1,000 All options are in-the-money because the exercise price is below the current price. 10 new shares are created if exercised. The proceeds from the sale of options are $5 x 10 = $50. We can use this money to buy back $50/$10 = 5 of the newly created shares. Fully Diluted Shares = 100 + 10 – 5 = 105 Fully Diluted Equity Value = $10 x 105 = $1,050

Answer 67

A strategic buyer would typically pay more for a company because of their willingness to pay a premium to potentially gain the synergies of lowering costs, improving their existing business and/or revenue synergies. The financial buyer typically looks at the company purely in terms of returns on a standalone basis unless they have other companies in their portfolio that could significantly improve the operations of the target

Answer 68

??? Assume no interest and constant NWC because the companies are not growing. Tax rate is 50% Manufacturing: - Likely to have depreciation and capital expenditures - Beta is likely to be less than one, which leads to a lower cost of equity - Has tangible assets that can be used as collateral Consulting: - Not likely to have depreciation and capital expenditures - Beta is likely to be above one, which leads to a higher cost of equity - Majority of its assets are intangible (e.g. human capital)

Answer 69

TBU - FCF. Growth in FCF.

Answer 70

Technology – PEG Growth Industries (no earnings) – P / Sales Real Estate – P / FFO Financial Institutes – P / BV