400Qs: Accounting, EV, Valuation, DCF Flashcards
1
Q
A
2
Q
Walk me through the 3 financial statements
A
- 3 major financial statements are Income Statement, Balance Sheet and Cash Flow Statement
-
Income Statement
company’s revenue and expenses, and goes down to Net Income -
Balance Sheet
Assets (Cash, Inventory PP&E) and Liabilities (Debt, Accounts Payable and Shareholders’ Equity).
Assets must = Liabilities + Shareholders’ Equity
3.Cash Flow Statement
Begins with Net income, adjusts for non-cash expenses and working capital changes, then lists cash flow from investing and financing activities, then net change in cash
3
Q
Can you give examples of major line items on the Income Statement
A
Income Statement: Revenue, COGS, SG&A, Operating Income, Pretax income, Net Income
4
Q
Can you give examples of major line items on the Balance Sheet
A
Balance Sheet: Cash, Accounts Recievable/Payable, Inventory, PP&E, Accrued Expenses, Debt, Shareholders’ Equity
5
Q
Can you give examples of major line items on the Cash Flow Statement
A
Cash Flow Statement
Net Income, D&A, Stock-based Compensation, Changes in Operating Assets & Liabilities, Cash Flow from Operations, CapEX, Cash Flow from Investing, Sale/Purchase of Securities, Dividens Issued, Cash Flow from Financing.
3 main sections: operating activities, investing and finanicng activities.
Add the net cash flow from all 3 sections
6
Q
How do you calculate cash flow from operations
A
CFO = Net Income + Non-Cash Expenses + Changes in Working Capital
Non- cash expenses (e.g. D&A, Gain or Losses on Sale of Assets)
Working capital - difference between a company’s current assets and current liabilities.
7
Q
How does Working Capital impact cash flow
A
- Increase in Current Assets (e.g., Accounts Receivable, Inventory): An increase in current assets means the company has invested cash in these assets, reducing available cash.
- Decrease in Current Assets: A decrease implies that assets have been converted to cash, increasing available cash.
- Increase in Current Liabilities (e.g., Accounts Payable): An increase indicates that the company has delayed cash outflows, thus retaining cash.
- Decrease in Current Liabilities: A decrease implies that the company has paid off liabilities, reducing available cash.
8
Q
Describe examples of Current Assets
A
Cash and Cash Equivalents: Liquid assets that can be readily used for payments.
Accounts Receivable: Money owed by customers for goods or services already delivered.
Inventory: Goods available for sale or raw materials used in production.
Other Current Assets: Prepaid expenses, marketable securities, etc.
9
Q
Describe examples of Current Liabilities
A
Accounts Payable: Money owed to suppliers for goods or services received.
Short-term Debt: Loans and other borrowings due within one year.
Accrued Liabilities: Expenses incurred but not yet paid (e.g., wages, taxes).
Other Current Liabilities: Deferred revenue, etc.
10
Q
How do we calculate cash flow from investing activities
A
CFI = Proceeds from Asset Sales - CapEx + Proceeds from Investment Sales - Investment Purchases
Capital Expenditures (CapEx): Subtract cash spent on purchasing fixed assets.
Proceeds from Sale of Assets: Add cash received from selling fixed assets.
Purchases of Investments: Subtract cash spent on buying investments.
Proceeds from Sale of Investments: Add cash received from selling investments.
11
Q
How do you calculate Cash Flow from Financing
A
CFF= Cash from Debt/Equity Issuance - Debt Repayment - Dividend Payments - Stock Repurchasing
12
Q
How to calculate FCF
A
FCO - CapEx = FCF
13
Q
How to rationalise all the cash flow segments
A
Add them all together to get net change in cash flow
14
Q
Break down the main process of the income statement
A
- **Revenue - COGS = Gross Profit **
- Gross Profit - Operating Expenses = Operating Income
Operating Expenses = SG&A and D&A.
- EBT = Opeating Income + (Non-Operating Income - Non-Operating Expenses)
Non-Operating Income and Expenses=
* Interest Income, Interest Expense, Gains or Losses on Sale of Assets
- Net Income = EBT - Income Tax Expense
15
Q
How do the 3 financial statements link together
A
Net income, from the Income statement, flows onto Shareholder’s Equity on the Balance Sheet, and into the top line of the Cash Flow statement
Balance sheet changes –> working capital changes on cash flow
Investing and financing activities –> affect assets such as PP&E, Debt and Shareholder’s Equity
16
Q
How are the cash and shareholders’ equity items on the Balance Sheet a plug
A
As they are a placeholder to be adjusted according to the cash flowing in from the Cash Flow statement.
Since cash is a part of the assets on the balance sheet, the ending cash balance on the balance sheet should match the ending cash balance from the cash flow statement. adjustments are made to shareholders’ equity, particularly through retained earnings. The net income (or loss) for the period flows into retained earnings within shareholders’ equity.
17
Q
What are retained earnings
A
Retained earnings represent the cumulative amount of net income that has been retained in the company rather than distributed as dividends.
Ending retained earnings = beginning retained earnings + net income - dividens paid.
18
Q
How does net income affect shareholder’s equity
A
Net income –> retained earnings
retained earnings is a key part of shareholder’s equity
19
Q
What is shareholder’s equity made up of
A
Represents owners claim after (total assets - total liabilities).
- Common Stock - par value of issued shares.
- Additional Paid in Capital (APIC) - excess amount paid for shares
- Retained Earnings- cumulative amount of net income retained
- Treasury Stock - represents cost of shares repurchased, reduces shareholder’s equity
- Accumulated Other Comprehensive Income (AOCI) - other unrealised gains and losses not in net income
20
Q
If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?
A
1 thing you care about when analysing financial health
Cash Flow Statement
Gives true picture of cash generation independent of all the non-cash expenses.
21
Q
Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?
A
Income Statement and Balance Sheet as you can then create the Cash Flow statement from both
(assuming you have the before and after version of the Balance sheet that correspond to Income Statement time periods)
22
Q
Walk me through how depreciation going up by $10 would affect the statements
A
- Income Statement- Operating income declines by $10 and assuming a 40% tax rate, Net Income goes down by $6
- Cash Flow Statement- Net Income goes down by $6 but depreciation is a non-cash expense that gets added back so overallnet cash flow goes up by $4.
- Balance Sheet - PP&E goes down by $10 on assets and Cash is up by $4.
Thus assets are down by $6, since net income fell by $6 as well, SHareholder’s equity on the liabilities and shareholders side fell by $6 too.
23
Q
How should you approach the questions to do with the impact of changing a line item on statements
A
Always go in the order:
- Income Statement
- Cash Flow Statement
- Balance Sheet
Thus you can make sure the balance sheet balances.
24
Q
How do Asset or Liability changes affect cash flow
A
Asset going up decreases cash flow
Liability going up increases cash flow
25
If Depreciation is a non-cash expense, why does it not affect the cash balance
* Depreciation is a non-cash expense, so it is tax-deductible as taxes are a cash expense.
* Depreciation reduces to amount of taxes you pay.
26
Where does Depreciation usually show up on the Income Statement
Each company does it differently, could be:
1. COGS
2. Operating Expenses
End result is the same, depreciation always reduces pre-tax income
27
What happens when Accrued Compensation goes up by $10
Confirm that accrued compensation is now being recognised as an expense (rather than just changing non-accrued to accrued compensation)
1. **Income Statement**: operating expenses goe up by $10, Pre-Tax Income goes up by $10 and Net Income falls by $6 (assuming a 40% tax rate)
2. **Cash Flow Statement**: Net Income down by $6 and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations i up by $4 and the net change in cash is up by $4.
3. **Balance Sheet**: Cash is up by $4, so Assets are up by $4. Accrued compenisation is a liability so liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balanced.
28
What is accrued compensation
Wages, salaries, bonuses and other forms of compensation that employees have earned but not been paid.
Recongised as a current liability on balance sheet and an expense on the income statement.
29
What is inventory
a current asset that a business holds for resale or production. Types of inventory:
1. Raw Materials
2. Work-in-Progress (WIP).
3. Finished Goods
4. Maintenance, Repair and Operations (MRO) Inventory
30
What are common inventory valuation methods
**First-In, First-Out (FIFO):**
* Assumes that the oldest inventory items are sold first.
* In times of rising prices, FIFO results in lower cost of goods sold and higher ending inventory value.
**Last-In, First-Out (LIFO):**
* Assumes that the newest inventory items are sold first.
* In times of rising prices, LIFO results in higher cost of goods sold and lower ending inventory value.
**Weighted Average Cost:**
This method averages the cost of all inventory items available for sale during the period and uses this average cost to value ending inventory and cost of goods sold.
**Specific Identification:**
This method tracks the actual cost of each specific item of inventory. It is practical for businesses with unique, high-value items.
31
What happens when Inventory goes up by $10, assuming you pay for it with cash?
1. **Income Statement**: no change
2. **Cash Flow Statement**: Decreases Cash Flow from Operations by $10, as does the Net Change in Cash at the bottom.
3. **Balance Sheet**: Inventory goes up by $10 but Cash Flow down by $10 so the changes cancel out
32
Why is the income statement not affected by changes in Inventory
Working capital changes do not show up on the Income Statement
Expense only recorded when goods associared with it are sold --> goes to COGS or Operating Expenses
33
Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
At the start of 'Year 1':
1. **Income Statement**: no change
2. **Cash Flow Statement**: $100 reduction in cash flow from investing, $100 increase from debt raised. Net cash stays the same.
3. **Balance Sheet**: increase in $100 in PPE, increase in debt of $100. Cancel each other out.
34
35
Let’s say Apple is buying $100 worth of new iPod factories with debt. The debt is high-yield so no principal is paid off, and assume an interest rate of 10%.
Also assume the factories depreciate at a rate of 10% per year. What happens at the start of Year 2?
**Income Statement**: Operating Income reduce by $10 by D&A and $10 in Interest. W tax, Net income would fall by $12
**Cash Flow Statement**: Net income down by $12, add back D&A to have CFO down by $2.
**Balance Sheet**:Cash down by $2 and PPE down by $2 --> ASsets down by $12.
Net Income down by $12 --> Shareholder's Equity down by $12 and balance.
36
Let’s say Apple is buying $100 worth of new iPod factories with debt.
The debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year.
At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.
**Income Statement**: $80 write down on pre-tax income, 40% tax--> Net income declines by $48
**Cash Flow Statement**: Net Income down by $48 but non-cash expense so added back, CFO increases by $32. Loan payback decreases CFI by $100 --> Net Change in Cash is a fall of $68.
**Balance Sheet** - Cash down by $68, PPE down by $80 --> assets down by $148.
Debt down $100 and Net Income down $48 --> Liabilites and Shareholders Eq. down by $148 so balance.
37
Apple is ordering $10 of
additional iPod inventory, using cash on hand. They order the inventory, but they
have not manufactured or sold anything yet – what happens to the 3 statements?
**Income Statement**: no changes
**Cash Flow Statement**:
Inventory up by $10 --> CFO decreases by $10 --> overall cash reduces by $10
**Balance Sheet**: inventory up by $10 --> Cash down by $10 --> balance :)
38
Apple is ordering $10 of
additional iPod inventory, using cash on hand. They sell the iPOds for a revenue of $20. Walk me through the 3 statements under this scenario
**Income Statement**:
Revenue up by $20 and COGS up by $10 --> Gross Profit up by $10 --> w tax, Net Income up by $6
**Cash Flow Statement**:
Net income up $6 and Inventory decreased by $10 --> CFO up by $16
**Balance Sheet:**
Cash up by $16 and Inventory down by $10 vs Net Income up by $6 --> Balance.
39
Could you ever end up with negative shareholder's equity?
Yes;
1. LBO's with dividend recap: owner has taken out a large portion of equity, can turn number negative
2. Also if losing money --> declinign retained earnings --> negative shareholder's equity
40
What is working capital and how is it used.
Working Capital = Current Assets - Current Liabilities
+ve shows company can pay off its short-term liabilities with it's short term assets
Operating working capital more common in models: (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt)
41
What does negative working capital mean, is it a bad sign?
not necessarily, dependent on:
1. Companies with subscriptions --> high defferred revenues --> -ve working capital
2. Retail and Restaurants --> upfront payment --> increased cash and large accounts payable --> -ve working capital
3. Could also be financial trouble or possible bankruptcy
42
Walk me through what happens on the 3 statements when there’s a writedown of $100.
**Income Statement**:
$100 write-down on pre-tax Y --> 40% tax, Net Income declines by $60
**Cash Flow Statement**:
Net Income down by $60, but write down is a non-cash expense so added back --> CFO and net changes increases by $40
**Balance Sheet**
Cash is up by $40 and assets down by $100 --> Asset's down by $60
Net Income down by $60 --> Shareholder's Equity down by $60
43
Walk me through a $100 “bailout” of a company and how it affects the 3
statements.
Clarify the bailout; debt, equity, both? most common equity investment form gov.
**Income Statement** - No Change
**Cash Flow Statement**
CFF up $100 --> net change up $100
**Balance Sheet**
Cash up $100 --> Assets up $100
Shareholder's Equity up $100
44
Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a
company’s balance sheet and how it affects the 3 statements.
**Income Statement**
Written down liability --> pre-tax income goes up by $100 --> w tax, Net Income goes up by $60
**Cash Flow Statement**
Net Income up by $60 --> debt write-down of $100 --> CFO and Net Cash down by $40
**Balance Sheet**
Cash down $60 --> Assets down $60
Debt down $100, Net Income up $60 --> Shareholder's Equity up by $40
45
When would a company collect cash from a customer and not record it as revenue
Companies that agree to perform services in the future collect cash upfront:
1. Web-based subscription software
2. Cell phone carriers that sell annual contracts
3. Magazine publishers that sell subcriptions
per GAAP, only record revenue when you perform services
46
What’s the difference between accounts receivable and deferred revenue?
Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been.
Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.
47
What’s the difference between cash-based and accrual accounting?
* Cash based accounting recognises revenue and expenses when cash is **actually recieved**
* Accrual recognises revenue when collection is **resonably certain** and expenses when they are **incurred rather than paid out in cash**
most big companies use accrual due to credit card uses
48
If cash collected is not recorded as revenue, what happens to it?
Goes into Deferred Revenue on the Balance Sheet under Liabilities
As the services performed, Deferred Revenue balance 'turns into' real revenue on the Income Statement
49
How long does it usually take for a company to collect its accounts receivable balance?
Generally the accounts receivable days are in the 40-50 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transactionvalue companies.
50
How do you decide when to capitalize rather than expense a purchase?
If the asset has a useful life of over 1 year, it is capitalised.
51
Let’s say a customer pays for a TV with a credit card. What would this look like
under cash-based vs. accrual accounting?
**Cash-based accounting**:
Revenue would not show up until company charges the company card and deposits the funds in the bank account.
**Accrual Accounting**:
Show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” Cash.
52
What is capitalising rather than expensing a purchase
Expensing:
* Immediate impact on income statement
* Used for items with short-term benefits or low costs
Capitalising:
* Cost is recorded on the balance sheet as an asset and then depreciation/amortised over it's useful life
* Used for larger purchases that provide long term benefits
53
Why do companies report both GAAP and non-GAAP ("pro forma") earnings
Many companies have non-cash charges (A,Stock-based compensation, deferred revenue write down) in their income statements. GAAP underestimates the profitability of a company.
54
A company has had positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen?
Possibilities:
1. Company spent too much on CapEx; these are not reflected in EBITDA
2. High interest expensure
3. Debt matures and unable to refinance, losing all the cash
4. Singificant one-time charges that bankrupt the company
As EBITDA excludes investment (and depreciation) in long-term assets, interest and one-time charges
55
Normally Goodwill remains constant on the Balance Sheet – why would it be
impaired and what does Goodwill Impairment mean?
Happens when company is acquired and intangible assets (customers, brand, intellectual prop.) and values them much worse
Can also happen when a company discontinues part of its operations and must impair the associated goodwill
56
Under what circumstances would Goodwill increase?
1. Company is acquired, goodwill increases as a 'plug' for purchase price
2. Company acquires another company for more than it's assets worth, leading to net goodwill increase
57
How is GAAP accounting different from tax accounting
1. GAAP accrual-based but tax is cash-based
2. GAAP normally uses straight line depreciation whereas tax accounting uses accelerated depreciation
3. GAAP more accurately tracks assets/liabilities whereas tax accounting only concerned with revenue/expenses in the current period and what income tax you owe.
58
What are deferred tax assets/liabillities
Temporary difference between what a company can dedict with cash tax purposes vs what they can deduct for book tax purposes
59
When do deferred tax assets/liabilities arise
Deferred Tax Liabilities: when you have a tax expense on the Income Statement but haven't paid that tax in cash
Deferred Tax Assets: when you pay taxes in cash but haven't expensed them on the income statement
60
When do deferred tax assets/liabilities have to do M&A deals
most common with asset write-ups and write-downs in M&A deals
asset write-up --> produce a deferred tax liability
asset write-down --> produce a deferred tax asset
61
Walk me through how you create a revenue model for a company
Either bottoms up (more common and reliable) or tops-down builds:
1. **Bottom-Up**: Start with individual products/customers estimate the average sale value, and then the growth rate in sales
2. **Tops-Down**: Start with overall market size and then estimate company's market share to get revenue
62
Walk me through how you create an expense model for a company
Bottoms up:
no. of employees by department --> avg. salary, benefits, bonuses --> assume growth rates based on revenue or other
COGS tied to revenue
CapEX and misc. epenses are related to a company's internal plans for expansion
63
Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?
Use estimates:
* For revenue, assume a simple growth rate
* For expenses, assume major expenses e.g. SG&A are a % of revenue
64
Walk me through the major items in Shareholders’ Equity.
1. **Common Stock**: par value of issued stock
2. **Retained Earnings**: net income 'saved up' over time
3. **Additional Paid in Capital**: how much stock based compensation issues and new stock exercised by employee options (contra equity)
4. **Treasury Stock**: dollar amount of shares the company has bought back
5. **Accumulated other comprehensive income**: misc. income
65
Walk me through what flows into retained earnings
**Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued**
66
Walk me through what flows into Additional Paid-In Capial (APIC)
Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued
67
Formula for APIC (Additional Paid In Capital)
APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises
Take the balance from last year, add this year’s stock-based compensation number, and then add in the value of new stock created by employees exercising options this year
68
What is the Statement of Shareholders’ Equity and why do we use it?
Shows the major items that comprise Shareholder's Equity
You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations
69
What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?
* Restructuring Charges
* Goodwill Impairment
* Asset Write-Downs
* Bad Debt Expenses
* Legal Expenses
* Disaster Expenses
* Change in Accounting Procedures
To be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, **it needs to affect Operating Income on the Income Statement**
Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges.
70
How do you project Balance Sheet items like Accounts Recieveable and Accrued Expenses in a 3-statement model
Assumption as %:
* **Accounts Recieveable**: % of revenue
* **Deferred Revenue**: % of revenue
* **Accounts Payable**: % of COGS
* **Accrued Expenses**: % of operating expenses or SG&A
carry out same % into the future or assume slight changes
71
How should you project Depreciation and CapEx
Simple way: project each one as a % of revenye or previous PP&E balance
Complex:
* PP&E Schedule that splits out different assets by useful lives.
* Assume straight-line depreciation over useful life
* Assumes CapEx based on historical investment
72
How do Net Operating Losses (NOLs) affect a company's 3 statements (quick and dirty method)
'Quick and dirty' - reduce taxable income by the portion of NOLs useable this year --> apply same tax rate and subtract new tax from old pretax income
73
Whate are NOLs (Net Operating Losses)
Occurs when a company's tax-deductible expenses exceed its taxable revenues
Can use this loss to offset taxable income in other years. Can also be carried forward to future years to reduce taxes
74
How do Net Operating Losses (NOLs) affect a company's 3 statements
Create a book vs cash tax schedule --> calculate Taxable Income based on NOLs vs calculate taxable income without the NOLs
Then book the difference as an increase to deffered tax liability on the balance sheet.
75
What’s the difference between capital leases and operating leases?
Operating leases: short-term leasing of equipment and property, do not involve any ownership.
Capital leases: used for longer-term and give ownership rights --> they depreciate, incure interest and are counted as debt
76
What are the 4 conditions, that if any are true, a lease is a capital lease
1. transfer of ownership at the end of the term
2. option to purchase the asset at a bargain price at end of term
3. Term of lease is greater than 75% of the useful life of the asset
4. if PV of the lease payments is greater than 90% of the asset's fair market value
77
Why do we look at both Enterprise and Equity Value
Enterprise Value = value of company attributale to all investors
Equity value = portion avaliable to shareholders (equity investors)
78
When looking at an acquisition of a company do you pay more attention to enterprise or equity value
Enterprise Value, as it's how much an acquirer really 'pays' and includes the mandatory debt repayments
79
What is the formula for Enterprise Value
EV = Equity Value + Debt + Preferred Stock + Minority Interest - Cash
(formula not entire story and gets more complex)
80
Why do you need to add Minority Interest to Enterprise Value
Whenever a company owns over 50% of another company, it is required to report 100% of the financial performance of the other company as part of its own performance.
Hence you must add minority interest to EV to reflect the subsidiary
81
How do you calculate fully diluted shares
Basic share county + dilutive effect of stock options + other dilutive securities (e.g. warrants, convertible debt or convertible preferred stock)
To calculate dilutive effect of options you use the Treasury Stock Method
82
What is the dilutive effect of stock options
The dilutive effect of stock options refers to the reduction in the ownership percentage and earnings per share (EPS) for existing shareholders when new shares are issued as a result of employees or others exercising their stock options.
83
What are dilutive securities
Financial instruments that can be converted into common stock, increasing outstanding shares and diluting ownership
84
What are warrants
* Warrants are similar to stock options but issued directly by the company and have a longer duration.
85
# 1.
What is convertible debt
Type of bond/loan that can be converted into a predefined number of shares, at discretion of bondholder
86
What is convertible preferred stock
Type of preferred share that gives the holder the option to convert the preferred shares into a certain number of common shares (usually at a fixed ratio)
87
What is a restricted stock unit (RSU)
RSUs are company shares given to employees as part of their conversion package, subject to vesting conditions.
88
What are convertible bonds
Type of bond that can be converted into a predetermind number of common shares during the bond's life, at the bondholder's discretion
89
If a company has 100 shares outstanding, at a share price of $10 each.
Also has 10 options outstanding at an exercise price of $5 each - what is it fully diluted equity value
Basic Equity: 100 * $10= $1000
When options exercised share count increases from 100 --> 110
Company has additional cash of $50 (10 * $5), which is used to buy back 5 of the new shares
Share count goes from 110 --> 105. Fully diluted equity value is $1,050
90
Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each – what is its fully diluted equity value?
$1,000. In this case the options’ exercise price is above the current share price (out of the money), so they have no dilutive effect as they are not expected to be exercised.
91
What is **fully diluted equity**
Total equity of a company that would exist if all potential sources of equity were exercised or converted into common stock
92
Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?
The “official” reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it.
The way I think about it: In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to “pay” to acquire
another company.
It’s not always accurate because technically you should be subtracting only excess cash –
the amount of cash a company has above the minimum cash it requires to operate.
93
Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?
In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller’s debt, so it is accurate to say that any debt “adds” to the purchase price.
However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I’ve personally never seen it, but once again “never say never” applies.
94
Could a company have a negative Enterprise Value? What would that mean?
Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with:
1. Companies on the brink of bankruptcy.
2. Financial institutions, such as banks, that have large cash balances.
95
Could a company have a negative Equity Value? What would that mean?
No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.
96
Why do we add Preferred Stock to get to Enterprise Value?
Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock.
97
How do you account for convertible bonds in the Enterprise Value formula?
If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the convertibles as part of the company’s Debt.
98
A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?
convertible bonds are in-the-money because the company’s share price is $100 and conversion price is $50. So we count them as additional shares rather than debt.
divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to find no. of individual bonds:
$10 million / $1,000 = 10,000 convertible bonds.
figure out how many shares this number represents. The number of
shares per bond is the par value divided by the conversion price:
$1,000 / $50 = 20 shares per bond
.
So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding.
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Why is the Treasury Stock Method not used with convertible bond calculation with diluted shares outstanding
We do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us.
100
What's the difference between **Equity Value** and **Shareholders' Equity**
Equity value = Market value
Shareholders' Equity = Book value
Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be any value. For healthy companies, Equity Value usually far exceeds Shareholders’ Equity.
101
Are there any problems with the Enterprise Value formula (**EV= Equity Value - Cash + Debt + Preferred Stock + Minority Interest**) you just gave me?
Too simple, need to add:
1. **Net Operating Losses** - similar to cash
2. **Long-Term Investments** - similar to cash
3. **Equity Investments** - similar to cash, should be discounted
4. **Capital Leases** - also have interest payments so should be added in like debt
5. **(Some) Operating Leases** - sometimes need to convert operating leases to capital leases and add them as well
6. **Unfunded Pension Obligations** - counted as debt asw
Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Minority Interest **– NOLs – Investments + Capital Leases + Unfunded Pension Obligations**
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Should you use the book value or market value of each item when calculating Enterprise Value?
Technically, you should use market value for everything.
In practice, use market value only for the Equity Value portion, because it’s almost impossible to establish market values for the rest of the items in the formula.
103
What percentage dilution in Equity Value is “too high?”
anything over 10% is odd.
If your basic Equity Value is $100 million and the diluted Equity Value is $115 million, you might want to check your calculations – it’s not necessarily wrong, but over 10% dilution is unusual for most companies.
104
What are the 3 major valuation methodologies?
Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.
105
Rank the 3 valuation methodologies from highest to lowest expected value.
There is no ranking that always holds.
In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium
a DCF could go either way and it’s best to say that it’s more variable than
other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.
106
When would you not use a DCF in a Valuation
1. If the company has unstable or unpredictable cash flows (e.g. start ups)
2. When working capital and debt serve a fundamentally different role
(e.g. banks and financial institutions do not re-invest debt and working capital is a huge part of their balance sheet)
107
What other Valuation methodologies are there? Give 6
1. **Liquidation Valuation**: Selling company's assets at fair market value - liabilities = determine capital that equity investors recieve
2. **Replacement Value** – Valuing a company based on the cost of replacing its assets
3. **LBO Analysis** – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
4. **Sum of the Parts** – Valuing each division of a company separately and adding them together at the end
5. **M&A Premiums Analysis** – Find the acquisition premium to establish what your company is worth
6. **Future Share Price Analysis** – Projecting a company’s share price based on the P / E multiples of comps, then discounting it back to its PV
108
When would you use a liquidation valuation
Used to see wether equity shareholders will recieve any capital after debts have been paid off.
Advise struggling business on wether to sell off assets or entire company
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When would you use Sum of the Parts
Used in conglomerates with unrelated divisions as can't use same comps and precedents for diff divisions.
110
When do you use an LBO Analysis as part of your valuation
Used to establish purchase price a PE firm could pay, which is usually lower than what companies will pay
Often used as a 'floor' on a possible valuation
111
What are the most common multiples used in Valuation
EV/Revenue, EV/EBITDA, EV/EBIT, P/E , and P/BV (Share Price / Book Value per Share)
112
What are some examples of industry-specific multiples?
Technology (Internet): EV / Unique Visitors, EV / Pageviews
Retail / Airlines: EV / EBITDAR
Energy: EV / EBITDAX, EV / Daily Production, EV / Proved Reserve Quantities
Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations)
For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring,
so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.
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When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?
You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company.
The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.
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Would an LBO or DCF give a higher valuation?
Could go either way, but mostly LBO will give a lower valuation
This is as an LBO valuation only looks at the terminal value, while the DCF looks at both a company's cash flows throughout and it's terminal value.
(NOte: LBO gives a price for a given IRR rather than a valuation)
115
How would you present these Valuation methodlogies to a company or its investors?
Usually use a 'football field' chart where you show the valuation range
116
How would you value an apple tree?
The same way you would value a company:
1. looking at what comparable apple trees are worth (relative valuation)
2. the value of the apple tree’s cash flows (intrinsic valuation).
117
Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise
Value / EBITDA?
EBITDA is avaliable to all investors, like Enterprise Value
Equity Value/ EBITDA is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part avaliable to equity investors
118
When would a Liquidation Valuation produce the highest value?
highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason
As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.
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Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?
You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.
You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet.
This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!
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What would you use in conjunction with Free Cash Flow multiples – Equity Value
or Enterprise Value?
**Unlevered FCF-Enterprise Value**
**Levered FCF-Equity Value**
Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered already includes Interest and the money is therefore only available to equity investors.
Debt investors have already “been paid” with the interest payments they received
121
You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?
very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead.
MIght be used when using revenue multiples for non-financial institutions
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How do you select Comparable Companies / Precedent Transactions?
3 main ways:
1. Industry
2. Financial Criteria (Revenue, EBITDA, etc.)
3. Geography
For precedent, often only look at past 1-2 years.
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What do you actually use a valuation for?
Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation.
It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view.
Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.
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Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?
1. Beaten earnings expectation and stock price rose
2. Some type of competitive advantage not reflected in financials (e.g. key patent or intellectual property)
3. Won a favourable ruling in a major lawsuit
4. Market leader in industry and greater market share
125
What are the flaws with public company comparables
* Never 100% comparable
* Stock market 'emotional'
* Share prices for small companies with low vol. trading, may not reflect their full value
126
How do you take into account a company’s competitive advantage in a valuation?
1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company.
In practice you rarely do all of the above – these are just possibilities
127
Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions
Not necessarily, if:
Distressed company: use 25th percentile
Competitive adv. company: 75th percentile
128
You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?
When big mismatch between M&A and public market
e.g. no public companies has been acquired recently but there have been a lot of small private companies acquired at very low valuations.
129
What are some flaws with precedent transactions?
* Rarely 100% comparable - transaction structure, coompany size and market sentiment all have huge effects.
* Data on precedents is more difficult to find, especially for private small acquisitions
130
Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen?
1. One process more competitive
2. One company had recent bad news or depressed stock price
3. In different industries with different median multiples
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Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?
Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?”
He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations.
In some industries there is also a large gap between EBIT and EBITDA –anything that is very capital-intensive, for example, will show a big disparity
132
The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s
profitability. What’s the difference between them, and when do you use each one?
P/E depends on **capital structure**, whereas EV/EBIT and EV/EBITDA are **capital-structure netural**.
This ise P/E for banks, financial insts. and other companies where interest payments are critical.
EV/EBIT includes D&A whereas EV/EBITDA excludes it --> use EV/EBIT where D&A is large, EV/EBITDA when fixed assets are less important.
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Why is P/E influenced by capital structure, but EV/EBIT(DA) isn't
EPS in P/**E** is derived from net income which is effected by capital structure.
A higher debt causes the P/E to fall due to higher interest payments depressing net income and EPS
EV/EBITDA: EV incl. both equity and debt (balancing both), while EBITDA excludes interest expeneses.
134
If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same
dollar amounts and everything else is held constant.
You would pay more for the one where you lease the machines.
Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not
reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher
135
How do you value a private company?
Same methodlogy; public comps, precdents and DCF. Differences:
* Apply a 10-15% **discount** to public comp as private company not as liquid
Valuation shows **Enterprise Value** rather than the implied per-share price as with public companies
* DCF estimate WACC based on public comps
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Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?
no discount because with precedent transactions, you’re acquiring the entire
company – and once it’s acquired, the shares immediately become illiquid.
137
Can you use private companies as part of your valuation?
Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.
138
How do you value banks and financial institutions differently from other
companies?
Utilise diff. multiples for public comps and precdents:
* Screen based on assets or desposits
* ROE, ROA, BV and TBV rather than EBITDA
* Use multiples such as P/E, P/BV, and P/TBV rather than EV/EBITDA
Rather than a traditional DCF, use different methodologies for **intrinsic valuation**:
* **Dividend Discount Model (DDM)**: sum up the PV of a bank's dividends for the future and then addd it to terminal PV, based on a P/BV
* **Residual Income Model**: take current BV and add the PV of the excess returns to that BV to value it. "Excess return" each year is (ROE * Book Value) - (Cost of Equity * Book Value)
139
Walk me through an IPO valuation for a company that's about to go public
We only care about relevant multiples with **public company comparables** to estimate the enterprise value.
Work to Equity Value from Enterprise Value and also subtract IPO proceeds to get 'new' cash
Divide by total number of shares to egt new share price
If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.
140
I’m looking at financial data for a public company comparable, and it’s April (Q2)
right now. Walk me through how you would “calendarise” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.
The “formula” to calendarize financial statements is as follows:
TTM = Most Recent Fiscal Year + New Partial Period – Old Partial Period
e.g. take company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year.
141
Walk me through an M&A premiums analysis
Looking at similar transactions and seeing the premiums:
1. Screen precedents (industry, date and size)
2. Get the Seller's share price before announced transaction
3. Calculate the day premiums
4. Get medians for each set and apply to companys current share price
142
Walk me through a future share price analysis
Projectin companies share price and then discounting back to PV:
1. Get the median historical P/E of public comps
2. Apply multiple to company's 1/2yr forward to projected EPS to get its implied future share price.
3. DIcount back to PV using a discount rate in line with Cost of Equity
Norm do a sensitivity anlysis with a range of PE and discount rates
143
Both M&A premiums analysis and precedent transactions involve looking at previous M&A transactions. What’s the difference in how we select them?
* All sellers in the M&A premiums must be **public**
* Use a broader set of transactions for M&A premiums; +10 and less stringent.
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145
Walk me through a Sum-of-the-Parts analysis
Value each division of a company using separate comps and transactions, then add up each division's value to get the total for the company.
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How do you value Net Operating Losses and take them into account in a valuation
NOLs based on how much they'll save the company in taxes in future years and then the PV of the sum of tax savings.
1. Assume a company can use NOLs to completely offset taxable income until the NOLs run out
2. Im Acquisition scenario, use SEction 382, and multiply the adjusted long-term, published by the IRS, rate by the equity purchase price of the seller to determine the maximum allowed NOL useage in each year.
You might look at NOLs in a valuation but you rarely add them in – if you did, they would be similar to cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa
147
I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?
This varies by bank and group, but two common methods:
1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range
148
I have a set of precedent transactions but I’m missing information like EBITDA
for a lot of the companies – how can I find it if it’s not available via public sources?
1. Search online and see if you can find press releases or articles in the financial
press with these numbers.
2. Failing that, look in equity research for the buyer around the time of the
transaction and see if any of the analysts estimate the seller’s numbers.
3. Also look on online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates
149
How far back and forward do we usually go for public company comparable and
precedent transaction multiples?
Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years.
Public Comps: More likely to look backward and foward more.
Precedent transactions: odd to go forward more than 1 year because your information is more limited
150
I have one company with a 40% EBITDA margin trading at 8x EBITDA, and
another company with a 10% EBITDA margin trading at 16x EBITDA. What’s the problem with comparing these two valuations directly?
Misleading to compare companies with v diff margins. One with higher margin will usually have a lower multiple.
Consider screening based on margins.
151
Walk me through how we might value an oil & gas company and how it’s
different from a “standard” company
Public comps and precedents similar but:
* Might screen on metrics like Proved Reserves or Daily Production --> R/P (Proved Reserves/ Last Years Production), EBITDAX
Could also use unlevered DCf or NAV (Net Asset Value) Model.
ALso different accounting models may effect valuation.
152
Walk me through how we would value a REIT (Real Estate Investment Trust) and
how it differs from a “normal” company.
REITs asset intensive and dep. on cash generation of assets:
* Price/FFO per Share (Funds from Operations) and Price/AFFO (Adjusted FFO), which adds back Depreciation and substact gains on property sales
* Value properties through NOI/cap rate
* Replacement Valuation is more common because can estimate the cost of buying new land and building new properties
153
Walk me through a DCF
DCF values a company based on PV of its cash flows and PV of it's terminal value
FIrst project company's financials using assumptions for re. growth, expenses, working capital; then get down to free cash flow for each year, sum and discount to NPV based on WACC
Determine the company's Termial Value using Multiples or Gordon Growth, discount back to NPV using WACC
Add NPV of Terminal Value + NPV of Projected FCF
154
Walk me through how you get from revenue to free cash flow
Revenue - COGS - Operating Expenses = Operating Income (EBIT)
EBIT * (1-Tax Rate) = NOPAT (Net Operating Profit After Taxes)
NOPAT + Depreciation + non-cash charges + Net Working Capital -CapEx = Unlevered Free Cash Flow
Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You should confirm that this is what the interviewer is asking for.
155
WHy do you minus CapEx to get FCF
CapEx is a cash outflow necessary to both sustain and grow operations.
Hence for FCF to be truly 'free' it must have no CapEx charge
156
What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?
Cash Flow from Operations - CapEx = Levered Cash Flow
To get to Unlevered Cash Flow, you then need to add back the tax-adjusted
Interest Expense and subtract the tax-adjusted Interest Income.
157
What is Net Working Capital and how does it affect Free Cash Flow
NWC = Current Assets - Current Liabiliites
Increase in working capital indicates more cash is tied up in operating the business
Decrease in working capital means company is freeing up cash from operations.
158
Why do you use 5 or 10 years for DCF projection
That’s usually about as far as you can reasonably predict into the future.
Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.
159
What do you usually use for the discount rate?
Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF (e.g. LFCF)
160
How do you calculate WACC
Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) +
Cost of Preferred * (% Preferred)
Cost of Equity derived from the CAPM, others look at comparable companies
161
# 1.
When calculating the WACC why is the (Cost of debt * (Debt %)) multipled by (1-tax rate)
Interest is Tax-Deductible, creating a tax shield and an after-tax cost of debt.
After Tax Cost of Debt = Cost of Debt * (1- tax rate)
Ensure the WACC appropiately reflects after tax costs of all forms of capital
162
How do you calculate the Cost of Equity?
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
Pull equity risk premium from *Ibbotson's*
Can also include a size, industry and country premium to account for performance
163
How do you get to Beta in the Cost of Equity calculation?
1. Look up the Beta for each Comparable Company (usually on Bloomberg)
2. un-lever each one, take the median of the set and then lever it based on your company’s capital structure.
3. Then you use this Levered Beta in the Cost of Equity calculation
164
What is the formula for un-levering and levering Beta
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
165
# 1.
Why do you have to un-lever and re-lever Beta
'Apples-to-Apples' theme
Betas levered to reflect debt/equity mix of that company --> need to unlever and relever to reflect our company
166
Would you expect a manufacturing company or a technology company to have a higher Beta?
A technology company, because technology is viewed as a “riskier” industry than manufacturing.
167
Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash
Flow in your DCF – what is the effect?
Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).
168
169
170
171
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
use the Cost of Equity rather than WACC since we’re not concerned with Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise
Value.
172
How do you calculate the Terminal Value?
1. Apply exit multiple to Y5 EBITDA, EBIT or FCF
2. Gordon's Growth
Terminal Value = Y5 FCF * (1+Growth Rate)/(Discount Rate - Growth Rate)
173
Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?
Normally always use comps
Use Gordon Growth if no good comps or have reason to believe multiples will change sig.
If v. cyclical might use long-term growth rates rather than exit multiples.
174
What’s an appropriate growth rate to use when calculating the Terminal Value?
Normally you use the country’s long-term GDP growth rate, the rate of inflation, or something similarly conservative.
175
How do you select the appropriate exit multiple when calculating Terminal Value?
Look at comps and pick median
Show a range of exit multiples and Terminal Values over that range
176
Which method of calculating Terminal Value will give you a higher valuation?
Hard to generalise as dep. on assumptions
Multiples more variable than the Gordon Growth method, as multiples span a wider range than possible long-term growth rates.
177
What’s the flaw with basing terminal multiples on what public company
comparables are trading at?
median multiples may change greatly in the next 5-10 years
normally look at a wide range of multiples and do a sensitivity
Multiples is particularly problematic with cyclical industries (e.g. semiconductors).
178
How do you know if your DCF is too dependent on future assumptions?
The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions
In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.
But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…
179
Should Cost of Equity be higher for a $5 billion or $500 million market cap
company?
It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be “more risky”).
180
What about WACC – will it be higher for a $5 billion or $500 million company?
trick question because it depends on whether the capital structure
is the same for both companies.
If the capital structure is the same:
WACC should be higher for the $500
million company
If capital structure is not the same:
Could go either way depending on how much debt/preffered stock each one has and what the interest rates are.
181
How do you calculate the Cost of Debt
Weighted Average Interest Rate = Pre-Tax cost of debt
After Tax-Cost of Debt = Pre-Tax cost of debt * (1-Tax Rate)
182
What’s the relationship between debt and Cost of Equity?
More debt means that the company is more risky, so the company’s Levered Beta will be higher – all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity
183
Cost of Equity tells us what kind of return an equity investor can expect for
investing in a given company – but what about dividends? Shouldn’t we factor
dividend yield into the formula?
Trick Question.
Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include dividends
184
How can we calculate Cost of Equity WITHOUT using CAPM
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
Use when dividends are v important or lack info on beta or other variables in CAPM
185
Cost of Equity tells us what kind of return an equity investor can expect for
investing in a given company – but what about dividends? Shouldn’t we factor
dividend yield into the formula?
One without debt will have a higher WACC **up to a certain point** then it increases
First Phase debt is 'cheaper' as:
* Interest on debt is tax-deductible
* Debt is senior to equity in capital structure, so get paid first.
* Interest rates on debt are lower than Cost of Equity, so Cost of Debt portion of WACC will contribute less than the Cost of Equity portion
Once debt is high enough, IR rises dramatically --> Cost of Debt increases to higher than Cost of Equity and additional debt increases WACC
Creates U-Shape graph.
186
Which has a greater impact on a company’s DCF valuation – a 10% change in revenue or a 1% change in the discount rate?
You should start by saying, “it depends” but most of the time the 10% difference in revenue will have more of an impact.
That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.
187
What about a 1% change in revenue vs. a 1% change in the discount rate?
The discount rate is likely to have a bigger impact on the valuation, though
the correct answer should start with, “It could go either way, but most of the time…”
188
How do you calculate WACC for a private company?
estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.
189
What should you do if you don’t believe management’s projections for a DCF
model?
* Create your own projections.
* Modify management’s projections to make them more conservative.
* sensitivity table based on management and more conservative growth rates and margins
190
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently and do not re-invest it in the business; use it to create loans
Interest is a critical part of banks’ business models and changes in working capital can be much larger than a bank’s net income – so traditional measures of cash flow don’t tell you much.
For financial institutions, it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF
191
What types of sensitivity analyses would we look at in a DCF?
Example sensitivities:
* Revenue Growth vs. Terminal Multiple
* EBITDA Margin vs. Terminal Multiple
* Terminal Multiple vs. Discount Rate
* Long-Term Growth Rate vs. Discount Rate
192
# 1.
A company has a high debt load and is paying off a significant portion of its
principal each year. How do you account for this in a DCF?
Trick question.
You don’t account for this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but we only go down to Cash Flow from Operations and then subtract Capital Expenditures to get to Free Cash Flow.
If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off – but we still wouldn’t count the principal repayments themselves anywhere.
193
What is the mid-year convention
Adjustment to DCF that assumes cash flows are recieved evenly throughout the year --> thus can be treated as if recieved in the middle of the year
194
Explain why we would use the mid-year convention in a DCF.
You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year – instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on.
With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second
year, 2.5 for the third year, and so on
195
What is the stub period in the DCF
Stub period refers to a partial period at the start or end of the forecast timeline shorter than a full year.
196
What discount period numbers would I use for the mid-year convention if I have a stub period – e.g. Q4 of Year 1 – in my DCF?
197
How does the terminal value calculation change when we use the mid-year
convention?
1. **Multiples Method**
add 0.5 to the final year discoutn number, to reflect the fact the company gets sold at the end of the year.
2. **Gordon Growth Method**
no adjustment as assuming cash flows grow into prepetuity and recieved throughout the year
198
If im working with a public company in a DCF, how do i calculate its per-share value
Enterprise Value --> + Cash, - Debt,- Preferred Stock, - Minority interests (and other debt like items) = Equity Value
Use circular calculation that takes into account basic shares outstanding, options, warrants, convertibles, and other dilutive securities.
It’s circular because the dilution from these depends on the per-share price – but the per-share price depends on number of shares outstanding, which depends on the per-share price.
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200
201
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
Mechanically same as DCF but dividends rather than FCF:
1. Project out the company’s earnings, down to EPS
2. Assume a dividend payout ratio of EPS based on historicals and how much regulatory capital it needs.
3. Use this to calculate dividends over the next 5-10 years.
4. Check to make sure that the firm still meets its target Tier 1 Capital and
other capital ratios – if not, reduce dividends.
5. Discount the dividend in each year to its present value based on Cost of Equity and then sum these up.
6. Calculate terminal value based on P / BV and BV in the final year, and
then discount this to its PV based on Cost of Equity.
7. Sum the PV of the terminal value and the PV of the dividends to get the company’s net present per-share value.
202
What is convertible debt
a loan that a company receives, which gives the bondholder the option to convert the debt into a specified number of shares of the company's common stock at a predetermined conversion price and under certain conditions.
203
When you’re calculating WACC, let’s say that the company has convertible debt.
Do you count this as debt when calculating Levered Beta for the company?
Trick question.
If the convertible debt is
**in-the-money** then you do not count it as debt but instead assume that it contributes to dilution, so the company’s Equity Value is higher.
**out-of-the-money** then you count it as debt and use the interest rate on the convertible for Cost of Debt.
204
We’re creating a DCF for a company that is planning to buy a factory for $100 in
cash in Year 4. Currently the PV of its Enterprise Value according to the DCF is $200.
How would we change the DCF to
account for the factory purchase, and what would our new Enterprise Value be?
add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.
The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) – the “4” just represents year 4 here. Then you would subtract this amount from the Enterprise Value.
