BIWS Equity Value, Enterprise Value, and Valuation Metrics and Multiples

Question 1

What do Equity Value and Enterprise Value MEAN? Don’t explain how you calculate them –
tell me what they mean!

Answer 1

Equity Value represents the value of EVERYTHING the company has (i.e., ALL its Assets), but
only to COMMON EQUITY INVESTORS (i.e., shareholders).
Enterprise Value represents the value of the company’s CORE BUSINESS OPERATIONS (i.e.,
ONLY the Assets related to its core business), but to ALL INVESTORS (Equity, Debt, Preferred,
and possibly others).

Question 2

So why do you look at both of them? Isn’t Enterprise Value always more accurate?

Answer 2

Neither one is “better” or “more accurate” – they represent different concepts, and they’re
important to different types of investors.
Enterprise Value and EV-based multiples have some advantages because they are not affected
by changes in the company’s capital structure as much as Equity Value and Equity Value-based
multiples are affected.
However, common shareholders and institutional investors often focus on Equity Value
because they care more about what a company’s shares are worth. And if you’re valuing a
public company, you’ll always have to “back into” its Implied Equity Value and its Implied Share
Price so you can compare that to its current share price.

Question 3

What’s the difference between Current Enterprise Value and Implied Enterprise Value?

Answer 3

Current Enterprise Value is what “the market” as a whole thinks the company’s core business
operations are worth to all investors; Implied Enterprise Value is what you think it’s worth
based on your views and analysis.
You calculate Current Enterprise Value for public companies by starting with Current Equity
Value, subtracting non-core-business Assets, and adding Liability and Equity line items that
represent different investor groups.
But you calculate Implied Enterprise Value based on valuation methodologies such as the
Discounted Cash Flow (DCF) analysis, comparable public companies, and precedent
transactions.

Question 4

Why might a company’s Current Enterprise Value be different from its Implied Enterprise
Value?

Answer 4

Remember that Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate).
Everyone agrees on a company’s current Cash Flow, but you might disagree with the market on
the Discount Rate or Cash Flow Growth Rate.
In most cases, your view of a company’s value will be different than the market’s view because
you believe its cash flow will grow at a faster or slower rate.

Question 5

Everyone knows how you move from Equity Value to Enterprise Value.
But WHY do you subtract Cash, add Debt, add Preferred Stock, and so on?

Answer 5

You subtract Assets when they represent non-core-business Assets. Cash and Investments are
examples, but Equity Investments (AKA Associate Companies), Assets Held for Sale, and Assets
Associated with Discontinued Operations also count.
You add Liability & Equity line items when they represent different investor groups beyond the
common shareholders. Debt and Preferred Stock are the most common examples, but
Unfunded Pensions and Capital Leases (among others) also qualify.

Question 6

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

Answer 6

The “Enterprise Value” here is the $800K total value of the house, and it corresponds to just the
“core value” of the house: The land, the foundation, the walls, rooms, etc.
The “Equity Value” is the $200K down payment you’re making, and it corresponds to everything
above PLUS any “non-core” Assets you get along with the house: Random tools and garden
supplies, lawn chairs, or anything else that you’re planning to sell immediately.

Question 7

Can a company’s Equity Value ever be negative?

Answer 7

Trick question. A company’s Current Equity Value cannot be negative because it is based on
Shares Outstanding * Current Share Price, and neither of those can be negative. It also can’t be
negative for private companies.
However, its Implied Equity Value can be negative because you use your assumptions to
calculate that. So if the company’s Implied Enterprise Value is $0, for example, and it has more
Debt than Cash, its Implied Equity Value will be negative.

Question 8

Can a company’s Enterprise Value ever be negative?

Answer 8

Yes. Both Current and Implied Enterprise Value could easily be negative – for example, a
company might have more Cash than its Market Cap (Current Equity Value) and no Debt. And
perhaps your Implied Enterprise Value is the same as, or very close to, its Current Enterprise
Value.

Question 9

Why do financing-related events such as issuing Dividends or raising Debt not affect
Enterprise Value?

Answer 9

Because Enterprise Value reflects the value of a company’s core business operations to ALL
investors in the company.
That definition means that if something does not affect the company’s core business, it won’t
affect Enterprise Value.
Issuing Dividends, issuing Stock, repurchasing Stock, issuing/repaying Debt, etc. do not impact a
company’s core business, so they do not affect Enterprise Value.
Note that in reality, there will still be a small impact on Enterprise Value; this is just the theory.

Question 10

Let’s say you determine a company’s Implied Value with the cash flow formula: Company
Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate).
Will this give you a company’s Implied Equity Value or Implied Enterprise Value?

Answer 10

It depends on the type of Cash Flow and the Discount Rate you are using. If you’re using Cash
Flow that’s available to ALL investors (i.e., Unlevered FCF or Free Cash Flow to Firm), and WACC
for the Discount Rate, this formula will produce the Implied Enterprise Value.
If you’re using Cash Flow that’s available ONLY to equity investors (i.e., Levered FCF or Free
Cash Flow to Equity), and Cost of Equity for the Discount Rate, this formula will produce the
Implied Equity Value.

Question 11

If financing-related events do not affect Enterprise Value, what DOES affect it?

Answer 11

Only changes to a company’s core business will affect Enterprise Value. For example, the
company wins a major new customer contract, or it announces higher-than-expected sales, or it
closes a factory, or it announces positive results from an expansion strategy into Africa.
But remember that this is all in theory. In reality, financing changes will still make a small impact
on Enterprise Value.

Question 12

If a company wins a major contract with a new customer, will ONLY Enterprise Value
change? Or will Equity Value also change?

Answer 12

Equity Value will change as well. The whole point of Equity Value is that it is affected by BOTH
operational and financial changes, whereas Enterprise Value is affected by ONLY operational
changes (in theory).

Question 13

Why does Enterprise Value NOT necessarily represent the “true cost” to acquire a
company?

Answer 13

First, because the buyer may not necessarily have to repay the seller’s Debt – in 99% of cases,
they do, or they have to “refinance it” by replacing it with new Debt, but there are exceptions.
Second, the buyer may not “get” the seller’s entire Cash balance. The seller needs a certain
minimum amount of Cash to continue operating, and so the seller’s Cash may not reduce the
effective purchase price 1-for-1.
Finally, the buyer has to pay additional fees for M&A advisory, accounting, legal services, and
financing to acquire another company, and none of those is reflected in Enterprise Value.

Question 14

In theory, if Companies A and B are the same in all respects, but Company A is financed
with 100% Equity, and Company B is financed with 50% Equity and 50% Debt, their Enterprise
Values will be the same.
Why is this NOT true in reality?

Answer 14

Because a company’s capital structure, whether current, optimal, or targeted, impacts the
Discount Rate you use to calculate the Implied Enterprise Value (and by extension, the Discount
Rate “the market as a whole” uses to value a company for its Current Enterprise Value).
Not only do the percentages of Equity, Debt, and Preferred Stock change WACC, but the Costs
of all these items also change as the company’s capital structure changes.
For example, more Debt will initially reduce WACC because Debt is cheaper than Equity. But
past a certain point, additional Debt will start to increase WACC because the risk to all investors
starts increasing at that stage.
Enterprise Value will be LESS affected by capital structure changes than Equity Value, but there
will still be some impact even from relatively small changes.

Question 15

A company issues $200 million in new shares. How do Equity Value, Enterprise Value, EV /
EBITDA, and P / E change?

Answer 15

Equity Value increases by $200 million because of the new shares, but Enterprise Value stays
the same because the $200 million of extra Cash offsets the higher Equity Value.
The P / E multiple increases, but EV / EBITDA stays the same.

Question 16

A company issues $200 million in new shares, but it will use $100 million from the proceeds
to issue Dividends to shareholders. How does everything change?

Answer 16

In this case, Equity Value increases by $200 million but then falls by $100 million because
Dividends reduce Equity Value, so Equity Value is up by only $100 million.
The company ends up with $100 million in cash. Enterprise Value stays the same because, once
again, the extra Cash offsets the higher Equity value.
The P / E multiple increases, but by less than in the previous question, and EV / EBITDA stays
the same.

Question 17

The company decides to use the $200 million to acquire another business for $100 million
instead. How does everything change?

Answer 17

Once again, Equity Value increases by $200 million initially, and Enterprise Value does not
change. However, after the company spends $100 million of Cash to acquire another company
– a core-business Asset – its Enterprise Value will increase by $100 million.
Its Equity Value will NOT change in this step because Equity Value does not distinguish between
core and non-core Assets; it includes the values of all Assets.
So the company’s Equity Value increases by $200 million, its Enterprise Value increases by $100
million, and both the P / E multiple and the EV / EBITDA multiple increase.

Question 18

What if the company uses the $100 million to acquire an Asset rather than an entire
company?

Answer 18

Once again, Equity Value increases by $200 million initially and does not change after the Asset
acquisition because the type of Asset acquired is irrelevant to Equity Value.
If this acquired Asset is a core-business Asset – for example, a factory – then the company’s
Enterprise Value will increase by $100 million. If it is not – for example, a short-term investment
– then the company’s Enterprise Value will not change.
So regardless of the classification, the P / E multiple increases. But the EV / EBITDA multiple
may or may not increase, depending on the type of Asset acquired.

Question 19

What changes with everything above if the company raises $200 million in Debt to do this
instead?

Answer 19

The main difference is that Equity Value no longer changes, and so the P / E multiple no longer
changes. Enterprise Value also doesn’t change because the extra Cash and extra Debt cancel
each other out.
However, as in the previous questions, if the company uses the Cash to acquire another
company or other core-business Assets, Enterprise Value and EV / EBITDA both increase.
If the company raises $200 million of Debt to issue $100 million in Dividends, Enterprise Value
and EV / EBITDA will stay the same through all of that, but Equity Value will decrease by $100
million because of the Dividends, and so the P/E multiple will also decrease.

Question 20

Let’s say the company raises $200 million in Debt to acquire another company for a
purchase price of $200 million. The other company’s Common Shareholders’ Equity is exactly
$200 million. How does everything change?

Answer 20

In the first step – a $200 million Debt issuance – neither Equity Value nor Enterprise Value will
change.
In the second step – an acquisition of another company for $200 million when its CSE is also
$200 million – the company’s Enterprise Value will increase by $200 million because this other
company counts as a core-business Asset.
So the P / E multiple stays the same and the EV / EBITDA multiple increases.

Question 21

How is this scenario different if the purchase price is still $200 million, but the other
company has only $100 million in Common Shareholders’ Equity?

Answer 21

The only difference is that now the company has to record $100 million of Goodwill (or Other
Intangible Assets, or a combination of both) on its Balance Sheet.
However, both of those are core-business Assets, so Enterprise Value still increases by $200
million, and everything else is the same as in the previous question.

Question 22

What happens to everything if a company issues $100 in Dividends?

Answer 22

Equity Value decreases by $100 million, but Enterprise Value stays the same because the lower
Equity Value and lower Cash balance cancel each other out. Also, the Cash used to issue these
Dividends is a non-core-business Asset.
As a result, the P / E multiple falls, but the EV / EBITDA multiple stays the same.

Question 23

A company has a Current Equity Value of $200, $50 in Cash, and $100 in Debt. If the
company spends $25 of its Cash balance to purchase PP&E, how does everything change?

Answer 23

The company’s Current Enterprise Value is: $200 + $100 – $50 = $250.
Its Equity Value won’t change when it uses $25 of Cash to purchase PP&E because Cash and
PP&E are the same – just Assets – from the perspective of Equity Value.
Its Enterprise Value will increase by $25 because the company has converted a non-corebusiness
Asset into a core-business Asset. $200 + $100 – $25 = $275, so its Enterprise Value is
now $275.
As a result, its P / E multiple stays the same, but its EV / EBITDA multiple increases.

Question 24

A company has excess Cash. What are the valuation implications if it uses that Cash to
repurchase shares vs. repay Debt?

Answer 24

Enterprise Value won’t change for either one. The reduced Cash balance offsets the reduced
Equity Value, and the reduced Cash Balance also offsets the reduced Debt balance.
However, Equity Value will decrease if the company repurchases shares.
So in a share repurchase, Equity Value and the P / E multiple will fall, but in a Debt repayment,
they’ll stay the same. And Enterprise Value and EV / EBITDA will stay the same for everything.

Question 25

A CEO finds $100 of Cash on the street and adds it to the company’s bank account. How
do Equity Value and Enterprise Value change?

Answer 25

Equity Value will increase by $100 because you have to attribute this “free Cash” to some
investor group, and Equity investors make the most sense because Equity on the Balance Sheet
also represents what the company has saved up internally from its operations.
Enterprise Value will not change because Cash is a non-core-business Asset, and the extra Cash
offsets the higher Equity Value in the calculation.

Question 26

12. A company issues a press release indicating that it expects its revenue to grow at 20%
    rather than its previous estimate of 10%. How does everything change?

Answer 26

This represents a difference in the company’s core business: It expects higher sales growth.
As a result, both its Enterprise Value and Equity Value will increase. Its Equity Value will
increase because the company’s Total Assets are more valuable if they are expected to
generate higher growth.
And the Enterprise Value will increase because its core-business Assets are certainly more
valuable if they’re expected to generate higher growth.
The Intuition: If a company announces higher-than-expected growth, its share price almost
always jumps up, reflecting a higher Equity Value and a higher Enterprise Value.

Question 27

When there’s an operational change, how can you determine whether Equity Value or
Enterprise Value will change by more?

Answer 27

Generally, Enterprise Value will change by more because it is affected only by these operational
changes. Since Equity Value is affected by both financial and operational changes, operational
changes tend to make less of an impact.

Question 28

Will operational changes impact a company’s Current or Implied Enterprise Value by
more?

Answer 28

Operational changes will tend to impact a company’s Implied Enterprise Value – your estimate
of the company’s value based on your views – by more because you can immediately reflect
your views by revising your calculations.
On the other hand, sometimes it takes time for “the market” to reflect these operational
changes fully, and so the Current Enterprise Value will take more time to change.

Question 29

You’ve explained that Equity Value represents the value of ALL assets.
If that’s the case, why doesn’t a Debt issuance boost Equity Value? After all, if a company
raises $100 in Debt, it gets $100 in extra Cash.

Answer 29

This is a trick question because the interviewer doesn’t state the LAST PART of the definition:
“The value of ALL assets but only to EQUITY INVESTORS.”
And that last part explains this effect: When a company’s Assets increase, if that increase is
funded by Debt (or any other non-equity investor), then Equity Value will not increase.

Question 30

What IS a valuation multiple?

Answer 30

A valuation multiple is shorthand for a company’s value based on its cash flows, cash flow
growth rate, and Discount Rate. Normally, you value a company with this formula:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate)
Instead of providing all that information, you can use a number like “10x” and express it in a
condensed way.
You can also think of valuation multiples as “per-square-foot” or “per-square-meter” values
when buying a house: They help you compare houses, or companies, of different sizes and see
how expensive or cheap similar houses, or companies, are.

Question 31

A company trades at a valuation multiple of 13x EV/EBITDA (based on its Current
Enterprise Value). What does that mean?

Answer 31

By itself, this number means nothing at all. It means something only in relation to other
companies and their multiples.
For example, if other, similar companies in the industry with similar growth profiles are trading
at multiples of 10x EV/EBITDA, then this company might be overvalued.
But if those other companies are trading at multiples of 16x EV/EBITDA, then perhaps this
company is undervalued.
A discrepancy in multiples is like a clue in a murder mystery: It points your investigation in the
right direction, but it doesn’t solve the mystery by itself.

Question 32

How can you use valuation multiples in real life?

Answer 32

The most common usage is to calculate valuation multiples for similar companies (“Comparable
Company Analysis” or “Public Company Comparable Analysis”) and see how the company
you’re analyzing stacks up (see the previous question).
But you can also use valuation multiples to determine a company’s yield. For example, if a
company has a P/E multiple of 10x, that means you earn 1/10, or 10%, for each dollar you
invest in its Equity.
So if you buy a share of the company for $10.00, you “get” $1.00 of Net Income (though the
company won’t necessarily distribute that much in cash).
This same concept applies to Enterprise Value-based multiples, but you have to assume that
you purchase $1.00 of the company’s entire capital structure instead of just its shares.
Finally, you can use multiples to determine a company’s implied FCF growth rate – the rate at
which the market expects it to grow.
Let’s say a company’s EV / EBITDA is 12x. Its Current Enterprise Value is $12,000, and its EBITDA
is $1,000. Its Unlevered Free Cash Flow is $500, and the appropriate Discount Rate is 10%.
Since Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), you can say:
$12,000 = $500 / (10% – FCF Growth Rate)
$12,000 * (10% – FCF Growth Rate) = $500
$12,000 * 10% – $12,000 * FCF Growth Rate = $500
$1,200 – $12,000 * FCF Growth Rate = $500

$12,000 * FCF Growth Rate = $700
FCF Growth Rate = 5.8%
This result tells you that the market expects this company’s cash flows to grow at around 5.8%
per year into the future.
You might then compare that to your views of the company’s growth to see if this company
might be overvalued or undervalued.

Question 33

Suppose that you graph the EV / EBITDA multiples for a set of similar companies along with
the revenue growth rates, EBITDA margins, and EBITDA growth rates.
Which operational metric will MOST LIKELY have the strongest correlation with the EV /
EBITDA multiples?

Answer 33

Since a company’s value depends on its cash flow, cash flow growth rate, and Discount Rate,
the EV/EBITDA multiples are most likely to be correlated with the EBITDA growth rates.
While EBITDA, Cash Flow, and Free Cash Flow are very different metrics, EBITDA growth is still
closer to cash flow growth than revenue growth is.
EBITDA margins don’t make much of an impact unless they are changing – only changing
margins will produce different growth rates.
There might be some correlation between revenue growth rates and EV/EBITDA multiples, but
the correlation will be stronger for revenue growth and EV / Revenue multiples.

Question 34

Despite this principle, why do valuation multiples and growth rates often NOT display as
much correlation as you might expect?

Answer 34

First, EBITDA growth and FCF growth are very different since FCF includes taxes, the Change in
Working Capital, and the full CapEx amount, whereas EBITDA excludes these.
Company valuation is ultimately based on cash flow growth, so growth rates in revenue,
EBITDA, EBIT, and Net Income are, at best, rough approximations of cash flow growth.
Also, not every comparable company necessarily has the same Discount Rate; perhaps the
company you’re analyzing is a lot riskier, or a lot less risky than the others.
Finally, non-financial factors could easily affect multiples. For example, if the company reported
recent legal troubles, announced the development of a new product, or recruited a key
executive, all those changes could affect its stock price and therefore its multiples.

Question 35

You’re valuing a mid-sized manufacturing company, and you’re comparing it to peer
companies in the same industry.
This company’s EV / EBITDA multiple is 15x, and the median EV / EBITDA for the comparable
companies is 10x. What’s the MOST likely explanation?

Answer 35

The most likely explanation is that the market expects the company’s cash flows to grow more
quickly than those of other companies. For example, other companies might be expected to
grow at 5%, but this company might be expected to grow at 10%.
The Discount Rate is unlikely to differ by a huge amount because these companies are all about
the same size and are in the same industry, which means the risk should be similar.
Non-financial factors could also affect the multiple – for example, recent positive news about
strategy, product, executives, intellectual property, or competitive performance might also
explain why this company trades at a higher multiple than the others.

Question 36

Would you rather buy a company trading at a 15x EV / EBITDA multiple, or one trading at a
10x multiple?

Answer 36

It’s completely dependent on what peer companies are trading at and how this company
compares.
If every company in the sector is trading at multiples of 20-25x, then 15x might be cheap; if
other companies are trading at multiples of 6-8x, then 10x might be expensive.
When you’re buying companies, you always try to find ones that are undervalued so that you
can sell the stock for a higher price in the future.

Question 37

Could a valuation multiple such as P / E or EV / EBITDA ever be negative? What would it
mean?

Answer 37

Yes, it’s possible for any valuation multiple to be negative (except for ones based on Revenue,
which could be $0 but couldn’t be negative).
If a company has a negative Net Income or negative EBITDA, the multiples will turn negative.
It means that this particular multiple is not meaningful for valuing the company, so you’ll have
to use other multiples or methodologies to value it.

Question 38

If a company has both Debt and Preferred Stock, why is it NOT valid to use Net Income
rather than Net Income to Common when calculating its P / E multiple?

Answer 38

You can use Equity Value or Enterprise Value in multiples, but you shouldn’t create “halfpregnant”
multiples that are based on metrics in between Equity Value and Enterprise Value.
Also remember that if you do not include an expense in the denominator of a multiple, you
have to include the Balance Sheet item corresponding to that expense in the numerator (and
vice versa).
So if you use Net Income rather than Net Income to Common in this case, you’ll have to use a
modified version of Equity Value that adds Preferred Stock, but none of the other items that
you typically add when calculating Enterprise Value.
This numerator will confuse anyone looking at your analysis, so you should stick with the
standard Equity Value calculation and pair it with Net Income to Common.

Question 39

If a company’s cash flow matters most, why do you use metrics like EBIT and EBITDA in
valuation multiples rather than CFO or FCF?

Answer 39

Mostly for convenience and comparability. CFO and FCF measure a company’s cash flows more
accurately, but they also take more time to calculate since you need a full or partial Cash Flow
Statement for them.
Also, the individual items within CFO and FCF vary a lot between companies, and vastly
different figures for Deferred Taxes, Stock-Based Compensation, and the Change in Working
Capital make it difficult to create meaningful comparisons.

Question 40

What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E?

Answer 40

First, you should note that you never look at just one multiple when valuing companies.
Valuation is about the big picture, and you want to evaluate the company across a variety of
multiples and methodologies.

But the interviewer will probably be annoying and press you on this point, so you can say that
with EV / EBITDA vs. EV / EBIT, EV / EBITDA is better in cases when you want to completely
exclude the company’s CapEx, Depreciation, and capital structure.
EV / EBIT is better when you want to exclude capital structure, but partially factor in CapEx and
Depreciation. It is common in industries, such as manufacturing, where those items are key
value drivers for companies.
The P / E multiple is not terribly useful in most cases because it’s affected by different tax rates,
capital structures, non-core business activities, and more – so you use it primarily to be
“complete” and ensure that you’ve covered all the common multiples.
Also, sometimes it is more relevant and important in certain industries, such as commercial
banks and insurance firms, where you do want to factor in the interest income and expense.

Question 41

What are the advantages and disadvantages of FCF vs. Unlevered FCF vs. Levered FCF?

Answer 41

The main advantage of Unlevered FCF is that it’s capital structure-neutral, so a company’s cash
flow will be the same regardless of its Cash, Debt, and Preferred Stock. It’s also easier and faster
to calculate than the others.
You’d use FCF or Levered FCF if you want to take into account the company’s capital structure,
and you’d use Levered FCF to be slightly more accurate since it includes (Mandatory?) Debt
Principal Repayments.
You almost always use Unlevered FCF in a DCF analysis to value a company; FCF is more
common for standalone financial statement analysis; and Levered FCF is rare, partially because
no one agrees on how to calculate it.
You can create a DCF analysis based on Levered FCF as well, but we strongly recommend
against doing this because it’s less reliable and harder to set up.

Question 42

When you use EBITDAR in the EV / EBITDAR multiple, how must you adjust Enterprise
Value?

Answer 42

If the denominator of a valuation multiple excludes an expense, then the numerator should
include the Balance Sheet item corresponding to that expense (and vice versa).
EBITDAR is EBITDA + Rental Expense, so it excludes this annual Rental Expense by adding it
back.

So with EBITDAR and EV / EBITDAR, you have to capitalize the company’s operating leases,
usually by multiplying the annual lease expense by 7x or 8x, and then add the capitalized leases
to Enterprise Value.
There is no existing Balance Sheet item since operating leases are off-BS, so you must create a
new Balance Sheet item by capitalizing these leases.

Question 43

Could Levered FCF ever be higher than Unlevered FCF?

Answer 43

Yes. Levered FCF includes Net Interest Expense, so if the company had a negative value for that
figure, i.e. it earned more in Interest Income than it spent on Interest Expense, and it also had
minimal Debt principal repayments, then Levered FCF might be higher than Unlevered FCF.
This scenario is highly unusual, but it is possible.

Question 44

If EBITDA decreases, how do Unlevered and Levered FCF change?

Answer 44

Think of what EBITDA includes: Only Revenue, COGS, and Operating Expenses. Unlevered FCF
and Levered FCF also include all those items, plus more.
So if EBITDA decreases, it means that Revenue has decreased, or that COGS or Operating
Expenses have increased.
If any of those happens, then both Levered FCF and Unlevered FCF should also decrease since
the Operating Income that flows into both of them will also be lower.
Technically, the FCF figures might stay the same if the D&A, Working Capital, or CapEx change in
such a way that the change offsets the drop in Operating Income.
But that’s not the main point of the question; it’s just an edge case.

Question 45

What are some different ways you can calculate Unlevered FCF?

Answer 45

The main methods are:
􀁸 Method #1: EBIT * (1 – Tax Rate) + Non-Cash Adjustments and Changes in Working
Capital from CFS – CapEx.
􀁸 Method #2: (EBITDA – D&A) * (1 – Tax Rate) + Non-Cash Adjustments and Changes in
Working Capital from CFS – CapEx.
􀁸 Method #3: CFO – (Net Interest Expense and Other Items Between Operating Income
and Pre-Tax Income) * (1 – Tax Rate) – CapEx.
Note that in Method #3, you’re reversing the interest expense, which is why we used a
negative sign for that term. The Interest Expense is a negative on the Income Statement, so if
you use a negative sign in front of it, you turn it into a positive.

Question 46

When you calculate Unlevered FCF starting with EBIT * (1 – Tax Rate), or NOPAT, you’re
not counting the tax shield from the interest expense. Isn’t that incorrect?

Answer 46

No, it’s correct.
If you’re excluding the impact of a company’s capital structure, you have to exclude
EVERYTHING related to its capital structure. You can’t say, “Well, let’s exclude interest… but
let’s still include the tax benefits from that interest.”
The tax savings from the interest expense do not exist if there is no interest expense.
If you counted the tax benefits from the interest expense, you’d have to include the entire
interest expense as well, which would turn it into Free Cash Flow rather than Unlevered FCF.

Question 47

Could a company’s EV / EBITDA multiple ever equal its P / E multiple?

Answer 47

Yes, it’s possible because Enterprise Value, EBITDA, Equity Value, and Net Income could be
almost any values.
For example, if Enterprise Value = $100, EBITDA = $10, Equity Value = $50, and Net Income =
$5, then EV / EBITDA = 10x and P / E = 10x as well.
In practice, P / E multiples tend to be higher than EV / EBITDA multiples because Net Income is
usually smaller than EBITDA by a greater percentage than Equity Value is smaller than
Enterprise Value.

Question 48

Two companies have the same P / E multiples but different EV / EBITDA multiples. How
can you tell which one has more Debt?

Answer 48

You might be tempted to say, “The one with the higher EV / EBITDA multiple,” but that’s
wrong. You can’t answer this question because the companies could be very different sizes.
For example, if they both have P / E multiples of 15x, but one company has Net Income of $10
and one has Net Income of $100, the one with Net Income of $100 is likely to have more Debt –
even if its EV / EBITDA multiple is lower.
If you assume that both companies have the same Net Income and the same EBITDA, then you
can “kind of” answer this question.
In that case, the companies have the same Equity Value, so the company with the higher EV /
EBITDA multiple must have a higher Enterprise Value.
Most likely, that means that it has more Debt.
HOWEVER, remember that other items factor into the calculation. Perhaps both companies
have the same amount of Debt, but the one with the higher EV / EBITDA multiple has less Cash.
Or the company with the higher multiple has a higher Unfunded Pension or Preferred Stock
balance.
But as originally stated, this question is too vague to answer unless you get more information.

Question 49

How do you decide whether to use Equity Value or Enterprise Value when you create
valuation multiples?

Answer 49

You have to look at which group of investors this operational metric is available to: All the
investor in the company (Equity, Debt, Preferred, and others), or just common Equity investors?
If it’s all the investors, use Enterprise Value; if it’s just equity investors, use Equity Value.
One easy rule of thumb is to look at whether the metric includes Net Interest Expense. If it
does, it pairs with Equity Value; if it does not, it pairs with Enterprise Value.
If you’re creating a valuation multiple based on a non-financial metric, such as Unique Users or
Subscribers, you almost always use Enterprise Value since those metrics are available to and
benefit all the investors in the company.

Question 50

Should you use Equity Value or Enterprise Value with Free Cash Flow?

Answer 50

It depends on the type of Free Cash Flow. If it includes Net Interest Expense, i.e. it is just “Free
Cash Flow” or Levered FCF, you use Equity Value.
If it does not include the Net Interest Expense, i.e. it is Unlevered FCF, you use Enterprise Value.

Question 51

Two companies have the same amount of Debt, but one company has Convertible Debt,
and the other has traditional Debt.
Both companies have the same Operating Income, Tax Rate, and Equity Value. Which
company will have a higher P / E multiple?

Answer 51

Since the interest rates on Convertible Debt are lower than the rates on traditional Debt, the
company with Convertible Debt will have a lower interest expense and therefore a higher Net
Income.
As a result, its P / E multiple will be lower. So the company with Convertible Debt will have a
lower P / E multiple, and the company with traditional Debt will have a higher P / E multiple.
Advanced Note: Technically, you may have to reflect on the Income Statement the
“Amortization of the Convertible Bond Discount,” which is a number that reflects how the
Liability component of a Convertible Bond is worth less than a normal Bond because of the
lower interest rate. If you do this, then the Net Incomes of both companies will be much closer,
and the P / E multiples may be almost the same.

Question 52

A company is currently trading at 10x EV / EBITDA. It wants to sell an Asset for 2x the
Asset’s EBITDA. Will that sale increase or decrease the company’s Enterprise Value?

Answer 52

It depends on what type of Asset it is. Assuming that it is a core-business Asset, then the sale
will reduce the company’s Enterprise Value because the company is trading away the Asset for
Cash, which is a non-core-business Asset.
If it’s not a core-business Asset, then the company’s Enterprise Value won’t change.
Even though the company’s Enterprise Value decreases in the first case, its EV / EBITDA
multiple increases because the Asset’s multiple was lower than the multiple for the entire
company.
Pretend that the company’s total EBITDA was $100, and this Asset contributed $20 of that
EBITDA. The company’s Enterprise Value before the sale was, therefore, $1,000.

The company now sells the Asset for $40. After the sale, the company’s Enterprise Value falls by
$40, and its EBITDA falls by $20. So its new EV / EBITDA is $960 / $80, or 12x.
This is why companies often sell under-performing divisions: To boost their valuation multiples
and increase their stock prices.

Question 53

Is it accurate to subtract 100% of the Cash balance when moving from Equity Value to
Enterprise Value?

Answer 53

No, but everyone does it anyway. The reasoning is that a portion of any company’s Cash
balance is a “core-business Asset” because the company needs a certain minimum amount of
Cash to continue running its business.
So technically, you should subtract only the Excess Cash, i.e. the portion of the Cash balance
above this number. For example, if the company has $1,000 in Cash but needs only $200 to run
its business, you should subtract $800 rather than $1,000 when calculating Enterprise Value.
However, companies rarely disclose this number, and it is almost impossible to determine on
your own, so in practice, everyone just subtracts the entire Cash balance.

Question 54

Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value?
The company doesn’t need it to continue operating its business.

Answer 54

Goodwill is a core-business Asset, so you should NOT subtract it when moving to Enterprise
Value.
Remember that Goodwill reflects the premiums paid for companies that the company
previously acquired – if you subtracted it, you’d be saying, “Those previous acquisitions are not
a part of this company’s core business anymore.”
And that’s true only if the company has shut down or sold those companies, in which case it
removes all Assets and Liabilities associated with them.

Question 55

Why might you subtract only part of a company’s Deferred Tax Assets (DTAs) when
calculating Enterprise Value?

Answer 55

Deferred Tax Assets can contain many different items, some of which are related to simple
timing differences or tax credits for operational items.
But you should subtract ONLY the Net Operating Losses (NOLs) that are in the DTA because
those are non-operational in nature.
There is some controversy on exactly which figure to subtract since NOLs are off-Balance Sheet
Assets with a small presence (roughly, NOLs * Tax Rate) within the DTA.
So some people argue that you should use the off-BS figure, some argue that it should be the
on-BS figure, and some argue for other approaches, such as calculating the PV of tax savings
from the NOL and subtracting that.
Don’t mention all of this in interviews – just acknowledge that you subtract NOLs when moving
from Equity Value to Enterprise Value.

Question 56

Why might someone argue that you should NOT add capital leases when moving from
Equity Value to Enterprise Value?

Answer 56

Some people argue that capital leases are operational items since owning vs. renting buildings
(or planes, stores, etc.) is an operational decision, not a financial one.
If capital leases are “operational liabilities” and they do not represent another investor group,
you should not add them in this calculation.
We disagree with this view because, in our opinion, all leases are financial in nature – they’re
similar to Debt since they require fixed payments for many years under non-cancelable
contracts.
So we treat capital leases as a Debt-like item, and we recommend capitalizing operating leases,
especially in industries where some companies rent and others own property.

Question 57

How do you factor in Working Capital when moving from Equity Value to Enterprise Value?

Answer 57

You don’t. Remember that Equity Value represents the value of ALL the company’s Assets but
only to equity investors.
So you subtract items only if they’re non-core-business Assets, and you add Liability and Equity
line items only if they represent different investor groups.
The Assets that comprise Working Capital all count as core-business Assets (e.g., Inventory,
Accounts Receivable, Prepaid Expenses, etc.), and the Liabilities in Working Capital are all
operational items that do not represent other investor groups (e.g., Accrued Expenses,
Deferred Revenue, etc.).
So there’s no reason to add or subtract Working Capital, as both Equity Value and Enterprise
Value reflect it implicitly.

Question 58

Why do you subtract Equity Investments, AKA Associate Companies, when moving from
Equity Value to Enterprise Value?

Answer 58

Two reasons. First, they’re non-core-business Assets since the company could operate fine
without them. You should, therefore, exclude them from Enterprise Value.
Second, you need to do this for comparability purposes. Metrics like EBITDA, EBIT, and Revenue
include 0% of these Equity Investments’ financial contributions, but Equity Value implicitly
includes the value of the stake.
So if a Parent Company owns 30% of an Associate Company, the Parent Company’s Equity
Value will include the value of that 30% stake. However, its Revenue, EBIT, and EBITDA include
nothing from it.
Therefore, you have to subtract this 30% stake when moving from Equity Value to Enterprise
Value to ensure that all Enterprise Value-based valuation multiples exclude Equity Investments
in both the numerator and the denominator.

Question 59

Why do you add Noncontrolling Interests when moving from Equity Value to Enterprise
Value?

Answer 59

First, these Noncontrolling Interests represent another investor group: Another company that
the Parent Company owns a majority stake in. Enterprise Value reflects all the investor groups
in a company, so you must add Noncontrolling Interests.
Second, you need to do this for comparability purposes. Since the financial statements are
consolidated 100% when the Parent Company owns a majority stake in the Other Company,
metrics like Revenue, EBIT, and EBITDA include 100% of the Other Company’s financials.
Equity Value, however, includes only the value of the actual percentage the Parent owns.
So if a Parent Company owns 70% of the Other Company, the Parent Company’s Equity Value
will include the value of that 70% stake. But its Revenue, EBIT, and EBITDA reflect 100% of the
Other Company’s Revenue, EBIT, and EBITDA.
Therefore, you have to add the 30% the Parent Company does not own – the Noncontrolling
Interest – when you move from Equity Value to Enterprise Value, so that Enterprise Value
reflects 100% of that Other Company’s value.
Doing so ensures that metrics such as EV / Revenue and EV / EBITDA include 100% of the Other
Company’s value and financial contributions so that the multiples are consistent.

Question 60

If a company has $10,000 in convertible bonds with a par value of $2,000 and a conversion
price of $20.00, how many diluted shares will there be?

Answer 60

There is not enough information to answer the question. You also need to know the current
stock price of the company to see if the convertible bonds could convert and create additional
shares.

Question 61

A company has 100 shares outstanding, and its current share price is $10.00. It also has 10
options outstanding at an exercise price of $5.00 each. What is its Diluted Equity Value?

Answer 61

Its Basic Equity Value is $1,000, or 100 * $10.00. To calculate the diluted shares, note that the
options are all “in-the-money” – their exercise price is less than the current share price.
When these options are exercised, 10 new shares get created – so the share count is now 110
rather than 100.
The investors paid the company $5.00 to exercise the options, so the company gets $50 in cash.
It uses that cash to buy back 5 of the new shares, so the diluted share count is 105, and the
Diluted Equity Value is $1,050.

Question 62

A company has 100 shares outstanding, and its current share price is $10.00. It also has 10
options outstanding at an exercise price of $15.00. What is its Diluted Equity Value?

Answer 62

$1,000. The options’ exercise price is above the current share price, so they have no dilutive
effect.

Question 63

A company has 1 million shares outstanding, and its current share price is $100.00. It also
has $10 million of convertible bonds, with a par value of $1,000 and a conversion price of
$50.00.
What are its diluted shares outstanding?

Answer 63

First, note that these convertible bonds are convertible because the company’s share price is
above the conversion price. So you count them as additional shares rather than Debt.
Next, you divide the value of the convertible bonds – $10 million – by the par value – $1,000 –
to figure out how many individual bonds there are:
$10 million / $1,000 = 10,000 convertible bonds.
Next, the number of shares per bond is the par value divided by the conversion price:
$1,000 / $50.00 = 20 shares per bond.
So the convertibles create 20 * 10,000, or 200,000 new shares, and the diluted share count is
1.2 million.
You don’t use the Treasury Stock Method with convertibles because the investors don’t pay the
company anything to convert the bonds into shares.

Question 64

A company has 10,000 shares outstanding and a current share price of $20.00. It has 100
options outstanding at an exercise price of $10.00.
It also has 50 Restricted Stock Units (RSUs) outstanding.
Finally, it also has 100 convertible bonds outstanding at a conversion price of $10.00 and par
value of $100.
What is its Diluted Equity Value?

Answer 64

Since the options are in-the-money, you assume that they get exercised, so 100 new shares are
created.
The company receives 100 * $10.00, or $1,000, in proceeds. Its share price is $20.00, so it can
repurchase 50 shares with these proceeds. There are now 50 additional shares outstanding
(100 new shares – 50 repurchased).
You add the 50 RSUs as if they were common shares, so now there’s a total of 100 additional
shares outstanding.

The company’s share price of $20.00 exceeds the conversion price of $10.00, so the convertible
bonds can convert into shares.
Divide the par value by the conversion price to determine the shares per bond:
$100 / $10.00 = 10 new shares per bond
There are 100 convertible bonds outstanding, so you get 1,000 new shares (100 convertible
bonds * 10 new shares per bond).
All of these changes create 1,100 additional shares outstanding, so the diluted share count is
now 11,100, and the Diluted Equity Value is 11,100 * $20.00, or $222,000.

Question 65

This same company also has Cash of $10,000, Debt of $30,000, and Noncontrolling
Interests of $15,000. What is its Enterprise Value?

Answer 65

You subtract the Cash, add the Debt, and then add Noncontrolling Interests:
Enterprise Value = $222,000 – $10,000 + $30,000 + $15,000 = $257,000.