Corporate Finance Theory (PSW)

Question 1

can you explain the concept of present value and how it relates to company valuation?

Answer 1

• The present value concept is based on the premise that “a dollar in the present is worth more than a dollar in the future” due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today.
  Present Value t=0 = Cash Flow t=1 / (1+r)^t=1
• For intrinsic valuation methods, the value of a company will be equal to the sum of the
  present value of all the future cash flows it generates. Therefore, a company with a high
  valuation would imply it receives high returns on its invested capital by investing in positive net present value (“NPV”) projects consistently while having low risk associated with its cash flows.

Question 2

what is equity value and how is it calculated?

Answer 2

• Often used interchangeably with the term market capitalization (“market cap”), equity value represents a company’s value to its equity shareholders. A company’s equity value is calculated by multiplying its latest closing share price by its total diluted shares outstanding, as shown below:
• Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding

Question 3

how do you calculate the fully diluted number of shares outstanding?

Answer 3

• The treasury stock method (“TSM”) is used to calculate the fully diluted number of shares outstanding based on the options, warrants, and other dilutive securities that are currently “in-the-money” (i.e., profitable to exercise).
• The TSM involves summing up the number of in-the-money (“ITM”) options and warrants and then adding that figure to the number of basic shares outstanding.
• In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact.

Question 4

what is the enterprise value and how do you calculate it?

Answer 4

• Conceptually, enterprise value (“EV”) represents the value of the operations of a company to all stakeholders including common shareholders, preferred shareholders, and debt lenders.
• Thus, enterprise value is considered capital structure neutral, unlike equity value, which is affected by financing decisions.
• Enterprise value is calculated by taking the company’s equity value and adding net debt, preferred stock, and minority interest.
• Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest

Question 5

how do you calculate equity value from enterprise value?

Answer 5

• To get to equity value from enterprise value, you would first subtract net debt, where net debt equals the company’s gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets.
• Equity Value = Enterprise Value – Net Debt – Preferred Stock – Minority Interest

Question 6

which line items are included in the calculation of net debt?

Answer 6

• The calculation of net debt accounts for all interest-bearing debt, such as short-term and long-term loans and bonds, as well as non-equity financial claims such as preferred stock and non-controlling interests. From this gross debt amount, cash and other non-operating assets such as short-term investments and equity investments are subtracted to arrive at net debt.
• Net Debt = Total Debt – Cash & Equivalents

Question 7

when calculating enterprise value, why do we add net debt?

Answer 7

The underlying idea of net debt is that the cash on a company’s balance sheet could pay down the outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company’s debt, and many leverage ratios use net debt rather than the gross amount.

Question 8

what is the difference between enterprise value and equity value?

Answer 8

• Enterprise value represents all stakeholders in a business, including equity shareholders, debt lenders, and preferred stock owners. Therefore, it’s independent of the capital structure. In addition, enterprise value is closer to the actual value of the business since it accounts for all ownership stakes (as opposed to just equity owners).
  What is the difference between enterprise value and equity value?
• To tie this to a recent example, many investors were astonished that Zoom, a video conferencing platform, had a higher market capitalization than seven of the largest airlines combined at one point. The points being neglected were:
  – The equity values of the airline companies were temporarily deflated given the travel restrictions, and the government bailout had not yet been announced.
  – The airlines are significantly more mature and have far more debt on their balance sheet (i.e., more non- equity stakeholders).

Question 9

could a company have a negative net debt and have an enterprise value lower than its equity value.

Answer 9

• Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies will have enterprise values lower than their equity value.
• If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value represents the value of a company’s operations, which excludes any non-operating assets. When you think about it this way, it should come as no surprise that companies with much cash (which is treated as a non-operating asset) will have a higher equity value than enterprise value.

Question 10

can the enterprise value of a company turn negative?

Answer 10

While negative enterprise values are a rare occurrence, it does happen from time to time . A negative enterprise value means a company has a net cash balance (total cash less total debt) that exceeds its equity value. Imagine a company with $1,000 in cash, no other assets and $500 in debt and $200 in accounts payable. There is $300 in equity in this business, while the enterprise value is -$200.

Question 11

if a company raises $250M in additional debt, how would its enterprise value change?

Answer 11

• theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised shouldn’t impact the enterprise value, as the cash and debt balance would increase and offset the other entry.
• However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact the company’s profitability and lead to a lower valuation from the higher cost of debt.

Question 12

why do we add minority interest to equity value in the calculation of enterprise value?

Answer 12

• Minority interest represents the portion of a subsidiary in which the parent company doesn’t own. Under US GAAP, if a company has ownership over 50% of another company but below 100% (called a “minority interest” or “non-controlling investment”), it must include 100% of the subsidiary’s financials in their financial statements despite not owning 100%.
• When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest must be added to enterprise value for the multiple to be compatible (i.e., no mismatch between the numerator and denominator).

Question 13

how are convertible bonds and preferred equity with a convertible feature accounted for when calculating enterprise value?

Answer 13

If the convertible bonds and the preferred equities are “in-the-money” as of the valuation date (i.e., the current stock price is greater than their strike price), then the treatment will be the same as additional dilution from equity. However, if they’re “out-of-the-money,” they would be treated as a financial liability (similar to debt).

Question 14

what are the two main approaches to valuation?

Answer 14

1. Intrinsic Valuation: For an intrinsic valuation, the value of a business is arrived at by looking at the business’s ability to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and is based on the notion that a business’s value equals the present value of its future free cash flows.
2. Relative Valuation: In relative valuation, a business’s value is arrived at by looking at comparable companies and applying the average or median multiples derived from the peer group – often EV/EBITDA, P/E, or some other relevant multiple to value the target. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called “trading comps,” or by looking at the multiples of comparable companies recently acquired, which is called “transaction comps.”

Question 15

what are the most common valuation methods used in finance?

Answer 15

comparable company analysis (“trading comps”): trading comps value a company based on how similar publicly traded companies are currently being valued at by the market
comparable transaction analysis (“transaction comps”): value company based on the amount buyers paid to acquire similar companies in recent years
discounted cash flow analysis (DCF): value’s a company based on the premise that its value is a function of its projected cash flows, discounted at an appropriate rate that reflects the risk of those cash flows
leveraged buyout analysis (LBO): will look at potential acquisition target under a highly levered scenario to determine maximum purchase price the firm would be willing to pay
liquidation analysis: used for company under (or near) distress and values assets of company under hypothetical, worst case scenario liquidation

Question 16

among the DCF, comparable companies analysis, and transaction comps, which approach yields the highest valuation?

Answer 16

Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factor in control premiums. Control premiums can often be quite significant and as high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.

Question 17

which of the valuation methodologies is the most variable in terms of output?

Answer 17

Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of the different valuation methodologies. Relative valuation methodologies such as trading and transaction comps are based on the actual prices paid for similar companies. While there’ll be some discretion involved, the valuations derived from comps deviate to a lesser extent than DCF models.

Question 18

advantages and disadvantages of using a DCF

Answer 18

ADVANTAGES
- The DCF values a company based on the company’s forecasted cash flows. This approach is viewed as the most direct and academically rigorous way to measure value.
- Considered to be independent of the market and instead based on the fundamentals of the company.
DISADVANTAGES
- The DCF suffers from several drawbacks; most notably, it’s very sensitive to
Flow (DCF)
- Forecasting the financial performance of a company is challenging, especially if the forecast period is extended.
- Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around three- quarters of the implied valuation.
While the value derived from a comps

Question 19

Advantages and disadvantages of trading comps approach

Answer 19

ADVANTAGES
- Trading comps value a company
looking at how the market values analysis is viewed by many as a
similar businesses.
- Thus, comps relies much more
heavily on market pricing to
determine the value of a company
(i.e., the most recent, actual prices
paid in the public markets).
- In reality, there are very few truly
comparable companies, so in effect, it’s always an “apples and oranges” opposed to being explicitly chosen comparison.
DISADVANTAGES
- while value derived from comps analysis is viewed as much more realistic assessment of how a company could expect to be priced, it’s vulnerable to how the market is not always right
- comps analysis is simply pricing, as opposed to a valuation based on the company’s fundamentals
- comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF)

Question 20

how can you determine which valuation method to use?

Answer 20

• Each valuation method has its shortcomings; therefore, a combination of different valuation techniques should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more defensible approximation and sanity-check your assumptions.
• The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa).
• For example, an analyst valuing an acquisition target may look at the past premiums and values paid on comparable transactions to determine what the acquirer must realistically expect to pay. The analyst may also value the company using a DCF to help show how far market prices are from intrinsic value estimates.
• Another example of when the DCF and comps approaches can be used together is when an investor considers investing in a business – the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuations derived using a DCF (although it bears repeating that the DCF’s sensitivity to assumptions is a frequent criticism).

Question 21

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