Corporate Finance theory + valuation methods Flashcards
1
Q
Explain present value
A
- present value: based on the idea that a dollar in the present is worth more than a dollar in the future due to the time value of money
- this is bcuz of potential to earn interest by investing it today
- Present V (t=0) = Cash Flow (t=1)/ (1+r)^t=1
2
Q
how is present value linked to valuation of a company
A
- for intrinsic methods like DCF, value of a company will be equal to the net present value of all future cash flows it generates
- hence a company with high valuations would imply it received high returns on the capital invested, and has high positive net present value, as well as low risk associated with its cash flow
3
Q
what is equity value and how is it calculated?
A
- equity value and Market cap are the same thing
- equity value is the company’s value to its shareholders
- calculated by: closing share proce * total diluted shares outstanding
4
Q
What is enterprise value and how do you calculate it
A
- Enterprise Value (EV) represents the value of the operations of a company to all shareholders, which includes common shareholders, preferred shareholders and debt lenders.
- Enterprise Value (EV) is a measure of a company’s total value, often considered more comprehensive than market capitalization alone.
- Theoretical cost to acquire the entire business, including its debt and cash positions.
- EV is widely used in financial analysis, especially in valuation multiples like EV/EBITDA, to compare companies regardless of their capital structures
- EV caluclated = company’s equity value + net debt + preferred stock + minority interest
4
Q
how to calculate the fully diluted number of shares outstanding?
A
- treasury stock method
- take basic share count + dilutive effect of options and other dilutive securities
-Determine the number of options or warrants outstanding and the exercise price of each. - Calculate how many shares would be issued if all options/warrants were exercised.
- Calculate the cash proceeds the company would receive from the exercise of these options/warrants.
- Determine how many shares the company could buy back at the current market price using those proceeds.
- Add the net increase in shares (new shares issued minus shares repurchased) to the basic shares outstanding.
5
Q
how to calculate equity value from enterprise value
A
- equity value = enterprise value - net debt - preferred stock - minority interest
6
Q
which line items are included in the calculations of net debt
A
- net debt accounts all interest bearing debt, so both long and short term debt + bonds + preferred stock and non-controlling interests
- net debt = total debt - cash & equivalents (short term/equity investment)
7
Q
when calculating EV, why do we add net debt to market cap
A
- market cap alone only accounts for company equity and not debt and cash holdings
- and during valuation for acquisition the acquirer takes over both the equity and the liabilities
- Debt: Represents obligations that a potential buyer would need to assume or pay off.
- Cash: Represents liquid assets that can be used to reduce the effective cost of acquisition.
8
Q
what is adjusted when u add net debt to market cap
A
- adding debt increases EV
- subtract cash: decreases EV, cuz company cash offsets purchase costs
9
Q
why use net debt instead of gross debt
A
- gross debt - cash = net debt
- cash can payoff/cancel out debt
- more realistic assessment: company can use cash reserve to pay down debt
- more comparable which has varying levels of cash and debt
- leverage ratios: financial ratios like Debt/EBITDA use net debt to provide clearer picture of leverage
10
Q
compare equity and enterprise value
A
Equity Value: value of company equity shares. Share Price * Outstanding Shares, Equity Shareholders, Dependent on cpaital structure + market fluctuations
EV: Total value of company for all stakeholders, Equity Value + net Debt + preferred stocks + Minority Interest. All stakeholders (equity, debt, preferred shareholders), neutral to capital structure, more comprehensive
11
Q
different multiples used for EV and equity value
A
- Equity Value: fundamental component in valuation ratios like Price-to-Earnings (P/E) and Price-to-Book (P/B) ratios
- Commonly used in ratios like EV/EBITDA, EV/Sales, and EV/EBIT, which are preferred over equity-based multiples for their comprehensive perspective
12
Q
zoom vs airlines example for enterprise and equity
A
- capital structure differences: airlines have high debt due to capital intensive nature of industry (high cap ex). Zoom: operated w lower debt levl and high cash reserves
- Equity V Perspective: Zoom: high market cap cuz increase demand for video conferences. Airlines: lower market cap due to covid setbacks
- EV perspective: Airlines: despite lower market cap high debt level increase EV, zoom: lower debt and high cash reserve, so more balances EV towards equity value
13
Q
can a company have a negative net debt balance and have an enterprise value lower than its equity value?
A
- net debt j mean company has more cash than debt
- i.e microsoft and apple have nuge negative net debt
- EV represents value of company’s operations which doesnt include non-operating assets like cash
14
Q
can EV of a company turn negative
A
very rare but yes, but it j means that a ngeative enterprise value means the net cash balance (cash is a lot bigger than debt)»_space;»> equity value
15
Q
If a company raises 250M in additional debt, how does its EV changes
A
- theoretically no impact, bcuz EV is neutral capital structure
- new debt raised bcuz cash and debt balance would increase and offset each other
- however, the cost of financing (like fees and interest expense) could lead to lower valuation from higher cost of debt
16
Q
A
17
Q
what is minority interest
A
it is the proportion of a subsidiary company in which the parent company doesn’t own
1. Under US GAAP as long as main company has >50% of subsidiary company but beloow 100% (non-controlling investment
2. it must include 100% of the subsidiary’s financials in their statements even they dont own 100%
3. this becomes a problem when calculating multiples bcuz the EV/EBITDA would include the subsidiary’s EV too and we don’t want that
18
Q
how do we include minority interest to equity value in the calculation of enterprise value
A
- when we use multiples like EV/EBITDA
- EBITDA reflects 100% of subsidiary’s earnings
- but EV only reflect the portion of subsidiary that the parent owns
- hence for more comprehensive comparison, we need to add the minority interest you add in the 100% subsidiary and align the EV and EBITDA
19
Q
what are 2 main approaches to valuations
A
- Intrinsic valuation: looking at the internal business, and its ability to generate cash flows. DCFs is most common type of intrinsic valuation, it is based on the notion that a business value = present value of its future free cash flows
- Relative Valuation: looking at comparable company’s multiples and applying average or median multiples derived from the ;eer group, often EV/EBITDA, P/E. Trading comps look at public companies current market value, and transaction comps look at comparable companies at the multiples it was acquired at
20
Q
Trading comps
A
looking at values of multiples for publicly traded companies, and look at their current market value
21
Q
transaction comps
A
based on recent or previous acquisition prices and multiples of similar sector.
can be adjusted
22
Q
discounted cash flow
A
DCF its value = the present value of its projected cash flows, discounted at an approapriate rate that reflects the risk of those cash flows
23
Q
LBO
A
potential acquisition target under highly leveraged scenario to determine the max purchase price
24
what type of valuation yields highest valuation
1. transaction comps, bcuz they include a premium, most premiums are somewhere around 25-50% above market price to account for synergies
2. hence multiples derived from this is higher value than trading comps or DCF
25
which valuation has most assumptions/variable
1. DCF because it is based on forward looking projections and assumptions such as risk
2. relative valuation is based on actual prices which are paid for or actual prices a company is on the market, hence less deviation
26
DCF vs trading comps
1. DCF Ad: based on intrinsic value and fundamental financials of a company, independent of market
2. DCF dis: sensitive to assumptions, is forecast period is long (can be quite unpredictable and challenging to predict), terminal value comprises 3/4s of the implied valuation which may be inaccurate
3. comps Ad: market value of business, actual deals
4. comps disad: very few accurate comparables (no exact company is the same), vulnerable to market conditions and not the company itsefl, implicit assumptions
27
how to determine which valuation method
1. use all three/combination
2. arrive at a more defensible approximation
3. DCF ad trading comps can be used together to compliment each other, give a market based and intrinsic sanity check
4. look at how far a DCF is compared to market prices
28
Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals?
No, because there is also assumptions for relative valuation, just not made by you, but made by others in the market.
Market is inefficient
29
what is FCF
1. free cash flow: cash flow remaining after accounting for recurring expenditures to continue operating
2. FCF = cash from operations - capex
30
why are periodic acquisitions excluded in FCF calculation
1. inflows and outflows of cash which are recurring an operational
2. periodic acquisition is one-time and unpredictable event, whereas Capex is recurring
31
difference between unlevered and levered FCF
1. unlevered FCF is cash flow a company generated after accounting for all operating expenses and investments
2. FCFF = EBIT * (1-tax rate) + D&A - changes in NWC - CapeX
3. levered FCF: cash flow after payment to lenders since interest expense and debt payments r deducted
4. FCFE = cash from oper - capex 0 debt principle payments
32
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 $5 each – what is its fully diluted equity value?
1. 100 * 10 = 1000 dollars
2. 10 shares * 5 = 50 dollards
3. 50 dollars can buy back 5 shares at 10dollar/share
4. hence 100 + 5 = 105 shares diluted, and 1050dollars
33
Could a company have a negative Enterprise Value? What would that mean?
1. EV = market cap + debt - cash + minority interest + preferred shares
2. so either market cap is rlly low
3. or net debt is negative, meaning cash is VERY positive
34
why add preferred stock to enterprise value
1. preferredn stock pays out a fixed dividend, and have higher claim to company assets than equity investors
2. seen as a debt
35
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.
36
Are there any problems with the Enterprise Value formula you just gave me?
- yes there are more things to add into the formular
- net operating losses shoudl be treated equal to cash
- investments should be treated as cash
- capital leases should be counted as debt
- any other leases or obligations should be counted as debt
EV = equity value - cash + debt + minority interest + preferred stock - NOLs - Investments + capital leases + other obligations (pensions)
37
Should you use the book value or market value of each item when calculating Enterprise Value?
1. technically should always use market value, but difficult to get market value for some items in the EV
2. so only use market value for equity value and the rest is from balance sheet
38
What percentage dilution in Equity Value is “too high?”
anything over 10% is odd
39
rank 3 valuation method
1. precedent transaction: has control premiums (but this also varies, cuz financial sponsors less likely to pay a lot of control premium
2. DCF has a lot of variables to it, so it can be high or low. often bullish because assumes optimism in future cash flow, sensitive to small assumptions
3. trading comps: public companies, reflect market conditions
40
when would u not use DCF in valuation
1. unpredictable cash flow or a high growth potential such as tech or biotech, and in this case its difficult to project its future cash flows
2. or a company which isnt expected to grow, or a downhill company because its hard to predict if there will be a turnaround in cashflow, altho u could use a DCF it would be less certain
41
other methodologies?
1. liquidation caluation: if a company went bankrupt and needs ro liquidate its asset to see how much capital for equity investors
2. replacement value - value company based on the cots of replacing its assets
3. LBO: determining how much a PE firm should pay for a company to have a good IRR (20-25%) and how much leverage to use
4. sum of parts: when dealing w big conglomerates w very different operating divisions, need to value each division separately
5. future share price analysis: projecting company share price based on P/E multuples of public companh comparables and discounting it to present value
42
What are the most common multiples used in Valuation?
1. EV/Revenue, EV/EBITDA, EV/EBITD, P/E (sahre price/Earnings per share), and P/BV (share price/Book value)
43
industry specific multiples
tech: EV/pageviews
retail arilins: EV/EBITDAR rent differs hugely depending on company
44
why do you use EV based and not equity value based multiples?
1. if what u are looking at applies to all investors then use EV
2. if it only applies to equity shareholders then can use equity value
45
would LBO or DCF give higher valuation
1. LBO you only get value from the company when you sell it and hence when you reach at the terminal value
2. DCF accounts for both company cash flows and the terminal value
Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.
46
How would you present these Valuation methodologies to a company or its investors?
Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.
47
how to value an apple tree
1. relative valuation (comparable or precedent transactions)
2. value of apple trees cash flow (how much cash flow it generates) DCF
48
When would a Liquidation Valuation produce the highest value?
1. unusual because usually liquidation is for companies which are going bamkrupt hence wont be worth a lot
2. but its when company has substatial hard assets like a lot of PP&E, and the market is undervalueing it by a lot
49
What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?
- levered free cash flow (cash flow straight from operations w no financing done to it, interest included alr) = hence only applies to equity shareholders, use equity value
- unlevered free cash flow has interests alr paid to debt investors, hence use EV
50
when would u use EV/Revenue
1. when loss making company
2. use equity/revenue when enterprise is negative
51
how to select comparables or precedent trasactions
1. industry
2. finanicla criteria (revenue, EBITDA) - revnue over 100mill
3. geography
4. time - in the past 2 years
52
How do you apply the 3 valuation methodologies to actually get a value for thecompany you’re looking at?
- get a set of multiples from a set of valuation methods/comparables, multiply it sby the relevant metric (i.e their EBITDAmltiple is 8x and their EBITDA is 500M, my implied EV would be 4B
- football field graph looks at minimum, maximum, 25th, median, 75th percentile
53
Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?
1. its stock price went up
2. IP or key patent (not shown on financials)
3. market leader and has greater market share
54
What are the flaws with public company comparables?
1. no company is 100% comparable to another company
2. stock market fluctautes a lot due to market volatility
3. small companies w small shareprices may not teflect their full value
55
How do you take into account a company’s competitive advantage in a valuation?
1. look at 75th percentile instead o median
2. use more aggressive projections in DCFs
3. add premiums to multiples
56
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?
- essentially a mismatch between M&A market and public market
- COVID-19, during covid deflated M&A valuations for airlines
- however, in non covid time that might not be the case, and hence precedent transactions would give u a lower valuation compared to current trading comps
57
What are some flaws with precedent transactions?
not always 100% comparable
small private companies or niche sectors are more difficult to compare
58
Two companies have the exact same financial profile 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 had more companies bidding on it
2. bad news or depressed stock price
59
Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?
1. EBITDA over looks D&A which is very important in capex heavy industries, where using EBITDA they can hide how much capex or D&A or cash is actually used to finance the operations
2. industries which are capex heavy also show large gap between EBIt and EBITDA
60
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?
1. P/E depends of companies capital structure, companies where debt and interest is significant to their operation shoudl use P/E since the comparison of debt and interest (what varies and determines) is not included in P/E
2. EV/EBIT, EV/EBITDA is capital neutral hence can be used in both
3. EV/EBIT shoudl be used if capex heavy and D&A heavy industry like manufacturing
4. EV/EBITDA used if D&A less important (internet comapnies, e-commerce)
61
how to value loss making company
1. DCF which assumes a turnaround and eventually generates free cash flow (but assumption???)
2. P/E cant be used cuz it will be negative, and a negative multiple doesnt make sens
3. if EBITDA is negative then EBITDA multiple also dont make sense
4. EV/revenue would make more sense here as revenue is not negative
5. industry specific/sector specific multiples: EV/subscribers
62
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.
1. in a lease situation, lease is counted in SG&A expense which is included in EBITDA, hence lowering EBIITDA, and hence given EV is same, it gives a higher EV/EBITDA
2. in depreciation situation, depreciation is not included in EBITDA so it gives higher EBITDA and lower EV/EBITDA
3. hence pay higher multiple for lease situation
63
How do you value a private company?
1. same as public use all 3 methods
2. but add a discounts of 10% on public company comparables cuz its less liquid, compared to public company
3. A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.
4. You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price
64
Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?
1. precdent transaction takes 100& ownership of company so shares become illiquid and control premium paid, so no need to ad additional discount
2. public comps have liquid shares and hence require a discount to compare them to illiquid precedent transactions
65
Can you use private companies as part of your valuation?
1. only precedent transactions of private companies
2. DCF and public compas require public infor such as market cap and wacc, and beta, which are not present in private companies
66
How do you value banks and financial institutions differently from other companies?
- You look at P / E and P / BV (Book Value) multiples rather than EV / Revenue, EV / EBITDA, and other “normal” multiples, since banks have unique capital structures.
- use bank specific metrics like net asset value to screen precedent transactions or Comps
- instead of DCF use dividend discount model, based on dividend projection rather than cash flow
67
I’m looking at financial data for a public company comparable, and it’s April (Q2) right now. Walk me through how you would “calendarize” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.
1. TTM = last year financial data - last year Q1(old partial period) + this year Q1 (new partial period)
68
Walk me through an M&A premiums analysis.
1. to look at the premiums a buyer would have to pay by looking at precedent transaction
2.identify a precedent transaction, and say it acquired it from 10/sharre to 15/share, 50% premium
3.apply that to different days of the current company by dividing its per share price w premium by share price today
69
Walk me through a future share price analysis.
1. project company's share price 1-2 yrs and discounted back to present value
2. get TTM P/E for public comps
3. Apply this P / E multiple to your company’s 1-year forward or 2-year forward projected EPS to get its implied future share price.
4. Then, discount this back to its present value by using a discount rate in-line with the company’s Cost of Equity figures.
70
Walk me through a Sum-of-the-Parts analysis.
1. select different comparable company multiples for each division, i.e division one has median 5x EV/EBITDA, and division 2 has median 8x EV/EBITDA
2. then times the multiple by the current EBITDA of company to get company total value
71
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?
1. most detailed
2. numbers in the middle range
3. dont pick same company u are doing M&A for = conflict
72
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. press release or financial article written on the acquisition
2. look at equity research for the buyer and see if anyone has estimated the numbers
3. CapIQ or Factset
73
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?
1. EBITDA multiple and EBITDA margin ar einversely proportional, one goes up and the other goes down, so its normal that 40% EBITDA margin has a lower EBITDA multiple
2. screen based on one
3. DO NOT TRY TO NORMALIZE EBITDA
74
Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.
1. industry specific multiples like Price/NAV
2. You need to project the prices of commodities like oil and natural gas, and also the company’s reserves to determine its revenue and cash flows in future years.
3. use NAV instead of DCF because everything flows from company reserves rather than EBITDA margin projections
75
Walk me through how we would value a REIT (Real Estate Investment Trust) and how it differs from a “normal” company.
1. look at price/FFO (funds from operation), NAV
2. value properties based on Net Operating Income/capitaliztaion rate
3. use replacement valuation method to calculate how much it costs to buy a land and build property
4. DCF from specific properties (more difficult to be used)
76
Walk me through a DCF.
1. A DCF is based on projecting a company's free cash flow and terminal value into the future 5-10 yrs and discounting it back to its present value and
2. first project company future free cash flow based on revenue growth, operating expenses, working capital, then you add each year's free cash flow and discount it using WACC or cost of equity to get to the net present value
3. then onece you have NPV of FCF you can use it to determine a company's TV based on exit multiple, or gordon growth method. Then also discount it back to present value
4. add the NPV of FCF and NPV of TV together to get company's enterprise value based on intrinsic value and not just accounting
77
walk me through how to get from revenue to free cash flow in the projections
1. for unlevered free cash flow
2. first revenue - COGS and SG&A (operating expenses) = EBIT (operating income)
3. EBIT * (1-tax rate) + non cash expenses - change in working capital - capex
4. levered FCF = net income + non cash charged - change in working capital - capex - debt repayements
78
what is free cash flow vs cash flow
1. free cash flow is the cash flow from purely operating activities, its the cash flow left after accounting for operating expenses and capex
2. cash flow is just cash flow from operating, financing and investments
3. free cashf low can be unlevered or levered
4. UFCF= Unlevered Free Cash Flow (UFCF)=EBIT×(1−Tax Rate)+Non-Cash Charges−Changes in Working Capital−Capital Expenditures
5. Levered Free Cash Flow (LFCF)=Net Income+Non-Cash Charges−Changes in Working Capital−Capital Expenditures−Debt Repayments (operating cash flow - capex)
79
difference between UFCF and FCF
1. UFCF applies to all investors (debt or equity), because it is before any financing adjustments has been done to it, before any interest payments -> gives ypu EV at end of DCF
2. LFCF only applies to equity shareholders because debt has already been paid and hence the remaining is only relevant to equity shareholders: uses net income instead of EBIT * (1-tax) and subtracts debt repayements, also uses cost of equity instead of WACC -> give equity value at end of DCF
80
Why do you use 5 or 10 years for DCF projections?
1. the amount you can predict a stable cash flow for
2. biotech or pharma may require more time 10yrs because it takes longer to generate stabilized cash flows
81
What do you usually use for the discount rate?
1. WACC weighted average cost of equity
2. use cost of equity if u just used LFCF
82
what does WACC actually mean and why is it used as a discount rate
- average return required by all of a company’s investors (debt and equity)
- the overall cost of financing the company’s assets given the capital structure (equity and debt investors)
- For example, if a company’s WACC is 8%, it means that any project or investment needs to generate at least an 8% return to be considered viable. Below that, the investment might destroy value, as it wouldn’t cover the required returns for both debt and equity holders.
- wacc varies w company risk profile and captures the risk and required return
83
How do you calculate WACC?
- Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred)
* preferred is just preferred stock bcuz u have to pay dividend
84
how to calculate cost of equity
1. CAPM
2. Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
3. risk free rate is the interest rate to put in banks or the bonds rate
4. equity risk premium is taken from a publication called Ibbotson’s.
5. can add other premiums such as industry premium, size premium, country premium to account for how much a company is expected to out-perform its peers is according to its market cap or industry
85
How do you get to Beta in the Cost of Equity calculation?
1. find beta of comparable companies on bloomberg, these are normally levered beta
2. unlever the beta on bloomberg by equation
3. Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
4. then find medium of a set of comparable companies
86
Why do you have to un-lever and re-lever Beta?
- levered beta reflects the debt/interest that has already been paid, hence only apllies to equity shareholders
- we want it to reflect debt and equity shareholders and all capital structure, so must include debt as well
- we want to look at how “risky” a company is regardless of what % debt or equity it has
- Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time
87
How do you calculate the Terminal Value?
1. exit multiple method: apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method)
2. gordon growth method: used when no good comparable companies,
3. Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate)
88
what does the terminal value mean?
1. the present value of all future cash flows beyond the forecast period, long term growth potential beyond forecasted period
2. gordon growth: perptual growth model
3. multiples model: assumes will exit or be sold at a specific exit multiple
89
when to use exit multiples vs gordon growth method?
1. use perpetual growth when cyclical industry or no comparable companies. Because needs to assume a long term growth rate (difficult assumption)
2. use multiples method if can find comparable company
90
What’s an appropriate growth rate to use when calculating the Terminal Value?
1. something conservative
2. GDP growth rate
3. inflation rate
91
Which method of calculating Terminal Value will give you a higher valuation?
1. very variable depending on assumptions
2. multiples are more variable cuz they give a range from comparable companies
92
How do you know if your DCF is too dependent on future assumptions?
1. if the EV you get is 50% or more from the terminal value
2. but actually most DCFs are all very dependent on future assumptions and TV, so 50% isnt that rare
3. 80-90% should defo concern u
93
Should Cost of Equity be higher for a $5 billion or $500 million market cap company?
1. cost of equity dependent on beta = smaller companies tend to be more risky and more volatile
2. hence smaller companies have larger cost of equity
94
What about WACC – will it be higher for a $5 billion or $500 million company?
1. depends on capital structure
2. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above
3. if not the same, depends on how much debt and interest rates
95
What’s the relationship between debt and Cost of Equity?
1. more debt = more risky = higher beta
2. additional debt = higher cost of equity given everything esle is equal
96
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?
1. divident return is alr counted in beta
2. cuz beta accounts for returns in excess of market, which alr includes dividends
97
How can we calculate Cost of Equity WITHOUT using CAPM?
Cost of equity = (divdend per share/share price) + growth rate of dividends
98
Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?
1. U shaped
2. one with debt will have a lower WACC up to a certain point bcuz debt is tax deductible
3. however up to a certain points when debt increases so much it increases cost of debt (dramatic increase in interest rates) it can lead to increasing WACC
99
Which has a greater impact on a company’s DCF valuation – a 10% change in
revenue or a 1% change in the discount rate?
- depends, but generally revenue, cuz it projects into the future too
100
What about a 1% change in revenue vs. a 1% change in the discount rate?
1. discount rate cuz it applies to all of FCF and terminal value
101
How do you calculate WACC for a private company?
- use comps
102
What should you do if you don’t believe management’s projections for a DCF model?
1. create own projections
2. add an extra discount to make it more conservative
3. have a sensitivity table with different revenue, TV
103
Why would you not use a DCF for a bank or other financial institution?
- banks use debt differently, they dont reinvest it but they sell it as a product
- interests and working capital also takes up a big chunk of their balance sheet
- use divident discount model instead
104
What types of sensitivity analyses would we look at in a DCF?
1. revenue growth vs terminal multiple
2. EBITDA Margin vs. Terminal Multiple
3. Terminal Multiple vs. Discount Rate
4. Long-Term Growth Rate vs. Discount Rate
105
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?
1. principle repayement is not counted in DCFs bcuz it is not in operating cash flow and is in financing cash flow
2. even looking at levered FCF, interest expense would decrease as the loan is being repayed, but that doesnt account for the debt repayement
106
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
Project out the company’s earnings, down to earnings per share (EPS).
2. Assume a dividend payout ratio – what percentage of the EPS actually gets paid
out to shareholders in the form of dividends – based on what the firm has done
historically and how much regulatory capital it needs.
3. Use this to calculate dividends over the next 5-10 years.
4. Discount each dividend to its present value based on Cost of Equity – NOT
WACC – and then sum these up.
5. Calculate terminal value based on P / E and EPS in the final year, and then
discount this to its present value based on Cost of Equity.
6. Sum the present value of the terminal value and the present values of the
dividends to get the company’s net present per-share value.
107
Walk me through a basic merger model.
1. analyze the merge of 2 financial profiles, looking at the purchase price, the capital structur eof the purchase, determining whether EPS is dilutive or accretive
2. making assumption abt the purchase in cash/stock/debt
3. determine valuation for shares outstanding for both company and project an income statement
4. combine income statement and add lines up such as revenue, operating expenses and adjusting for interest on cash and debt, get combines net income after buyers tax rate, and divide new share count to determine end EPS
108
Why would a company want to acquire another company?
1. buy out competition (regulations w that)
2. diversification: geography, product
3. IP, patent
4. acquire seller's customer for cross selling
5. can achieve sugnificant synergies and make deal accretive for shareholders
109
Why would an acquisition be dilutive?
1. additional net income from seller doesnt offset the buyers foregone interest on cash, extra interest paid on debt, or amorotization of tangibles
110
Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
1 if deal only incolves cash and debt
sum up interest expense for debt and foregone interest on cash
compare it against sellers pre-tax income
111
A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
1. depends
2. if all cash or all debt, then doesnt matter cuz no stock issued
3. if all stock based, then defo accretive, more earnings for less
112
What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?
1. all stock deal, high P/E acrquire lower PE, accretive
2. if buyer has lower P/E dilutive
3. if paying more for earnings which is valued higher than yours then dilutive
113
What are the complete effects of an acquisition
1. Foregone Interest on Cash
2. additional debt interest
3. additional shares outstanding
4. combined financial statements
5. creation of goodwill and other intangibles (premium)
114
f a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?
1. saving cash for something else
2. stocks trading at all time high, hence want to use stocks
115
Why do Goodwill & Other Intangibles get created in an acquisition?
1. value over fai market value
2. a premium for non tangible assets like IP
116
What is the difference between Goodwill and Other Intangible Assets?
1. goodwill cant be amortized (only impaired)
2. intangible assets are amortized
117
How are synergies used in merger models?
1. revenue: add revenue synergies to revenue figure on com,bines company
2. cost synergies: reduce compbines COGS and operating expense, boosts combines pre-tax income and raises EPS making deal more accretive
118
Are revenue or cost synergies more important?
1. no one can predict revenue synergies
2. cost synergies are straight forward and can be calculates
119
All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?
- cash because interest rates on cash is usually lower than interest rates on debt
- cash is less risky, cuz buyer might faik to raise sufficient funds from invesors
- stock is more expensive (more volatile and cost of equity is higher than cost of debt)
- cash less risky, share price could dip in a day
120
How much debt could a company issue in a merger or acquisition?
1. comps
2. look at LTM and find debt/ebitda, the apply to own EBITDA figure
121
Why do most mergers and acquisitions fail?
1. both parties have different interests in mind
122
What role does a merger model play in deal negotiations?
1. test various assumptions and sanity check
123
walk me through LBO
1. make asuumptions abt purchase price, debt/equity ratio, interest rate, and companys revenue growth
2. create a sources section: shows how you finance the transaction and what you use the capital for, how much investor equity is required
3. adjust company balance sheet for new debt and equity, and also ass in goodwill and other intangibles on the asset side to make everything balance
4. project company IS< BS and FCS and determine how much debt paid out per yr, available fash flow, and interest payments
5. assumption of exit multiples, and calculate IRR and how much equity is returned to firm after debt repayements
124
why do u use leverage when buying company
1. boost return: not using your money, easier to boost higher returns on less of your own equity
2. more capital for other companies
125
What variables impact an LBO model the most?
1. purchase and exit multiples
2. amount of leverage
3. operational activities: rev growth and EBITDA
126
How do you pick purchase multiples and exit multiples in an LBO model?
1. look at IRR target (20-25%) and exit multiples
2. look at comparable companies
127
What is an “ideal” candidate for an LBO?
1. stable cash flow
2. low risk business
3. less capex
4. opportunity for operation expense reduction to boost margin
5. good management team
128
How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?
1. use IRR to back dolveto determine the purchase price PE firm should pay to achieve that IRR
129
an you explain how the Balance Sheet is adjusted in an LBO model?
1. debt is added to liabilities
2. shareholder equity replaced by equity the PE firm is contributing
3. asset side: cash asjusted for cash used to finance transaction, goodwill &others are used as plug to balcne the sheet
130
We saw that a strategic acquirer will usually prefer to pay for another company in cash – if that’s the case, why would a PE firm want to use debt in an LBO?
1. PE wants to sell the company later
2. not concerned by cost of debt because it is looking to sell company anyways to boost return
131
How could a private equity firm boost its return in an LBO?
1. Lower the Purchase Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company’s growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
132
What is meant by the “tax shield” in an LBO?
1. interest a firm pays on debt is tax deductible, save money of taxes and increase cash flow
2.however debt will still decrease cash flow compared to non debt company bcuz interest rate still decreases net income
133
What is a dividend recapitalization (“dividend recap”)?
1. a company takes on new debt so it can pay a special divident to the PE firm that bought it
134
why would PE want to divident recap one of its portfolio companies
1. to boost return
2. more leverage
3. divident recap helps recover some equity investment in the company
135
how to calculate IRR , what doe sit mean
1. rate of return that makes the sum of all future cash flows equal to the initial investment
2. IRR = initial investment + (cash flow yr 1/(1+IRR)^n)
136
what is MoM, and how to calulate
1. money multiple
2. calculates how much money you earned compared to your initial investment
3. MoM = total cash inflow/initial investment
137
why does LBO give a lower valuation than DCF?
1. because with LBOs you essentially want to exit in the end, so you want to make as much IRR as possible, which means lower entrance multiple for a higher exit multiple
2. also you dont sum up the FCF because that would be used to pay back debt each year
3. you also have a target IRR and work backwards to get a entrance multiple for LBO
4. whereas for DCF you dont have a predetermined exit, and you are not planning to sell company off
138
if a company has no revenue and no profit, how do you value it
1. cant use majority of multiples, bcuz no profit AND NO REVENUE (no sales)
2. cant use DCF bcuz no cash flows cuz no revenue. DONT TRY TO PREDICT CASH FLOWS
139
can you still use a DCF if a company doesnt have revenue?
NO, because you cant predict cash flow
140
can you use a DCF if a company had no profit
1. yes, no profit doesnt mean no cash flow
2. cash can still come in from issuing shares, debts
3. and D&A decreases profit but doesnt decrease cash flow
4. so no profit can still show positive cash flow
141
