Equity

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 a company has (its Net Assets) but only to EQUITY INVESTORS (i.e., common shareholders). Enterprise Value represents the value of the company’s CORE BUSINESS OPERATIONS (its Net Operating Assets) but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

Question 2

Why do you use both Equity Value and Enterprise Value? Isn’t Enterprise Value 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 TEV-based multiples have some advantages because they are not affected by changes in the company’s capital structure as much as Equity Value and Eq Val-based
multiples are affected. However, in valuation, one methodology might produce Implied Enterprise Value, while another might produce Implied Equity Value, so you will need to move between them to analyse a company. Finally, you use both of them because actions taken by one investor group affect all the other groups. If a company raises Debt, that also affects the risk and potential returns for common shareholders.

Question 3

Why do you pair Net Assets with Common Shareholders in Equity Value, but Net Operating Assets with All Investors in Enterprise Value? Isn’t that an arbitrary pairing?

Answer 3

No. The logic is that Common Shareholders’ Equity can be generated internally (via Net Income) or raised externally (Stock Issuances), so the company can use it for both Operating and Non-Operating Assets. But if the company raises funds via outside investors (Debt, Preferred Stock, etc.), then most likely it will use those funds to pay for Operating Assets, rather than spending the money on random Non-Operating Assets (such as a side business for a software company). This rule does not always hold up in real life, but this is the basic rationale.

Question 4

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

Answer 4

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 the core-business operations are worth based on your views and analysis. You calculate Current Enterprise Value for public companies by starting with Current Equity Value, subtracting Non-Operating Assets, and adding Liability and Equity line items that represent other investor groups (i.e., ones beyond the common shareholders). 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 5

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

Answer 5

Remember that Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount 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 6

Why do you subtract Cash, add Debt, and add Preferred Stock when moving from Equity Value to Enterprise Value in the “bridge”?

Answer 6

You subtract Non-Operating Assets because Enterprise Value reflects only Net Operating Assets. Cash and Investments are examples of Non-Operating Assets, but Equity Investments (Associate Companies), Assets Held for Sale, and Assets Associated with Discontinued Operations also count. You add Liability & Equity line items that represent other investor groups beyond the common shareholders because Enterprise Value represents All Investors. Debt and Preferred Stock are the most common examples, but Underfunded Pensions, Capital Leases, and Noncontrolling Interests also qualify.

Question 7

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 7

The “Enterprise Value” here is the $800K total price of the house, and the “Equity Value” is the $200K down payment you’re making.

Question 8

Could a company’s Equity Value ever be negative?

Answer 8

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 could be negative because you use your views and assumptions to calculate that. If the company’s Implied Enterprise Value is $0, for example, and it has more Debt than Cash, then its Implied Equity Value will be negative. Note, however, that you typically say its Equity Value is $0 in cases like this.

Question 9

Could a company’s Enterprise Value ever be negative?

Answer 9

Yes. Both Current and Implied Enterprise Value could be negative – for example, a company might have Cash that exceeds its Current Equity Value and no Debt. And your Implied Enterprise Value might be the same as, or close to, its Current Enterprise Value. Once again, you often say the company’s Enterprise Value is simply $0 in cases like this

Question 10

Why do financing events such as paying Dividends or issuing Debt not affect Current Enterprise Value?

Answer 10

Current Enterprise Value changes only if Net Operating Assets change. Paying Dividends reduces the company’s Cash and Common Shareholders’ Equity, and issuing Debt increases the company’s Cash and Debt. None of these is an Operating Asset or Liability, so Current Enterprise Value cannot possibly change.

Question 11

You estimate a company’s Implied Value with Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate. Will this give you the company’s Implied Equity Value or Implied Enterprise Value?

Answer 11

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

Question 12

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

Answer 12

Only changes to the company’s Net Operating Assets (i.e., changes to its “core business”) affect Enterprise Value. For example, if the company purchases PP&E using Cash, or it raises Debt to purchase PP&E or Inventory, both of those will increase Current Enterprise Value.

Question 13

Is it possible for a single change to affect both Current Equity Value and Current Enterprise Value?

Answer 13

Yes. For this to happen, Net Operating Assets must change, and Common Shareholders’ Equity must also change. So, for example, if the company issues $100 of Common Stock to fund the purchase of $100 in PP&E, both Eq Val and TEV (total enterprise value) will increase by $100.

Question 14

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

Answer 14

First, because the treatment of the seller’s existing Debt and Cash differs based on the terms of the deal. The buyer may not necessarily “repay” the seller’s Debt – it could instead refinance it and replace it with new Debt – and it may not “get” all the seller’s Cash.
Also, the buyer has to pay additional fees for the M&A advisory, accounting, and legal services, and the financing to acquire another company, and those are not reflected in its Enterprise Value.

Question 15

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, then their Enterprise Values will be the same. Why is this NOT true in reality?

Answer 15

Because a company’s capital structure, whether current, optimal, or targeted, affects the Discount Rate used to calculate the Implied Enterprise Value (and the Discount Rate “the market as a whole” uses for the company’s Current Enterprise Value). Not only do the percentages of Equity, Debt, and Preferred Stock affect WACC, but the Cost of each one also changes as the company’s capital structure changes. For example, going from no Debt to a small amount of Debt may initially reduce WACC because Debt is cheaper than Equity. But past a certain point, additional Debt will increase WACC because the risk to all investors starts increasing at that stage. Enterprise Value is LESS affected by capital structure changes than Equity Value, but there will still be some effect.

Question 16

What about private companies? How do the concepts of Equity Value and Enterprise Value work there?

Answer 16

Eq Val and TEV still apply to private companies, but you cannot calculate Current Equity Value with Current Share Price * Shares Outstanding because private companies do not have publicly traded shares. All you can do is look at the company’s most recent valuation in a fundraising (e.g., for a tech startup) or some other outside assessment of the company to estimate its Current Equity Value. This also makes it difficult to calculate Current Enterprise Value, so you often focus on Implied Equity Value and Enterprise Value rather than comparing your estimates to what the market thinks the company is currently worth.

Question 17

Does Common Shareholders’ Equity (CSE) change?

Answer 17

If so, then Equity Value changes by the amount that CSE changes. If not, then Equity Value does not change. You can also think of this as, “Do Net Assets change?” but be careful because if there are Noncontrolling Interests or Preferred Stock, Net Assets no longer equals CSE! Items that affect CSE include Net Income, Dividends, Stock Issuances, and Stock Repurchases

Question 18

Do Net Operating Assets (NOA) change?

Answer 18

If so, then Enterprise Value will change by the amount that NOA changes. It doesn’t matter which investor group was responsible because Enterprise Value reflects all investors. You could also get questions about how valuation multiples change, but these questions are a bit pointless because the historical financial metrics (Revenue, EBITDA, Net Income, etc.) will not change immediately after a capital raise, acquisition, or another event takes place. So, you can answer any question about valuation multiples by explaining what happens to Equity Value and Enterprise Value (e.g., if TEV increases, then TEV / EBITDA also increases).

Question 19

A company issues $200 in Common Shares. How do Equity Value and Enterprise Value change?

Answer 19

CSE increases by $200, so Eq Val increases by $200.
NOA does not change because neither Cash nor CSE is operational, so TEV stays the same. Alternatively, in the TEV formula, the extra Cash offsets the higher Equity Value.

Question 20

A company issues $200 in Common Shares, and it uses $100 from the proceeds to pay Dividends to the common shareholders. How does everything change?

Answer 20

CSE increases by $100 after both changes, so Eq Val increases by $100. NOA does not change because neither Cash nor CSE is operational, so TEV stays the same. Alternatively, in the TEV formula, the extra Cash offsets the higher Equity Value.

Question 21

The company decides to use the $200 in proceeds from new Common Stock to acquire another business for $100 instead. How does everything change?

Answer 21

CSE increases by $200 from this issuance, so Eq Val increases by $200. Of this $200 in proceeds, $100 remains in Cash, and $100 is allocated to Acquired Assets from the other business. These Acquired Assets are Operating Assets, and no Operating Liabilities change, so NOA increases by $100. TEV, therefore, increases by $100.

Question 22

What if the company (has $200 of common stock) uses that same $100 from new Common Stock to acquire an Asset rather than an entire company?

Answer 22

CSE still increases by $200, so Eq Val is up by $200. If this Asset is considered “Operating” or “Core,” such as a factory, then NOA increases by $100, so TEV also increases by $100. If not – for example, the Asset is a short-term investment – then NOA does not change, and TEV stays the same.

Question 23

What happens if this company (issued $200 in common stock) issues $200 in Debt to fund a $100 Asset acquisition instead?

Answer 23

The main difference is that Eq Val no longer changes because CSE does not change as a result of a Debt issuance. If this $100 Asset is Operational, NOA increases, so TEV increases by $100; if not, TEV stays the same.

Question 24

A company issues $200 of Debt to fund a $200 Equity Purchase Price acquisition of a company with $150 in Common Shareholders’ Equity. How do Equity Value and Enterprise Value change, considering that the acquirer must create Goodwill?

Answer 24

The $50 of Goodwill here does not affect anything because Goodwill is an Operating Asset. $200 of Acquired Company Assets vs. $150 of Acquired Company Assets and $50 of Goodwill make the same impact on both Eq Val and TEV. This $200 Debt Issuance does not affect CSE, so Eq Val stays the same. TEV increases by $200 because NOA increases by $200 (Operating Assets increase by $200, and no Operating Liabilities change).

Question 25

A company issues $100 in Preferred Stock to purchase $50 of PP&E. How do Equity Value and Enterprise Value change?

Answer 25

CSE does not change because Preferred Stock issuances flow into Preferred Stock within Equity, not Common Shareholders’ Equity. Therefore, Eq Val stays the same. NOA increases by $50 because the PP&E is an Operating Asset, and no Operating Liabilities change, so TEV increases by $50.

Question 26

Now the company issues $100 in Preferred Stock to repurchase $50 of Common Stock. How do Equity Value and Enterprise Value change?

Answer 26

CSE decreases by $50 because of this repurchase, so Eq Val decreases by $50. NOA does not change because Cash, Preferred Stock, and CSE are all Non-Operating, so TEV stays the same.

Question 27

A company issues $150 of Debt and $50 of Common Stock to acquire $175 of PP&E and $25 of Short-Term Investments. How do Equity Value and Enterprise Value change?

Answer 27

CSE increases by $50 because of the Common Stock Issuance, so Eq Val increases by $50. The $175 of PP&E counts as an Operating Asset, and no Operating Liabilities change (Debt is Non-Operating), so NOA increases by $175, and TEV also increases by $175.

Question 28

Current Equity Value represents the Market Value of ALL Assets. But if that’s the case, why doesn’t a $100 Debt issuance boost Equity Value? The company receives $100 in extra Cash from this issuance, which should boost its Total Assets.

Answer 28

This is a trick question because the interviewer makes two mistakes in the premise:
1) Equity Value represents Net Assets, not Total Assets.
2) And Current Equity Value represents the Net Assets’ market value only to Equity Investors.
So, Eq Val does not change in this scenario because Common Shareholders’ Equity does not change, so nothing related to point #2 changes. And Net Assets doesn’t even change, going along with point #1.

Question 29

A company purchases $100 of Inventory using Cash. How do Equity Value and Enterprise Value change?

Answer 29

There are no changes on the Income Statement in this initial step because the Inventory has not yet been sold. On the Balance Sheet, CSE stays the same in this initial step, so Eq Val stays the same. NOA increases by $100 since Inventory is an Operating Asset, and no Operating Liabilities change, so TEV increases by $100.

Question 30

A company purchases $100 of Inventory using Cash. Now assume the Inventory is sold for $200 and walk me through how the entire process from beginning to end affects Equity Value and Enterprise Value.

Answer 30

On the Income Statement, Revenue is up by $200, and Pre-Tax Income is up by $100 (due to the $100 of Inventory now being recognized as COGS). Net Income increases by $75 at a 25% tax rate.
On the CFS, Net Income is up by $75, and there are no other changes (Inventory went up and now goes down), so Cash is up by $75 at the bottom.
On the Balance Sheet, Cash is up by $75 on the Assets side, and CSE is up by $75 on the L&E side.
Since CSE is up by $75, Eq Val increases by $75. NOA does not change because Cash is not an Operating Asset and no Operating Liabilities change, so TEV stays the same.
Intuition: This 2-step process represents the company generating Net Income and letting it sit in Cash; that process does not make its core business more valuable, so TEV does not increase.

Question 31

A company collects $200 of cash from a customer upfront for a service that it has not yet delivered. How do Equity Value and Enterprise Value change?

Answer 31

This change is recorded as a $200 increase in Cash on the Assets side of the Balance Sheet, and a $200 increase in Deferred Revenue on the L&E side. CSE does not change because there’s no Net Income generation yet, and there are no Dividends, Stock Issuances, or Stock Repurchases, so Eq Val stays the same. NOA decreases by $200 because the Deferred Revenue is an Operating Liability, and no Operating Assets change. Therefore, TEV decreases by $200.

Question 32

A company collects $200 of cash from a customer upfront for a service that it has not yet delivered. Now, the company delivers the service to the customer and recognizes the $200 as Revenue, along with $100 in Operating Expenses. Walk me through how the entire process from beginning to end affects Equity Value and Enterprise Value.

Answer 32

On the IS, Pre-Tax Income is up by $100, and Net Income is up by $75 at a 25% tax rate. On the CFS, Net Income is up by $75, and nothing else changes (DR went up and now goes down), so Cash is up by $75.
On the BS, Cash is up by $75 on the Assets side, and CSE is up by $75 on the L&E side.
Since CSE is up by $75, Eq Val increases by $75. NOA does not change because Cash is Non-Operating, and no Operational Liabilities have had a cumulative change, so TEV stays the same.
Intuition: This 2-step process represents the company generating Net Income and letting it sit in Cash; that process does not make its core business more valuable, so TEV does not increase.

Question 33

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 33

This event would be recorded as a $100 Extraordinary Gain on the Income Statement. If you ignore Taxes completely, Net Income increases by $100, Cash increases by $100, and on the Balance Sheet, Cash is up by $100 on the Assets side, and CSE is up by $100 on the L&E side. CSE is up by $100, so Eq Val increases by $100. NOA does not change because no Operating Assets or Liabilities change, so TEV stays the same.
If you factor in Taxes and assume a 25% rate, Net Income and Cash increase by $75 instead, so Eq Val increases by $75, and TEV remains the same.
Intuition: “Finding” a Non-Operating Asset on the street does not make a company’s core business more valuable.

Question 34

A company experiences a disaster at one of its factories and records a $100 PP&E Write-Down. It also decides to issue $50 in Common Stock to get the funds required to replace this factory in the future. How do Equity Value and Enterprise Value change?

Answer 34

The PP&E Write-Down reduces Pre-Tax Income by $100 and Net Income by $75 at a 25% tax rate. On the CFS, Net Income is down by $75, but the Write-Down is non-cash, so you add back $100. You also reflect the $50 Stock Issuance in CFF, so Cash at the bottom increases by $75. (We’re ignoring Cash vs. Book Taxes in this question and assuming the Write-Down is deductible for both, for simplicity.)
On the BS, Cash is up by $75, and Net PP&E is down by $100, so the Assets side is down by $25. The L&E side is also down by $25 due to the $75 Net Income reduction and $50 Stock Issuance. CSE is down by $25, so Eq Val is down by $25. NOA is down by $100 due to the $100 PP&E Write-Down, and no Operating Liabilities change, so TEV decreases by $100.
Intuition: Changes to Operational line items can affect both TEV and Eq Val, but the impact on Eq Val may be “reduced” if the company also changes its capital structure at the same time.

Question 35

A company has excess Cash. How do Equity Value and Enterprise Value change if the company uses the Cash to repay Debt vs. repurchase Common Stock?

Answer 35

NOA does not change in any case because nothing here is operational, so TEV stays the same. In the first case – Debt repayment – CSE does not change because Debt issuances and repayments do not affect it, so Eq Val does not change. In the second case – a Common Stock repurchase – CSE decreases, so Eq Val decreases.

Question 36

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 36

This change relates more to the company’s Implied or Intrinsic value. Since the company expects higher sales growth, both its Implied Enterprise Value and Implied Equity Value will increase because they are both based on the company’s expected future cash flows. Current Eq Val and Current TEV may also increase if the company’s share price instantly jumps up, but you can’t link the change to one specific line item on the Balance Sheet changing; there won’t be an immediate change on the BS right after this announcement.

Question 37

What IS a valuation multiple?

Answer 37

A valuation multiple is shorthand for a company’s value based on its Cash Flow, Cash Flow Growth Rate, and Discount Rate. You could value a company with this formula: Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate
But instead of providing all that information, valuation multiples let you 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 they are, relative to similar houses or companies.

Question 38

. How do you use valuation multiples in real life?

Answer 38

Most often, you use them in “Comparable Company Analysis” or “Public Comps” when you find public companies similar to the one you’re analyzing and use their multiples to value your company. For example, you might screen companies by geography, industry, and financial size so that they are similar to your company. Then, you look at the growth rates of various metrics and their corresponding multiples to see how your company is currently priced. For example, if the median EBITDA growth of this set of companies is 10%, and your company is growing at 20%, but your company’s TEV / EBITDA and the median TEV / EBITDA of the set are similar, then perhaps your company is undervalued.
If the companies are truly comparable, then they should have similar Discount Rates and Cash Flow figures. So, the differences in Cash Flow Growth Rates should explain most of the difference in the multiples.

Question 39

Why are valuation multiples and growth rates often NOT as correlated as you might expect?

Answer 39

The first problem is that company valuation is based on cash flow, which is different from metrics like EBIT and EBITDA (which are just approximations of cash flow). So, even if a company’s EBITDA growth is 10%, its Cash Flow growth might be 5% or 20% or (5%) due to items like Taxes, the Change in Working Capital, and so on.
Also, it’s difficult to find 100% comparable companies in most industries, so there will usually be differences in the Discount Rates because the risk and potential returns will differ. Finally, “current events” always affect the multiples, even if they don’t change a company’s long-term performance. For example, legal troubles, a newly announced product, or a new executive could all change a company’s short-term market valuation.

Question 40

You’re valuing a mid-sized manufacturing company. This company’s TEV / EBITDA multiple is 15x, and the median TEV / EBITDA for the comparable companies is 10x. What’s the most likely explanation?

Answer 40

The most likely explanation is that the market expects this company’s cash flows to grow more quickly than those of the comparable companies. For example, other companies might be expected to grow at 5%, but this company might be expected to grow at 15%. 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 and potential returns should be similar. “Current events” could also affect the multiples, but it’s hard to say what they might be without additional information.

Question 41

Would you rather buy a company trading at a 10x TEV / EBITDA multiple, or one trading at a 5x multiple?

Answer 41

It depends on how each company compares to its peers, or comparable companies, in terms of growth rates and multiples. If the 10x company is growing at the same rate as its peer companies, but the peer companies are trading at multiples in the 13x-16x range, then the 10x company looks like a good deal. And if the 5x company is growing more slowly than its peer companies, despite trading in the same range (4-6x EBITDA), then the 5x company might be expensive for the growth it offers. When you buy companies, you always try to find ones that are undervalued – which means similar or lower multiples than peer companies, despite the same or higher growth.

Question 42

Walk me through how you calculate EBIT and EBITDA for a public company.

Answer 42

With EBIT, you start with the company’s Operating Income on its Income Statement and then add back any non-recurring charges that have reduced Operating Income. With EBITDA, you do the same thing and then add Depreciation & Amortization from the
company’s Cash Flow Statement so that you get the all-inclusive number (D&A on the Income Statement is often embedded fully or partially in other line items there). You do not add back items like the Amortization of Debt Issuance Fees or the Amortization of Debt Discounts because they are typically components of the Net Interest Expense on the IS.

Question 43

Is anything different under U.S. GAAP vs. IFRS for these calculations of EBIT and EBITDA for a public company? Do the multiples differ at all?

Answer 43

The main difference is that under U.S. GAAP, both EBIT and EBITDA fully deduct the Lease or Rental Expense, but under IFRS, they do not – because the Lease Expense is split into Interest and Depreciation elements. EBIT under IFRS deducts part of the Lease Expense, while EBITDA adds back or excludes the entire Lease Expense. You still use Enterprise Value in the numerator of these valuation multiples, but under IFRS, you must add Operating Leases to Enterprise Value, and EBIT is no longer a valid metric (unless you adjust it). Under U.S. GAAP, no adjustment for Operating Leases is required, and TEV / EBIT and TEV / EBITDA are both valid multiples as-is.

Question 44

How do you calculate “Free Cash Flow” (just FCF, not Levered or Unlevered FCF), and what does it mean? Are there any differences under U.S. GAAP vs. IFRS?

Answer 44

Free Cash Flow is defined as Cash Flow from Operations – Capital Expenditures, assuming that Cash Flow from Operations deducts the Net Interest Expense, Taxes, and the full Lease Expense. It tells you how much Debt principal the company could repay, or how much it could spend on activities such as acquisitions, dividends, or stock repurchases. The main difference under the two accounting systems is that IFRS-based companies often start their Cash Flow from Operations sections with something other than Net Income, which means you may need to adjust CFO by subtracting the Net Interest Expense, the Interest element of the Lease Expense, or other items from elsewhere on the Cash Flow Statement. Also, under IFRS, you should not add back the entire D&A line item on the CFS – only the D&A that’s unrelated to the leases. That way, you ensure that the full Lease Expense is deducted.

Question 45

How do you calculate Unlevered FCF and Levered FCF, and how do you use them differently than normal Free Cash Flow?

Answer 45

Unlevered Free Cash Flow equals Net Operating Profit After Taxes (NOPAT) + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx.
Levered Free Cash Flow equals Net Income to Common + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx – (Mandatory?) Debt Repayments + Debt Issuances (?).
You normally use UFCF in DCF valuations because it lets you evaluate a company while ignoring its capital structure; FCF is more useful for standalone company analysis and determining a company’s Debt repayment capacity. LFCF is not useful for much of anything because people disagree about the basic definition, but you could use it in a Levered DCF, and it may better represent the Net Change in Cash.

Question 46

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

Answer 46

Mostly for convenience and comparability. FCF and UFCF measure a company’s cash flow more accurately, but they also take more time to calculate since you need to review the full Cash Flow Statement and possibly adjust some of the items. Also, the individual items within FCF and UFCF vary quite a bit between different companies, regions, industries, and accounting systems, so you often need to normalize these figures, which requires discretion and explanation.

Question 47

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

Answer 47

If the financial metric in the denominator of the valuation multiple deducts Net Interest Expense, then it pairs with Equity Value because the Debt Investors can no longer be “paid” after they earn their interest; only Equity Investors can earn something now. If the metric does not deduct Net Interest Expense, then it pairs with Enterprise Value. This rule applies to both financial metrics (EBIT, EBITDA, etc.) and non-financial ones (Unique Users, Subscribers, etc.).

Question 48

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 48

You can use Equity Value or Enterprise Value in multiples, but you shouldn’t create multiples that are based on metrics in between Equity Value and Enterprise Value. If you use Net Income rather than Net Income to Common, you’ll have to use Equity Value +
Preferred Stock in the numerator – which is halfway to Enterprise Value, but missing the adjustments for Debt, Cash, etc. This numerator will confuse anyone looking at your analysis, so you should stick with the standard Equity Value metric and pair it with Net Income to Common.

Question 49

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

Answer 49

It depends on the type of Free Cash Flow. If the FCF metric deducts Net Interest Expense, i.e., it is either “Free Cash Flow” or Levered FCF, use Equity Value. If it does not deduct the Net Interest Expense, i.e., it is Unlevered FCF, use Enterprise Value.

Question 50

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

Answer 50

First, note that you never look at just one multiple when valuing companies. You want to evaluate companies across different multiples and methodologies to get the big picture.
TEV / EBITDA is better in cases where you want to exclude the company’s CapEx and capital structure completely.
TEV / EBIT is better when you want to ignore capital structure but partially factor in CapEx (via the Depreciation, which comes from CapEx in previous years).
So, TEV / EBITDA is more about normalizing companies and more useful in industries where CapEx is not a huge value driver, while TEV / EBIT is better when you want to link CapEx to the company’s value (e.g., for an industrials company).
The P / E multiple is not that useful in most cases because it’s affected by different tax rates, capital structures, non-core business activities, and more; you use it mostly as a “check,” and since it’s a standard multiple everyone knows.

Question 51

In the TEV / EBITDAR multiple, how do you adjust Enterprise Value?

Answer 51

If the denominator of a valuation multiple excludes or adds back an expense on the Income Statement, then the numerator should add the Balance Sheet item corresponding to that expense. EBITDAR is EBITDA + Rental Expense, so it adds back the Rental Expense. Therefore, in TEV, you must add the company’s on-Balance Sheet Operating Leases. Under IFRS, EBITDAR = EBITDA because companies do not record the Rental Expense at all, so (TEV + Operating Leases) / EBITDAR = (TEV + Operating Leases) / EBITDA.

Question 52

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

Answer 52

EBITDA = Revenue – COGS – Operating Expenses Excluding D&A.
If EBITDA decreases, it means that Revenue has dropped, or that COGS or Operating Expenses have increased. Unlevered FCF and Levered FCF also add and subtract all these items, plus more. As a result, both Levered FCF and Unlevered FCF will also decrease since the Operating Income that flows into both of them will be lower. Technically, the FCF figures might stay the same if changes in D&A, the Change in Working Capital, or CapEx offset the drop in Operating Income. A decrease in Operating Income will also reduce UFCF and LFCF, assuming everything else stays the same.

Question 53

What are some different ways you can calculate Unlevered FCF?

Answer 53

If you assume that metrics like EBIT and EBITDA have been adjusted for non-recurring charges and that Cash Flow from Operations (CFO) deducts Net Interest Expense, Taxes, the full Lease Expense, and other standard items:
• Method #1: EBIT * (1 – Tax Rate) + D&A and Possibly Other Non-Cash Adjustments +/- Change in Working Capital – CapEx.
• Method #2: (EBITDA – D&A) * (1 – Tax Rate) + D&A and Possibly Other Non-Cash Adjustments +/- Change in Working Capital – CapEx.
• Method #3: CFO – (Net Interest Expense and Other Items Between Operating Income and Pre-Tax Income) * (1 – Tax Rate) – CapEx.
In Method #3, you’re reversing the Net Interest Expense, which is why that term has a negative sign in front.

Question 54

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

Answer 54

No, it’s correct. If you’re ignoring the company’s capital structure, you have to ignore EVERYTHING related to its capital structure.

Question 55

When you create “forward multiples” based on projections for metrics such as Revenue and EBITDA, how do you adjust Enterprise Value? Do you project it forward as well?

Answer 55

No. You never “project” Equity Value or Enterprise Value when calculating multiples for use in Public Comps or Comparable Company Analysis. Instead, you always use each company’s Current Equity Value or Current Enterprise and divide them by the historical metrics and the projected metrics. In other words, the numerator stays the same for both historical and projected metrics. This is because Current Eq Val and Current TEV represent past performance as well as the market’s future expectations for the company.

Question 56

Two companies have the same P / E multiples but different TEV / EBITDA multiples. How can you tell which one has higher Net Debt, assuming that each one has only Equity, Cash, and Debt in its capital structure?

Answer 56

You might be tempted to say, “The one with the higher EBITDA multiple,” but that’s wrong because the companies could be different sizes. For example, if both companies have P / E multiples of 15x, but one has Net Income of $10, and one has Net Income of $100, the Equity Values are $150 and $1,500. If the TEV / EBITDA multiples are 20x for the first one and 10x for the second one, and EBITDA is $20 for the first one and $200 for the second one, the TEVs are $400 and $2,000. So, the first one has a Net Debt of $250, and the second one has a Net Debt of $500. But if you change the company sizes so that the first one has Net Income of $150 and EBITDA of $300, and the second one has Net Income of $100 and EBITDA of $200, you’ll get the opposite result: the first one now has higher Net Debt. If you constrain the companies and say that their Net Income and EBITDA figures are the same, then yes, the company with the higher TEV / EBITDA multiple will have the higher Net Debt.

Question 57

Two companies have the same amount of Debt, but one 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 57

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. Therefore, it will have a lower P / E multiple than the company with traditional Debt because both companies have the same Equity Value.
Advanced Note: Technically, you should record the “Amortization of the Convertible Bond Discount” on the Income Statement, which reflects how the Liability component of a Convertible Bond is worth less than that of an equivalent, traditional Bond because of the lower interest rate. If you do this, then the Net Incomes of both companies will be much closer, so the P / E multiples may be almost the same.

Question 58

A company is currently trading at 10x TEV / EBITDA. It wants to sell an Operating Asset for 2x the Asset’s EBITDA. Will that transaction increase or decrease the company’s Enterprise Value and its TEV / EBITDA multiple?

Answer 58

The sale will reduce the company’s Enterprise Value because the company is trading an Operating Asset for Cash, which is a Non-Operating Asset. Even though the company’s Enterprise Value decreases, its TEV / EBITDA multiple increases because the Asset’s multiple was lower than the entire company’s multiple.
Pretend that the company’s total EBITDA was $100, and that this Asset contributed $20 of that EBITDA. Therefore, the company’s Enterprise Value before the sale was $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 TEV / EBITDA is $960 / $80, or 12x.

Question 59

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

Answer 59

No, but everyone does it anyway. A portion of any company’s Cash balance is an “Operating Asset” because the company needs a minimum amount of Cash to continue running its business. So, technically, you should subtract only the Excess Cash, i.e. MAX(0, Cash Balance – Minimum Cash). However, companies rarely disclose this number, and it varies widely between different industries, so everyone subtracts the entire Cash balance.

Question 60

Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value?

Answer 60

The company doesn’t need it to continue operating its business. Goodwill reflects the premiums paid for previous acquisitions – 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 should have removed all Assets and Liabilities associated with them.

Question 61

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

Answer 61

Deferred Tax Assets 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) in the DTA because those are considered Non-Operating Assets (and they have some potential value to acquirers in M&A deals); they’re less related to operations than the rest of the items in a DTA. You may also reduce the NOL in proportion to the Valuation Allowance / DTA, as the Valuation Allowance indicates that the company does not expect to realize the full benefits of the DTA.

Question 62

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

Answer 62

You don’t. Equity Value represents Net Assets to Common Shareholders, and Enterprise Value represents Net Operating Assets to All Investors.
Each item in Working Capital counts in both Net Assets and Net Operating Assets, so you don’t adjust anything because both Eq Val and TEV include the full value of Working Capital.
NOTE: By “Working Capital” here, we mean “Operating Working Capital,” i.e., the Working Capital number excluding Cash, Debt, etc.

Question 63

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

Answer 63

First, they’re Non-Operating Assets since the Parent Company has only minority stakes in these companies and, therefore, cannot control them. Second, you subtract them for comparability purposes. Metrics like EBITDA, EBIT, and Revenue include 0% of these companies’ financial contributions, but Equity Value implicitly includes the value of the stake (e.g., 30% of the Associate Company’s Value if the Parent owns 30% of it). Therefore, you subtract the Equity Investments when moving from Equity Value to Enterprise Value to ensure that the numerator of TEV-based multiples – Enterprise Value – completely excludes Equity Investments, matching the metrics in the denominator that also exclude them.

Question 64

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

Answer 64

First, these Noncontrolling Interests represent another investor group beyond the common shareholders: the minority shareholders of the Other Company in which the Parent Company owns a majority stake. The Parent Company effectively controls this Other Company now, so it counts these minority owners as an investor group. Second, you add NCI 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 include 100% of the Other Company’s Revenue, EBIT, and EBITDA. Therefore, you 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 TEV / Revenue and TEV / EBITDA include 100% of the Other Company in both the numerator and the denominator.

Question 65

Should you add on-Balance Sheet Operating Leases in the Equity Value to Enterprise Value bridge?

Answer 65

Under U.S. GAAP, you could either add them or ignore them. If you add them, however, you have to pair TEV Including Operating Leases with EBITDAR; multiples such as TEV / EBIT and TEV / EBITDA are no longer valid because the denominators deduct the full Rental Expense. Under IFRS, you pretty much have to add the Operating Leases in the TEV bridge because metrics such as EBITDA already exclude the Interest and Depreciation elements of the Lease Expense. It’s questionable whether or not Operating Leases represent “another investor group,” so this adjustment is made mostly for comparability and consistency.

Question 66

At a high level, how do Pensions factor into the Enterprise Value calculation?

Answer 66

Only Defined-Benefit Pension plans factor in because Defined-Contribution Plans do not appear on the Balance Sheet. You should add the Unfunded or Underfunded portion, i.e., MAX(0, Pension Liabilities – Pension Assets), in the TEV bridge because the employees represent another investor group in this case. They agree to lower pay and benefits today in exchange for fixed payments once they retire, and the company must fund the pension and invest the funds appropriately. If contributions into the pension plan are tax-deductible, then you should also multiply the number by (1 – Tax Rate) in the bridge.

Question 67

What is the difference between Basic Equity Value and Diluted Equity Value? What do they mean?

Answer 67

Basic Equity Value is Common Shares Outstanding * Current Share Price, while Diluted Equity Value includes the impact of dilutive securities, such as options, warrants, RSUs (restricted stock units), and convertible bonds, and is Diluted Shares Outstanding * Current Share Price. Companies create and issue these dilutive securities to incentivize employees to stay at the company (and to raise funds, in the case of convertible bonds). Diluted Equity Value is a more accurate measure of what the company’s Net Assets are worth to common shareholders.

Question 68

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 68

Its Basic Equity Value is 100 * $10.00 = $1,000. To calculate the diluted shares, note that the options exercise price is less than the current share price. When these options are exercised, 10 new shares are created, so the share count increases to 110. The investors paid the company $5.00 to exercise each option, 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 69

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 and Diluted Equity Value?

Answer 69

First, note that these convertible bonds are convertible into shares because the company’s share price is above the conversion price. So, you do count them as additional shares. These convertible bonds will create $10 million / $50.00 = 200,000 new shares. You don’t use the Treasury Stock Method with convertibles because the investors don’t pay the company to convert the bonds into shares; they paid for the bonds upon the first issuance. So, the diluted shares are 1.2 million, and the Diluted Equity Value is $120 million.

Question 70

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 70

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 net additional shares outstanding. 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 individual convertible bonds, so you get 1,000 new shares.
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 71

This same company (with Diluted Equity Value $222,000) also has Cash of $10,000, Debt of $30,000, and Noncontrolling Interests of $15,000. What is its Enterprise Value?

Answer 71

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

Question 72

A company issued a convertible bond in a “capped call” transaction where it also purchased call options on its own stock at an exercise price equal to the conversion price and sold warrants on its stock at a higher exercise price. How would you estimate the dilution in this case?

Answer 72

In capped call transactions, the call options typically offset all the initial dilution from the convertible bond. New shares get created, but then the company exercises its call options to repurchase them. Then, you apply the Treasury Stock Method to the warrants sold at the higher exercise price, such as $100 if the conversion price is $60 or $70. So, if the company’s current share price is $40, there will be no dilution until it reaches $100 – at which point you will use the TSM to calculate the dilution from the warrants.
Note: This logic may not hold up if the company purchases a different number of call options, such as 1,000 when the potentially dilutive shares from the convertible bond are 1,100 or 1,200. So, we are making some simplifying assumptions here, but this is the basic idea.