General IB Flashcards
Walk me through a DCF
1- The first step of a DCF model is to build a five-year forecast of the three financial statements, based on certain business assumptions and their performance.
2- Next, Determine a terminal value for cash flows after they stabilize after the forecast period
3- Then, I’d discount the forecast period and the terminal value back to the present value with a discount rate.
Finally, I’d arrive at the enterprise value for the business
How do you calculate your terminal value?
One way is to treat the free cash flows as a perpetuity, assuming the business is ongoing. You take the last forecasted free cash flow number and multiply that by 1 plus a terminal growth rate (has to be reasonable, usually at the same rate as GDP). The denominator will be the discount rate less the growth rate.
OK, and how do you get to the discount rate?
For an unlevered firm, the appropriate discount rate to use is the WACC, or weighted average cost of capital. Capital can include debt, equity and preferred shares.
The appropriate rate for the debt is the after-tax blended interest rate It is after-tax because interest is tax deductible. The appropriate rate for the preferred shares is the preferred coupon. This is not tax deductible.
WACC is calculated by taking the percentage of debt, equity, and preferred shares of total firm value and multiplying the individual components by the required rate of return on that security. The terminal value of the project must also be determined and discounted accordingly
The return on equity for the firm is based on the Capital Asset Pricing Model, or CAPM (pronounced “Cap-M”).
OK, hold on a second, what is the CAPM?
The CAPM is a model which calculates the expected return on an asset based on its sensitivity to systematic (or undiversifiable) risk.
CAPM is widely used throughout finance for pricing risky securities
The appropriate formula for the return on equity would be: Risk-free rate (10-year government bond) + equity beta x market risk premium (expected return on stock market – risk-free rate)
The result should give an investor the required return or discount rate they can use to find the value of an asset.
If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?
Depreciation is a non-cash charge on the Income Statement, so an increase of $10 causes Pre-Tax Income to drop by $10 and Net Income to fall by $6, assuming a 40% tax rate.
On the Cash Flow Statement, Net Income is down by $6 but you add back the $10 of Depreciation since it’s a non-cash expense, so cash at the bottom is up by $4.
On the Balance Sheet, cash is up by $4 on the Assets side, but PP&E has declined by $10 due to the added Depreciation, so the Assets side is down by $6.
On the L&E side, Retained Earnings is down by $6 because of the reduced Net Income on the Income Statement, so both sides of the Balance Sheet are down by $6 and it remains in balance.
Please walk me from Enterprise Value to Equity Value (or the other way around).
Equity Value represents the value of all the assets a company has, but only to common equity investors (i.e., shareholders) in the company. Enterprise Value represents the value of only the company’s core business assets, but to all investors in the company (equity, debt, preferred, etc.).
So to move from Equity Value to Enterprise Value, you subtract non-core assets, and you add items that represent other investor groups.
In practice, this means starting with Equity Value and subtracting cash (technically excess cash, but usually simplified to just cash) and other non-core assets such as short-term/long-term investments, and then adding debt, preferred stock, non-controlling interests, and other items that represent other investor groups in the company.
To move from Enterprise Value to Equity Value, you do the opposite and subtract all those items representing other investor groups and add the non-core assets such as cash, investments, etc.
Please walk me from revenue to free cash flow.
First, clarify what type of Free Cash Flow they want. Unlevered? Levered? Something else?
Assuming it’s Unlevered FCF — or what’s available to all investors in the company (which pairs with Enterprise Value):
Start with revenue and subtract COGS and Operating Expenses to get to Operating Income, or EBIT. Multiply by (1 - Tax Rate) to get to Net Operating Profit After Taxes, or NOPAT.
Then, add back the non-cash charges that appear on the Cash Flow Statement, primarily Depreciation & Amortization, and reflect the Change in Working Capital, which may be either positive or negative (follow the sign used on the company’s CFS). And then subtract Capital Expenditures (CapEx)
How are the three main financial statements connected?
The three main financial statements are balance sheets, income statements, and cash flow statements.
Net income links to both the balance sheet and the income statement, with net income flowing into the stockholder’s equity via retained earnings on this period’s balance sheet.
After all of these are linked, the sum of the cash is added to the previous period’s ending balance
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It gives the investor a good idea of how profitable the company is. It’s a quick metric for the net income of an organization before certain deductions are made
Three ways to value a company.
Comparable
Precedent
DCF
What is accretion / dilution?
How much will some per-share financial metric change as a result of a transaction?
Pros & Cons of each valuation method?
Comparable
Pros: the best representation of market value
Cons: Additionally, it may be difficult to come up with a good set of comps – and there are many factors that can explain differences in comps (growth, market position).
Precedent
Pros: Convey the history of what buyers paid
Cons: do not tell a full story. For instance, the buyer may have paid more because of perceived synergies or less because the target was in distress. Also, precedent transactions can be too dated – market conditions may have changed.
DCF
Pros: the most obvious pro is that is a representation of intrinsic value. Its a sound methodology in calculating what the company is worth.
Cons: it is extremely dependent on the assumptions behind the DCF – DCFs are forward looking, and no one can predict the future.
Why do we look at both enterprise and equity values?
You look at both because Equity Value is the number the public-at-large sees, while
Enterprise Value represents its true value.
What’s more important: Enterprise Value or Equity Value
Enterprise Value, because that’s how much an acquirer really “pays” and includes the
often mandatory debt repayment
When would you not use a DCF?
You do not use a DCF if the company has unstable or unpredictable cash flows (tech or
bio-tech startup) or when debt and working capital serve a fundamentally different role.
For example, banks and financial institutions do not re-invest debt and working capital
is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.
