JPM Technical Screen Flashcards
Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet).
On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same.
On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.
Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?
After a year has passed, Apple must pay interest expense and must record the depreciation.
Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income would fall by $12. On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12.
On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.
Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back.
At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3
statements.
After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements.
First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line.
With a 40% tax rate, Net Income declines by $48.
On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $32.
There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100.
Overall, the Net Change in Cash falls by $68.
On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether.
On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance.
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a writedown of $100.
First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60.
On the Cash Flow Statement, Net Income is down by $60 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40.
On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it’s not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60.
On the other side, since Net Income was down by $60, Shareholders’ Equity is also down by $60 – and both sides balance.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
Several possibilities:
- The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative.
- The company has high interest expense and is no longer able to afford its debt.
- The company’s debt all matures on one date and it is unable to refinance it due to a “credit crunch” – and it runs out of cash completely when paying back the debt.
- It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.
Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges – and all of these could end up bankrupting the company.
What are the 3 major valuation methodologies?
Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.
Rank the 3 valuation methodologies from highest to lowest expected value.
Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium
built into acquisitions.
Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.
What other Valuation methodologies are there?
Other methodologies include:
• Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
• Replacement Value – Valuing a company based on the cost of replacing its assets
• LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
• Sum of the Parts – Valuing each division of a company separately and adding them together at the end
• M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth
• Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value
What are some examples of oil industry multiples?
EV/EBITDA - important valuation multiple. valuable b/c it is unaffected by capital structure, which makes it superior to P/E multiples. The EV/EBITDA ratio compares the oil and gas business, free of debt, to EBITDA. This is an important metric as oil and gas firms typically have a great deal of debt and the EV includes the cost of paying it off. EBITDA measures profits before interest.
EV/EBITDAX - EBITDAX is EBITDA before exploration costs for successful efforts. It is commonly used in the U.S. to standardize different accounting treatments for exploration expenses, which consist of the full cost method or the successful efforts method. A low ratio indicates that the company might be undervalued.
EV/DACF - This is enterprise value compared to debt-adjusted cash flow. The capital structures of oil and gas firms can be dramatically different. Firms with higher levels of debt will show a better P/CF ratio, which is why many analysts prefer the EV/DACF multiple.
EV/2P - This is enterprise value compared to proven and probable reserves. It’s an easily calculated metric which requires no estimates or assumptions. It helps analysts understand how well its resources will support the company’s operations.
Generally, the EV/2P ratio should not be used in isolation, as not all reserves are the same. However, it can still be an important metric if little is known about the company’s cash flow. When this multiple is high, the company would be trading at a premium for a given amount of oil in the ground. A low value would suggest a potentially undervalued firm.
Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?
This could happen for a number of reasons:
• The company has just reported earnings well-above expectations and its stock price has risen recently.
• It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property.
• It has just won a favorable ruling in a major lawsuit.
• It is the market leader in an industry and has greater market share than its competitors.
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?
Possible reasons:
- One process was more competitive and had a lot more companies bidding on the target.
- One company had recent bad news or a depressed stock price so it was acquired at a discount.
- They were in industries with different median multiples.
Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.
You use the same methodologies, except:
• You look at industry-specific multiples like P / MCFE and P / NAV in addition to the more standard ones.
• 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.
• Rather than a DCF, you use a NAV (Net Asset Value) model – it’s similar, but everything flows from the company’s reserves rather than simple revenue
growth / EBITDA margin projections.
In addition to all of the above, there are also some accounting complications with energy companies and you need to think about what a “proven” reserve is vs. what is more speculative.
How do you calculate the Terminal Value?
You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.
The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).
A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
Trick question. You can’t tell unless you also know that it’s an all-stock deal. If it’s an all-cash or all-debt deal, the P/E multiples of the buyer and seller don’t matter because no stock is being issued.
Sure, generally getting more earnings for less is good and is more likely to be accretive but there’s no hard-and-fast rule unless it’s an all-stock deal
What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?
In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.
On an intuitive level if you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’re
paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.
