OE - Advanced Valuation Flashcards
Reconcile free cash flow to enterprise value.
Enterprise value is the sum of all future discounted free cash flows.
Walk me through the valuation of a firm with special emphasis on the market multiples method.
Determine which multiples are most appropriate or most commonly used for the industry. Determine typical range and average of selected multiples using comparable companies. Account for recent unusual items or effects of debt on multiple (i.e., higher debt lowers P/E).
Which multiple do you use for which industries?
Use P/E for industries generally mature, profitable companies (i.e., consumer, retail, power and utilities etc.)
Use EV /Sales for businesses where high percentages of sales are recurring (i.e., software companies) or when earnings or EBITDA are negative.
Use EV/EBITDA for industries involving high CapEx with long depreciation periods (or for companies with higher than average debt payments) (i.e., oil/gas, utilities, etc.)
Use price divided by an industry-specific metric for early-stage companies not yet profitable (i.e., price/page views for Internet startups)
If you could pick one of the three to value a company , which would you use and why - EBIT, EBITDA, or NI?
I would use EBITDA to value a company. Net income is affected by the capital structure, and while a lot of people use it (P/E ratio), it is not a good way to value the worth of the entire company. It doesn’t show the operating cash flow that a company that a company generates. Obviously, this depends on the industry (for a bank you would use net income or book value instead of EBITDA).
I think it’s better to use EBITDA than EBIT because “cash is king” and D&A is not a cash outflow. The other reason why you would use EBITDA instead of EBIT is when you are valuing companies that involve tremendous up-front capital expenditures and companies that have large depreciation and amortization burdens, you could see negative EBIT numbers (hard to value a company with negative EBIT) but have high EBITDA values. But for less capital-intensive businesses, you could use EBIT instead of EBITDA (capitalizing as opposed to expensing will not have as large an effect on EBIT as it does on EBITDA).
Therefore, I use EBITDA, but it really depends on the type of business.
Is the cost of equity higher for a sponsor or for a blue chip firm like IBM? Why?
The cost of equity would most likely be higher for a sponsor than a blue chip company, as the sponsor and its investors would expect a higher ROE on the investment than would IBM, given the leverage (and increased risk) that comes with most sponsor acquisitions.
How would you change a DCF to reflect the fact that revenues are uncertain (as in a drug that has not yet been approved by the FDA)?
You can use a higher discount rate to reflect the risk or make a base / low / high-case toggle.
Explain adjusted present value. (APV)
The adjusted present value method is used to determine the value of a potential project to the levered firm by starting with the value of the project to an unlevered firm and adding the net present value of debt. The net present value of debt is the sum of the four financing side effects: the tax shield, the cost of issuance, the cost of financial distress (bankruptcy), and subsidies to debt financing (by obtaining debt at the tax-exempt rate granted by the public sector).
Explain option pricing.
Use the Black-Scholes model option pricing model.
In order to understand the model itself, divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.
Although slower than the Black-Scholes model, the binomial pricing model (which models the underlying instrument over time as opposed to at a particular point) is considered more accurate, particularly for longer-dated options and options on securities with dividend payments. For these reasons, various version of the binomial model are widely used by practitioners in the options markets.
How do you value NOLs?
NOL = Net Operating Loss. NOLs result from periods in which the firm’s allowable tax deductions are greater than the taxable income. This results in a negative taxable income, which is used to recover past tax payments (loss carry-backs) or reduce future tax payments (loss carry-forwards). Thus, the value of the NOL is the discounted tax shield (NOL x effective tax rate) because the NOL will reduce taxable income in future periods. Large NOL may have to be alloted over several periods, and if the firm will not have positive future income, the NOL will have limited or negligent value.
What Internet business model do you think will work and why? How is the market pricing these companies?
A model that is able to monetize its assets among a popular user base. There seems to be somewhat of a precedent of the most successful Internet companies to start off free to users and then move forward with a large user base to ultimately offer products for a fee, beyond just advertisement fees. An example of this is LinkedIn, where you can join for free and get many benefits but must pay to receive additional benefits. The market places a premium on those companies that have wide user base (a large, unpenetrated market) with the ability to now or in the future monetize the user base and assets that are in place. The obvious examples are Google, Facebook, and Yelp.
What is wrong with the P/Sales multiple?
Price is an equity value, and sales is a firm value measure. EV / Sales would be correct.
How do you value a retail bank? How do you calculate the cost of debt for that bank based on their deposits on the liability side? If two banks have the same valuation but a different ROE, which is better?
Retail banks are valued differently because of their use of debt. You could use comparable company analysis using equity-based multiples such as price/book or price/earnings.
In general, you cannot use ROE To compare companies in different industries, as companies in some industries require more assets than others.
In terms of the two retail banks, you would want to determine the retention ratio of each in addition to the ROE, since g=ROE x retention ratio. ROE is irrelevant if earnings are not reinvested. If the banks have the same valuation, same retention ratio, and one has a higher ROE, you would want to invest in the one with the higher ROE.
How would you go about valuing a startup candy factory?
Look at similar startup candy factory trading multiples, transaction multiples, and perform a DCF based on estimated growth rates, depending on similar growth rates in the same industry. Evaluate the industry as a whole and the future of the candy factory business to determine reasonable cash flow projections. This includes looking at candy demand, sugar production and prices, manufacturing, consumer sentiment, etc.
When bankers compare multiples, do they look at trailing or forward multiples?
Bankers use both; though for valuation work, forward multiples are preferred. The market prices companies based on their future earning potential, so projections are commonly used as the basis for determining a firm’s relative valuation. The most notable exception is in a DCF when calculating the terminal value using the EBITDA method, a trailing multiple is used.
You are trying to use DCF to value Netflix and Walmart. You can use a five-year DCF for one of them and a ten-year DCF for the other. Which do you choose to value with the ten-year DCF?
This question doesn’t have a clear answer but is designed to see how you think about DCF and valuation. On the one hand, Netflix is much further from being in a steady state, so you can argue that it makes more sense to value it using the ten year DCF. On the other hand, Netflix will be far more difficult to project into future years so it may make more sense to apply the five year DCF to it. Walmart can more easily projected out for ten years, but that may not be necessary since it is closer to steady-state.
