OE - Basic Valuation

Question 1

If you could use only one financial statement to value a company, which would you choose and why?

Answer 1

The cash flow statement is most valuable as a standalone because it is the only financial statement that can be used to construct a FCFE DCF on a standalone basis.

Question 2

If you had access to only two financial statements, which would you choose and why?

Answer 2

The balance sheet and the income statement, because you could build the cash flow statement from them.

Question 3

What are the three most common ways to value a company?

Answer 3

1. Comparable Companies Analysis
2. Precedent Transactions
3. Discounted Cash Flow

Question 4

In what situations would each method be the most appropriate? (ways to value a company)

Answer 4

In order to properly value a company, a banker would use all three methods and then triangulate an appropriate range of values for a company based on the results.

If a company has negative current earnings, a comparable analysis may be inappropriate whereas a DCF may project out to a point where earnings are positive.

Precedent transaction is most appropriate when valuing a deal similar to those that have recently occured.

Question 5

Which valuation technique will result in the highest value? (Rank them all by value)

Answer 5

Highest value: Precedent transaction: typically includes a control premium and synergies

DCF: Optimistic assumptions frequently give a higher value than comparables (not always the case)

Comparables company analysis

Question 6

Walk me through a DCF

Answer 6

To do a DCF analysis, you first need to project free cash flow for a period of time (say, five years). Free cash flow equals EBIT less taxes plus D&A less CAPEX less change in working capital.

Note that this measure of cash flow is unlevered, or debt free. This is because it does not include interest and so is independent of debt and capital structure.

Next we need a way to predict the value of the company / assets for the years beyond the projection period. This is known as the terminal value.

We can use one of two methods for calculating terminal value, either the Gordon Growth (also called perpetuity growth) method or the terminal multiple method.

To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow forever. This growth rate should be modest, for example, the average long-term expected GDP growth or inflation (2-3%). To calculate terminal value, we multiply the last year’s free cash flow by 1 plus the chosen growth rate and then divide by the discount rate less the growth rate.

The second method, the terminal multiple method, is one that is more often used in banking. Here we take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple. The most common metric to use is EBITDA. We typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last 12 months (LTM) basis.

Now that we have our projections of free cash flows and terminal value, we need to “present value” these at the appropriate discount rate, also known as the weighted average cost of capital (WACC). Finally, summing up the present value of the projected cash flows and the present value of the terminal value gives us the DCF value. Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of enterprise value, not equity value.

Question 7

Explain beta in plain English. How do you compute beta?

Answer 7

Beta essentially tells us how much systematic, or undiversifiable, risk a particular asset has relative to an average asset (the market).

The average asset beta is by definition 1.0, so the asset beta indicates the tendency of change in an asset’s returns relative to market changes.

Betas greater than 1.0 indicate the asset returns will be more volatile than the market and the betas less than 1.0 (but greater than -1.0) will be less volatile than the market.

Beta is computed by using a standard regression to determine a straight-line fit for the returns of the asset versus the returns of the market (e.g. S&P 500) over a specific time period. The slope of the regression line is the asset’s beta.

Question 8

Which company would have a higher beta, a waste management company or a high tech company? Why?

Answer 8

A high tech company will have a higher beta given the volatility of returns for tech firms. A waste management company is not impacted significantly by changes in the market because waste management needs to remain stable throughout the business cycle.

Question 9

What are the drivers of Beta?

Answer 9

The financial leverage of the business, the operational leverage of a business, the cyclicality of the industry, how discretionary the company’s products are.

Question 10

What does it mean if a stock has a beta of 2?

Answer 10

A beta of 2 signifies a volatile stock in reference to the overall market. A beta of 2 in general means that the stock is twice as volatile as the overall global market (e.g. when the market goes down 1%, the stock will theoretically go down 2% on average, since it is twice as volatile).

From CAPM (capital asset pricing model), a stock with a beta of 2 will require a rate of return much higher than a less risky stock with a beta this is less than 1.

Question 11

What would you use as a proxy for the long-term risk-free rate?

Answer 11

A long-dated Treasury bond such as the 10- or 30- year. Note: Practitioners often use the 10-year because it is more liquid and more frequently issued than the 30-year.

Question 12

How do you calculate a firm’s cost of equity?

Answer 12

The cost of equity is generally calculated from CAPM:

Re = Rf + B x (Rm-Rf)

Rf - The risk free rate, generally uses trading yield from the 10-year Treasury Note (the most liquid issuance)

Rm-Rf = Equity risk premium. Generally in the 6-7% range (depending on which historical period is used)

B = Beta. There are different ways to calculate this:

If your company is public, you could use the predicted betas on the sites like Bloomberg or CapIQ (these will be calculated using regression for specific time periods: 1yr, 3yr, 5 yr, etc.)

Another way is to take the betas of comparable public companies, and unlever each of them using the below formula:

Unlevered beta = Levered beta / [1 + (D/E) x (1-tax rate)]

This will provide you with an “asset beta” for each firm, which is independent of its capital structure. Once the unlevered betas have been computed, take the mean and relever it using your company’s capital structure (Debt / Equity):

Relevered beta = Unlevered beta x (1 + (D/E) x (1 - tax rate))

Note: capital structure is based on target capital structure (not current D/E) as the company will likely revert to this level over time

Question 13

How would you calculate the cost of debt?

Answer 13

The cost of debt can normally be observed directly or indirectly, as the interest rate the firm pays on new borrowing. For a firm with outstanding debt, the yield to maturity on a firm’s bonds (not the coupon rate) is the market required rate on the firm’s debt.

Alternatively, you can use the firm’s bond rating (or the bond rating of comparable firms) and find the interest rate on the newly issued bonds with the same rating.

If the firm does not have any outstanding debt (and no credit rating) you could compute the cost of debt “bottoms up” by taking the rate on a risk-free bond (e.g. US Treasury) whose duration matches the term structure of the new corporate debt being priced, and adding a risk premium. This risk premium will rise as the amount of debt increases (since all other things being equal, risk rises as the amount of debt rises).

Since debt is deductible for tax purposes, the cost of debt is computed after-tax to make it comparable with the cost of equity. Thus, for profitable firms, debt is reduced by the tax shield. The formula can be written as (risk free rate + credit risk rate) x (1 - tax rate).

Question 14

Which is cheaper and why, the cost of equity or the cost of debt?

Answer 14

Debt is cheaper than equity for two reasons:

1) Debt investors have a prior claim if the company goes bankrupt, making debt safer than equity and warranting a lower return; for the company this translates into an interest rate that is lower than the expected return on equity.
2) Interest paid is tax deductible, and a lower tax bill effectively creates cash for the company. When you issue debt in the form of bonds, you pay interest out to your investors - this interest is tax deductible. When you issue equity, you pay out dividends.

These dividends represent corporate income and are subject to double taxation: you, the corporation, pay taxes once, and the equity holder pays taxes another time. Because debt circumvents taxation at the corporate level, the cost of debt is less than the cost of equity. This is called the “tax shield on debt.”

Question 15

What factors affect a firm’s cost of debt?

Answer 15

External interest rates: e.g., Fed funds rate. As this rises, the cost of issuing new public debt will also rise.

Riskiness of the business: Cost of debt will change with the riskiness of the business. For example debt for a cyclical business (auto, manufacturing, retail) will be more expensive than debt for a noncyclical business (healthcare).

Tax rates: Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

Public debt market conditions: Supply and demand in the bond market or syndicated loan market at the time of issuance: if demand is greater than supply, debt will be relatively cheaper, and if supply is greater than demand, debt will be relatively more expensive.

Question 16

How do you calculate WACC?

Answer 16

The WACC (weighted average cost of capital) is the discount rate used in a discounted cash flow (DCF) analysis to present value-projected free cash flows and terminal value. WACC reflects the cost of each type of capital (debt [D], equity [E], and preferred stock [P]) weighted by its percentage of the overall capital structure.

WACC = Re x (E/(E+D+P)) + Rd x (D/(E+D+P)) x (1 - tax rate) + Rp x (P/(E+D+P))

Cost of equity is determine by CAPM. To estimate the cost of debt, we can analyze the interest rates / yields on debt issued by similar companies. Similar to estimating the cost of debt, estimating the cost of preferred requires us to analyze the dividend yields on preferred stock issued by similar companies.

Question 17

How do you calculate WACC?

Answer 17

The WACC (weighted average cost of capital) is the discount rate used in a discounted cash flow (DCF) analysis to present value-projected free cash flows and terminal value.

WACC reflects the cost of each type of capital (debt [D], equity [E], and preferred stock [P]) weighted by its percentage of the overall capital structure.

WACC = Re x (E/(E+D+P)) + Rd x (D/(E+D+P)) x (1-tax rate) + Rp x (P/(E+D+P))

Cost of equity is determined by CAPM. To estimate the cost of debt, we can analyze the interest rates / yields on debt issued by similar companies. Similar to estimating the cost of debt, estimating the cost of preferred requires us to analyze the dividend yields on preferred stock issued by similar companies.

Note: a simplified version of WACC excludes preferred stock (firm may not have any):

WACC = Re x (E/(E+D)) + Rd x (D/(E+D)) x (1 - tax rate)

Question 18

If you have cost of debt of 10% and cost of equity of 10% what is your WACC?

Answer 18

It depends on your target capital structure and taxes. Use the WACC formula once you have these two inputs to calculate WACC:

WACC = your equity to value ratio x cost of equity + your debt to value ratio x cost of debt x (1-tax rate)

Question 19

What are the primary weaknesses of DCF?

Answer 19

The primary weakness of a DCF is the fact that it relies on tons of assumptions, and it takes a lot of time relative to the other valuation metrics. It also is heavily dependent on the terminal value.

Question 20

What is the most volatile part of DCF?

Answer 20

The assumptions that go into projecting out the free cash flows are the least predictable element of a DCF, and slight changes in these assumptions lead to large changes in the valuation.

However, a 20% change in your WACC will have a greater effect on your NPV than a 20% change in the growth rate of your FCFs, or a 20% change in your terminal value growth rate.

However, the shorter the DCF projection period, and if you use an exit multiple, then a 20% change in the exit multiple used could generate a larger change in your NPV than a 20% change in your WACC.

Question 21

Describe the two most important components of a DCF. Why are these components the most important? How do you mitigate this?

Answer 21

The two most important components of a DCF are the expected growth rates of the free cash flows and the discount rate (WACC). These components are the most important because they have the biggest effect on valuation due to their compounding effect on future cash flows. The best way to mitigate their effects is through sensitivity analysis. This will give a better perspective of the range of potential valuations (worst case, base case, and best case scenarios).

Question 22

What has a more positive influence on terminal growth value in a DCF - a 1% decrease in the discount rate (r) or a 1% increase in the terminal growth rate (g)?

Answer 22

An increase in the terminal growth rate (g) will have a greater impact on the terminal growth value. This is explained clearly when you look at the Gordon Growth model formula (FCF x (1+g) / (r-g). A 1% decrease in r will decrease the denominator by 1%. A 1% increase in g achieves the same impact on the denominator, with the added benefit of increasing the numerator by 1%. As such, a 1% increase in the terminal growth rate will have a more positive influence on the terminal growth value than a 1% decrease in the discount rate.

Question 23

How many years should you project out DCF?

Answer 23

There is no defined answer. You should project out cash flows until the cash flows reach steady-state growth.

Question 24

If you had a 10-year and a 20-year DCF projection with the same growth and discount rates, would you get the same valuation when you discounted back the cash flows?

Answer 24

If the discount rate and growth rates were exactly the same, then the DCF values should be the same when using the Gordon Growth method for your terminal value (this assumes the steady-state growth rate is the same as the terminal value growth rate). If, however, you decided to use an exit multiple to calculate your terminal value, then you will get a different valuation for the different timeframes.

Question 25

Do deferred taxes affect a DCF?

Answer 25

Increases in deferred tax assets are subtracted from and increases in deferred tax liabilities are added to net operating profit after taxes (NOPAT) in calculating FCF. Deferred taxes are recorded at their cash value (no consideration for time value of money). They are also based on current income tax rates. When making cash flow projections, an analyst could raise or lower the company’s effective tax rate to reflect deferred tax liabilities or assets.

Question 26

How would the DCF model for an industrials company differ from that of a high-tech company?

Answer 26

Presumably the industrials company would have a much lower WACC (assuming reasonable capital structures). A high-tech company would also tend to have a much higher growth rate than the industrials company, with much less stable cash flows. One should also project out the DCF for more years with a tech company than an industrials company given that the former will likely reach maturity over a longer period.

Question 27

What is IRR? How is it calculated?

Answer 27

The IRR (internal rate of return) is the rate of return that makes the NPV of the cash flows of a project / investment equal to 0.

If there is only inflow and outflow, then the formula is (CFend/CFbegin)^1/periods.

The easiest thing to do is use the Excel = IRR function. If there are cash flows in multiple periods, manually checking IRR is extremely time-consuming; you would have to set up the equation so that 0 = cash outflow + CF 1/(1+r) + CF2 / (1+r)^2 etc. and find r through trial and error.

Question 28

What are some key factors you look for when trying to find comparable companies during a relative valuation?

Answer 28

There is not right or wrong answer here but certain things that you look for should be: market size, revenue base, gross margins, operating margins, profit margins, growth rates and growth potential.

It ultimately depends on which ratios you are using for the multiples approach. For instance if you are using EV/Sales, you want to ensure that you source in comparable companies with the same profit margin.

If you are using P/E you want to make sure that you use comparable companies with similar leverage ratios.

Question 29

How would you determine what an appropriate peer group of companies is?

Answer 29

You can find comparable companies by understanding the business model of the firm you are researching. The firm doesn’t have to be in the same sector, but the operations should be comparable. Size, regional / global reach, and stage of growth should all be taken into consideration.

Question 30

You have two hours to value a telecom company using comparables analysis. Walk me through the steps you would take.

Answer 30

With two hours, I would first look at the company’s EBITDA and customer numbers. Then I would look at other telecommunications companies located in similar regions (rural or urban, same country, etc.) with similar offerings (wireless or wire-line) that are of a similar size (do not want to compare startups with mature companies). I would then gather the median EBITDA multiple and price / customer multiple and then use that as the valuation metric for the company I am valuing (that could easily be done within two hours).

Question 31

How can you value a private company?

Answer 31

Depends on your access to information, however, public comparables is the most common along with intrinsic valuation (DCF) if management projects are provided.

Question 32

Walk me through a sum of parts analysis and when it would be useful?

Answer 32

When a company has multiple subsidiaries or is a conglomerate like GE, you should use a sum of parts analysis to value each part of the business independently. It is commonly used for oil and gas companies, for example, to value their different asset plays separately and consolidate the values to arrive at a total enterprise value.

The difficulty of using a sum of parts valuation is finding financials for each part of the business unit. Typically you can use DCFs to value each portion of the conglomerate if you have the appropriate cash flow figures. Often times, if you see that a particular part of the conglomerate resembles a pure play publicly traded firm, you can use the multiples from that company (or group of companies) and apply them to the specific portion of the firm you are valuing.

Question 33

Besides the three main valuation methodologies, how else can you value a company?

Answer 33

For financial institutions you could use a dividend discount model, residual income, and regression. For asset-heavy companies you can look at liquidation value and net asset value (e.g. oil and gas and real estate).

Question 34

Is there anything wrong with using a Market Cap / EBITDA multiple?

Answer 34

Yes. Market cap is an equity valuation metric, whereas EBITDA is an enterprise valuation metric.

Think of using firm value with pre-interest income / cash flows (firm income) and using equity value with post-interest income / cash flows.

Question 35

Why would a stock be trading at a market price that is much higher than the price derived from an intrinsic valuation?

Answer 35

A stock could be trading higher than the valuation metrics if it is an acquisition target and arbitrage investors get involved.

The acquirer may be willing to pay more than the intrinsic value due to expected synergies.

This would make the value larger than any of the three valuation methods (paying for synergies). An expected bidding war could also increase the trading price of a company.

Question 36

What should be higher: EBIT or EBITDA multiples?

Answer 36

Since EBITDA should be higher than EBIT (positive D&A), the EBIT multiples should be higher than their respective EBITDA multiples.

Question 37

What is a typical P/E or EV / EBITDA for this industry?

Answer 37

The answer to this question will depend on which group you are recruiting with at the bank (tech v. industrials v. FIG etc.) Use Capital IQ or other sources to see where companies in the space are trading and research which multiples are most relevant (Power and Utilities trades on P/E while Industrials trade on EV / EBITDA for example).

Question 38

You have one hour to conduct a comparable analysis for a company. What do you do?

Answer 38

Most banks maintain internal databases of relevant comps and update the data, including research analyst forecasts, continuously. Other places to find comps are the company filings and databases such as Capital IQ.

Question 39

How would you go about figuring out what the peer group is for a private company?

Answer 39

Look at public companies with similar characteristics to find companies in its peer group.

These characteristics include:

• Companies in the same line of business
• Companies with similar sizes / market caps
• Companies in a similar growth stage (i.e. startup, growth, maturity, decline etc.)
• Companies with similar management structures

Question 40

How do you calculate the cost of debt for a private company?

Answer 40

Come up with a synthetic bond rating using the financial characteristics of the firm. Some of the financial characteristics you would look at when coming up with bond ratings would be interest coverage ratio, quick ratio, debt to equity ratio etc. Once you find the synthetic rating, use the same process outlined above to calculate the market cost of debt.

You can also estimate the rating for private debt based on comparable publicly traded debt to come up with an appropriate yield. You can then add some type of liquidity premium to account for the less liquid nature of private debt.

Eric:

Find the average interest rate of cost of debt and do (1 - the tax rate)

Question 41

If you use U.S. rates and risk premium, how do you capture the additional risk of investing in an emerging market?

Answer 41

The additional risk is captured in the beta of the stock - this can be supported mathematically as it is the only remaining variable in CAPM other than the return of the market and the risk-free rate. Typically, an emerging market beta will be well over 1, which in the CAPM equation leads to a higher required rate of return. You would also use the local risk-free rates to account for differences in inflation expectations, etc.

Question 42

How would you value a stock that doesn’t pay dividends?

Answer 42

Same way as any other firm: use a DCF calculation or look at multiples of comparable companies.

Question 43

Value an industrial manufacturing company.

Answer 43

Use one of the three valuations methods: DCF / Gordon Growth, Comparable Companies analysis, and Precedent Transactions. Note: Precedent Transactions will have an acquisition premium baked in.

Question 44

How can the CAPM be modified for firm size?

Answer 44

Historically, small stocks tend to have higher returns and larger betas.

Ke = Rf + [B x (Rm-Rf)] + SP

SP = appropriate size premium based on the firm’s market capitalizations