Technicals Flashcards
If you Could Use Only One Financial Statement to Evaluate the Financial State of a Company, Which Would You Choose?
I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating.
- The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business.
- And the Balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing.
Why would a company issue equity rather than debt to fund its operations?
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- If the company feels its stock price is inflated they can raise a large amount of capital compared to the percentage of ownership sold
- If the projects the company plans to invest in with proceeds may not produce immediate or consistent cash flows to pay debt
- If the company wants to adjust cap structure or pay down debt
- If the owners of the company want to sell off a portion of their ownership
What is WACC and how do you calculate it
Weighted Average Cost of Capital. It is used as the discount rate in a Discounted Cash Flow analysis to calculate the present value of a firm’s cash flows and terminal value. It reflects the overall cost of raising new capital, which is also a representation of the riskiness of investment in the firm.
What are ways you can value a company, and which will give you the highest valuation?
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Comparable Companies: Take the average from multiple comparable companies (Based on size, industry, EBITDA) and assume that the firm should be priced similarly
Market Capitalisation: Share price x Outstanding number of shares. This can only be used for public companies
DCF Analysis: The sum of the present values of projected cash flows. We can project out cash flows for a 10,15,20 year period and then discount them to present value using WACC. This gives us our enterprise value
Precedent Transactions: The value of the firm when it was bought out previously, or the value of other firms recently sold in the industry
- Precedent transactions typically give the highest valuation as firms usually pay a CONTROL Premium for synergies
- DCF 2nd highest as those projecting out cash flows will often be optimistic in their views, and that the company will continue to grow
- Market Comparables 3rd as there are no synergies and premiums
- Market Cap last as there are no synergies, just equity value
Major factors that drive M&A activity
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- Create new synergies and save costs
- Acquire new tech or pipelines. We see this a lot in the Healthcare industry
- Grow market share by removing a competitor
- Buying a supplier or distributor to increase supply chain pricing power
- Improve financial metrics
Why would a firm raise Debt instead of Equity?
The cost of issuing debt can be cheaper as the interest expense on the debt/bond is tax deductible
Walk me through the three main financial statements
The Income Statement discloses a company’s revenues and expenses, which together yield net income over a period of time. The Balance Sheet discloses a company’s assets, liabilities, and equity on a specific date. The Cash Flow Statement starts with net income from the Income Statement; then adjusts for non-cash expenses, non-operating expenses like capital expenditures, changes in working capital, or debt repayment and issuance, to arrive at the company’s closing cash balance.
How are the three financial statements connected?
Net income flows from Income Statement into the Cash Flow Statement (CFS) as Cash Flow from Operations. Net income less dividends are added to retained earnings from the prior period’s Balance Sheet (BS) to come up with retained earnings as on the date of the current period’s BS. The opening cash balance on the CFS is from the prior period’s Balance Sheet while the closing cash balance on the CFS is the balance on the current period’s Balance Sheet.”
Walk me through the Income Statements
The first line of the income statement represents revenue or sales. From that, we subtract the cost of goods sold, which gives us gross margin.
After subtracting operating expenses from gross margin we get Operating Income (EBIT).
We then add/subtract interest expense, taxes and other expenses to arrive at our Net Income
What is Enterprise Value (EV)
EV Formula
What each component means and why it is included
The value of an entire firm, both debt and equity. EV is the main valuation metric we use.
In basic terms, Enterprise Value = Equity Value + Net Debt
In more depth:
EV = Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash
Market value of equity = Market Cap
Preferred Stock - Preferred stockholders have a higher claim to dividends than common stockholders, but typically have limited voting rights compared to common stock holders. We include it in EV as it is a hybrid security, holding features of both equity and debt, but it is TREATED LIKE DEBT as it gives fixed dividend payments.
Minority Interest/Non-controlling interest - We add on controlling interest If a firm owns 90% of another firm, we must consolidate 100% of the firm into ours and report those metrics into our financial statements. The minority interest would therefore be 10%
By including the noncontrolling interest, the total value of the subsidiary is reflected in EV. As it is included in EBITDA, so it must be included into the EV so we can use EV/EBITDA correctly
Debt - Included because it must be paid off when firm is acquired
Cash - Subtracted as if you buy a firm for 100m and they have 20m in cash, you’ve essentially only paid 80m
What is EBITDA
EBITDA is Earnings before interest, taxes, depreciation, and Amortisation.
We use it because it is useful when comparing companies with different debt and tax profiles.
This is because it ignores the impacts of non-operating factors such as these, giving us a more accurate reflection of the firm’s operating profitability.
Strategic Buyer vs Financial Buyer
Strategic Buyer - A firm that wants to acquire another firm for business reasons such as growth, synergies etc.
Financial Buyer - A firm looking to acquire another company purely as an investment, such as a PE firm completing a Leveraged Buyout (LBO) of a firm.
4 most common Valuation Multiples
EV/Revenue
EV/EBITDA
EV/EBIT
P/E (Share Price
Earnings per Share)
and P/BV (Share Price / Book Value).
If the company’s valuation ratio is higher than the peer average, the company is overvalued
High and low Price/Earnings Ratio meanings
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends
Using comparable multiples
You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing.
Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4
billion.
