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Valuation Flashcards

1
Q

What are the 3 valuation methodologies, used to determine how valuable a company is?

A
  • public comps (relative to peers)
  • acquisition comps / pres trx (relative to precedent transactions)
  • discounted cash flow (intrinsic value)
  • multiples are shorthand for cash flow-based valuation
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2
Q

Which valuation methodologies to you use to determine “how much could an acquirer pay”?

A

2 “affordability” analyses

1) Merger Consequences Analysis - tells you how much strategic buyer could pay
2) LBO - tells you how much financial buyer could pay

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3
Q

Who can usually afford to pay more, strategic buyers or financial buyers?

A

Strategic buyers, due to synergies

Financial buyers are more constrained

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4
Q

Which methodology would you focus on in context of an IPO?

A

Public comps. Not enough cash flow to use DCF

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5
Q

How do you pick public comps?

A
  • a peer that loosely overlaps operationally and financially is deemed a good comp

Operations: products, geography, customer, distribution, supply chain, seasonality (these are the more qualitative aspects)

Financial aspects: size, growth (sales, EBITDA, EPS), financial risk (leverage, etc.), profitability (these are the more quantitative aspects)

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6
Q

How do you calculate Market Value?

A
  • Market value = price x shares outstanding
  • Use diluted shares to reflect options and convertible securities
    • Modified TSM to reflect potential shares from options –> repurchase shares at current market price with option proceeds
    • diluted shares outstanding = shares originally outstanding + ITM options - shares repo’d
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7
Q

Why is it important to use the Treasury Stock Method?

A

Because if you don’t, the stake you’re getting may be smaller (proportionally) than you realize

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8
Q

How do you calculate Enterprise Value?

A

Enterprise Value = Equity Value + Total Debt + Preferred Stock + Minority Interest - Cash & Equivalents

  • re Debt: Include capitalized leases, in addtn to short- and long-term Debt
  • re Minority Interest: it is the portion of a consolidated sub that is NOT owned by parent (think of it as an outside investors’ equity investment in your co, or as money you owe to outside investor)
  • This is consistent with other definition
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9
Q

What’s typically bigger, Enterprise Value or Equity Value?

A

TEV is usually greater than EqVal, because companies tend to have more debt than cash

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10
Q

What goes in the numerator, and what goes in the denominator, of a valuation multiple?

A

Numerator –> equity valuate or enterprise value

Denominator –> financial statistic

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11
Q

Why do we have to adjust for / normalize non-recurring items?

A
  • these items are NOT expected to be part of normal course of business in future
  • goal is to evaluate on-going business earnings and cash flows
  • provides better comparisons between different periods’ results

common examples: restructuring charges, gain/(loss) on sale of divisions, asset impairment charges, legal settlements

typically, you only have to adjust on a pre-tax basis, because you’re adjusting for pre-tax multiples (since these are the multiples we use in comps)

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12
Q

In addition to normalizing financial statistics, you also need to calculate the Latest Twelve Months. How do you do it?

A

LTM = Fiscal Year + Most Recent Period(s) - Period Ending One Year Prior to Most Recent

^ need to normalize numbers for each period

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13
Q

Why calculate LTM?

A

1) most recent info
2) controls for seasonality
3) controls for different fiscal year ends

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14
Q

What are the different Equity Performance Multiples?

A

Price / EPS

Market Value / Net Income

Market Value / Book Value

PE / Growth Rate

  • apply only to equity shareholders
  • after interest expense, preferred dividends, and minority interest expense
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15
Q

What are the different Enterprise Performance Multiples?

A

Enterprise Value / Sales

Enterprise Value / EBITDA

Enterprise Value / EBIT

  • statistics applicable to all capital holders
  • before interest expense, preferred dividends or minority interest expense
  • numerator must include all forms of capital (debt and other)
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16
Q

What are the main drivers behind multiples?

A
  • risk

e. g. 1) financial risk: leverage ratio (Debt / EBITDA) … excessive would be greater than 3x
2) operational risk: EBITDA margin (EBITDA / sale), returns

  • growth
    e. g. sales, EBITDA, EPS

Look at at these factors when assessing whether or not a company is over/under valued

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17
Q

What are the steps in creating a multiple?

A

1) Calculate numerator: EqVal or Enterprise Value
2) Calculate denominator: financial metric (Sales, EBITDA, EBIT, net income) … normalize it (often when normalizing, earnings will go up, so taxes will also go up)

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18
Q

In pres trx, the price reflects:

A

1) control premium
2) potential synergies (cost & revenue)

also consider:

  • timing (bull or bear mkt? bull - higher multiples; bear - lower multiples) and surrounding events
  • nature (hostile or friendly? private or auction?)
  • consideration paid (in general, cash deals lead to higher premiums, because cash out shareholders for synergies vs. stock dealers, sellers participate in upside)
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19
Q

How do you pick acquisition comps?

A
  • operations
  • financial aspects
  • timing
  • size (usually based on Transaction Value)
  • consideration paid
  • circumstances surrounding deal (e.g. strategic or financial buyer?)
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20
Q

What’s a DCF Analysis?

A
  • intrinsic value of the company
  • based on UNLEVERED free cash flows (avail to all capital holders + independent of capital structure)
  • value equals the sum of the present values of 1) unlevered free cash flows, and 2) projected terminal value
  • intrinsic (theoretical), as opposed to relative (based on value of other companies)
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21
Q

Advantages of a DCF?

A
  • intrinsic valuation (theoretical worth) based on projected unlevered free cash flows
  • flexible, adaptable analysis (can change growth rates, operating margins, synergies, etc., and see how they impact value)
  • objective calculation (through present value calculation)
  • always obtainable
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22
Q

How do you calculate cost of equity in WACC?

A

Cost of equity = risk free rate + (levered beta * market risk premium)

for rfr, look to 10 yr govt bond

for mrp, look to ibbotson’s report

It tells you the average price a co’s stock “should” return each year, over the very long term, factoring in both stock-appreciation and dividends

In a valuation, it represents the percentage an Equity investor might earn each year

To a co, it tells you the cost of funding its operations by issuing additional shares to investors

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23
Q

What is the Terminal Value?

A
  • value of the business BEYOND the projections. Used due to the impractical nature of extended forecast period (i.e. 20 or 30 yrs)
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24
Q

Terminal Approach versus Perpetuity Growth Rate Method

A
  • perpetuity growth rate is the academically proven approach, but less common because takes more work
  • but usually often, both are used
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25
Q

To calculate Unlevered FCF in a DCF, which items do you need to project?

A

1) Revenue
2) COGS and Operating Expenses
3) Taxes
4) Depreciation & Amortization
5) The Change in Working Capital
6) Capital Expenditures

  • all regularly occurring and relate to all investors

These items all correspond to

Unlevered FCF = NOPAT + Non-Cash Adjustments and Change in Working Capital from CFS - Capex

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26
Q

What is the formula for WACC?

A

WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred * % Preferred

  • WACC always pairs with Unlevered FCF b/c both represent all investors in a co
  • If you invest proportionally in co’s entire capital structure, WACC gives you expected, long-term annual return
  • If it’s expected to change in explicit forecast period, you should reflect that in DCF (i.e. a co’s risk profile can change as it matures over time)
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27
Q

How do you calculate the Cost of Debt?

A

Can take risk-free rate, and then add a default spread based on company’s expected credit rating after it issues additional debt

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28
Q

How do you calculate the Cost of Preferred?

A

Look at how much co would have to pay if it issued additional Preferred Stock

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29
Q

How do you isolate inherent business risk in Beta? (wrt calculating Cost of Equity)

A

You have to un-lever it … and then re-lever it, to make it reflect the risk from the leverage of the company you are valuing

Bu = Bl / [1 + ((1-tax rate)*(D/E))]
Bl = Bu * [1 + ((1 - tax rate)*(D/E))]
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30
Q

How do you choose a growth rate for the Terminal Period?

A
  • should be low; below the GDP growth rate of the country, and perhaps in-line with rate of inflation
  • in developed mkts, percentages should be in low single digits (i.e. 1-3%)
  • even in emerging mkt, percentage should be closer to 3-4% (not dramatically higher)
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31
Q

How do you calculate Terminal Value?

A
  • Perpetuity Growth Method: assume company’s Cash Flow Growth Rate stays the same in perpetuity (and that Discount Rate stays the same)
  • Gordon Growth Method: Terminal Value = [Last FCF in forecast period x (1 + Terminal Growth Rate)] / (WACC - Terminal Growth Rate)
  • Exit Multiple Method: value business as a multiple of an operating statistics (useless if no truly comparable companies)
  • Just, e.g., take Terminal EBITDA/EBIT/NOPAT, multiply it by multiple, and discount it to PV
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32
Q

How do you back into Implied Equity Value and Implied Share Price from Implied Terminal Value?

A
  • add non-core business Assets and subtract Liability and Equity line items that represent other investor groups
  • then, you divide by the co’s diluted share count to calculate it’s Implied Share Price, which you compare to its Current Share Price
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33
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Smaller company

A
  • cost of equity: Higher
  • cost of debt: Higher
  • WACC: Higher
  • Implied Value from Unlevered DCF: Lower
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34
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Bigger company

A
  • cost of equity: Lower
  • cost of debt: Lower
  • WACC: Lower
  • Implied Value from Unlevered DCF: Higher
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35
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

No Debt to Some Debt

A
  • cost of equity: Higher
  • cost of debt: Higher
  • WACC: Lower, then Higher
  • Implied Value from Unlevered DCF: Higher, then Lower
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36
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Emerging market

A
  • cost of equity: Higher
  • cost of debt: Higher
  • WACC: Higher
  • Implied Value from Unlevered DCF: Lower
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37
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Some Debt to No Debt

A
  • cost of equity: Lower
  • cost of debt: Lower
  • WACC: Depends
  • Implied Value from Unlevered DCF: Depends
  • Depends on what “some Debt” means
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38
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Higher Risk-Free Rate

A
  • cost of equity: Higher
  • cost of debt: Higher
  • WACC: Higher
  • Implied Value from Unlevered DCF: Lower
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39
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Lower Risk-Free Rate

A
  • cost of equity: Lower
  • cost of debt: Lower
  • WACC: Lower
  • Implied Value from Unlevered DCF: Higher
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40
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Higher Equity Risk Premium

A
  • cost of equity: Higher
  • cost of debt: N/A
  • WACC: Higher
  • Implied Value from Unlevered DCF: Lower
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41
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Lower Equity Risk Premium

A
  • cost of equity: Lower
  • cost of debt: N/A
  • WACC: Lower
  • Implied Value from Unlevered DCF: Higher
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42
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Higher Beta

A
  • cost of equity: Higher
  • cost of debt: N/A
  • WACC: Higher
  • Implied Value from Unlevered DCF: Lower
43
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Lower Beta

A
  • cost of equity: Lower
  • cost of debt: N/A
  • WACC: Lower
  • Implied Value from Unlevered DCF: Higher
44
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Higher Taxes

A
  • cost of equity: Lower
  • cost of debt: Lower
  • WACC: Lower
  • Implied Value from Unlevered DCF: Depends, usually Lower
  • Assuming co has Debt. If it does not, taxes won’t make an impact because there won’t be any tax savings from interest paid on Debt.
  • Reduces Cost of Equity b/c you use that tax rate when re-levering Beta … Higher tax rate enhances cost benefits of Debt, which means addtl Debt is also less risky for Equity investors
  • Implied Val usually decreases b/c a higher tax rate also reduces co’s Free Cash Flow
45
Q

How does X change on DCF impact the Cost of Equity, Cost of Debt, WACC, and Implied Value?

Lower Taxes

A
  • cost of equity: Higher
  • cost of debt: Higher
  • WACC: Higher
  • Implied Value from Unlevered DCF: Depends, usually Higher
  • Assuming co has Debt. If it does not, taxes won’t make an impact because there won’t be any tax savings from interest paid on Debt.
46
Q

Which drivers make the biggest impact on DCF output?

A

Discount Rate and Terminal Value

B/c DR affects everything and PV of TV often represents over 50% of co’s Implied Value

Assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above

47
Q

What is “Comparable Public Comps” analysis?

A

Instead of projecting and analyzing a company’s cash flows, you compare the company to other, similar companies (or similar companies that were acquired) and use the valuation multiples from those companies to value the one you’re looking at.

48
Q

What is a common set of metrics and multiples to use in public comps?

A

In most industries, you’ll look at 1 sales-based metric, and 2 profitability-based metrics

EV / Revenue, and Revenue Growth

EV / EBITDA, and EBITDA Growth and Margins

Net Income, P / E, and Net Income Growth and Margins

49
Q

Why is it important to pick “similar” companies in public comps?

A

By picking “similar companies,” you’re ensuring that the Cash Flow and Discount Rate for the companies are in similar ranges.

Therefore, if one company trades at higher multiples than another, its Cash Flow Growth Rate should be higher.

____ longer answer
Because the comparable companies and transactions should have similar Discount Rates and Free Cash Flow figures.

Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate.

If the companies in your set all have similar Discount Rates and Free Cash Flows, it’s easier to conclude that one company trades at higher multiples because its expected growth rate is higher.

If the companies do not have similar Discount Rates and Free Cash Flows, it’s harder to draw meaningful conclusions.

50
Q

You want to calculate a company’s LTM revenue as of June 30th, 2025. If the company’s fiscal year ends on December 31st, you would:

A

1) Start with the revenue on its income statement for the full year 2024, i.e., what the co has earned between Jan 1 2024 and Dec 31 2024
2) Then, add revenue for the 6 months from Jan 1 2025 through June 20 2025
3) Then, subtract the revenue for the 6 months between Jan 1 2024 and June 30 2024

If co has non-recurring charges (e.g. restructuring, write-downs, legal expenses, goodwill impairment), you’ll add back these charges in the calculations for the metrics affected by these non-recurring items

51
Q

What are the key differences between public comps and pres trx analyses?

A

1) main difference is that with pres trx, you calculate valuation multiples based on what acquirers have paid to acquire other co’s, not what those co’s shares are currently trading at on the stock market
2) you still screen based on industry, geography, and size, but each rule is based on the seller
3) M&A mkt changes rapidly over time, so you need to look at co’s from recent past (2-3 yrs, ideally)
4) When calculating metrics and multiples with pres trx, everything is based on the purchase price / balance sheet as of the announcement date of the deal

52
Q

What would your advice to a client be if their shares are overvalued in the market?

A
  • probably not a good time to sell: the co trades at a premium to its intrinsic value, and acquirer would have to pay even more to acquirer the co. A standard 30% premium would make the co even more overvalued, meaning that an acquirer would need to realize massive synergies to make the math work
  • but it might be a good time to raise equity: co’s benefit from raising Equity when they trade at higher multiples and premiums to their intrinsic values; Equity produces less dilution in those cases because the co can issue fewer shares to raise the same amt of capital
53
Q

Trade-Offs of Different Methodologies

A

See table

54
Q

When would you not use a DCF in a valuation?

A

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.

55
Q

Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

A
  • EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together.
  • Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure - only the part available to equity investors.
56
Q

What would you use in conjunction with Unlevered Free Cash Flow multiples?

A

Enterprise Value

-Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors

57
Q

What would you use in conjunction with Levered Free Cash Flow multiples?

A

Equity Value

  • Levered Free Cash Flow already includes Interest and the money is therefore only available to equity investors
  • Debt investors have already “been paid” with the interest payments they received.
58
Q

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

A
  1. The company has just reported earnings well-above expectations and its stock price has risen recently.
  2. It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property.
  3. It has just won a favorable ruling in a major lawsuit.
  4. It is the market leader in an industry and has greater market share than its
    competitors.
59
Q

How do you take into account a company’s competitive advantage in a valuation?

A
  1. Look at the 75th percentile or higher for the multiples rather than the Medians.
  2. Add in a premium to some of the multiples.
  3. Use more aggressive projections for the company.
    - rarely do all of above in practice
60
Q

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case?

A

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.

61
Q

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?

A

Possible reasons:

  1. One process was more competitive and had a lot more companies bidding on the target.
  2. One company had recent bad news or a depressed stock price so it was acquired at a discount.
  3. They were in industries with different median multiples.
62
Q

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

A

EBITDA excludes the often sizable Capital Expenditures companies make and hides how much cash they are actually using to finance their operations.
In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a big disparity.

63
Q

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability. What’s the difference between them, and when do you use each one?

A

P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical.

EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it - you’re more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).

64
Q

If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant.

A

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher

65
Q

What are the advantages and disadvantages of the 3 main valuation methodologies?

A

Public comps are useful because they’re based on real market data, are quick to calculate and do not depend on far-in-the-future assumptions. However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential.

Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps. However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples.

DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends. However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.

66
Q

Which of the 3 main methodologies will produce the highest Implied Value?

A

Kind of a trick question

The best answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”

67
Q

How do you move from Revenue to Free Cash Flow in a DCF?

A

First, confirm we’re talking about unlevered

Subtract COGS and Operating Expenses from Revenue to reach EBIT

Then, multiply EBIT * (1 - Tax Rate), add back D&A, and factor in Changes in Working Capital

Finally, subtract CapEx to calculate Unlevered FCF

Levered FCF (FCF to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 - Tax Rate), and you also factor in changes in Debt principal

68
Q

What does the discount rate mean?

A

The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry.

A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate means lower risk and lower potential returns.

A higher Discount Rate makes a company less valuable because it means the investors have better options elsewhere; a lower Discount Rate makes a company more valuable.

69
Q

How do you calculate Terminal Value in a DCF?

A

1) Multiples Method, or 2) Gordon Growth Method

With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF
in the final year of the forecast period. For example, if you apply a 10x EV / EBITDA multiple to
the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000.

With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free
Cash Flows in the Terminal Period and assume they’ll grow at that rate forever. Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate)

The Gordon Growth Method is better because growth always slows down over time; all companies’ cash flows eventually grow more slowly than GDP.

70
Q

What does WACC mean intuitively?

A

WACC is the expected annual return if you invest proportionally in all parts of the co’s capital structure

To a co, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time

Investors might invest in a co if their expected IRR exceeds WACC, and a co might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC

71
Q

How would you estimate the Cost of Equity for a US based tech company?

A

This q tests ability to make a guesstimate based on common sense and knowledge of current market rates

You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta around 1.5. So, if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.”

72
Q

Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?

A

In a valuation, you’re estimating the co’s Implied Value – what it should be worth

The historical Beta corresponds more closely to the co’s Current Value – what the market says it’s worth today

By un-levering Beta for each comparable co, you isolate each co’s inherent business risk. Each co might have a different capital structure, so its important to remove the risk from leverage and isolate just the inherent business risk

You then take the median Unlevered Beta from these co’s and re-lever it based on the capital structure (targeted or actual) of the co you are valuing

This way the re-levered beta reflects what the volatility of this co’s stock should be, based on the median business risk of its peer co’s and THIS CO’s capital structure

73
Q

What are the formulas for un-levering and re-levering Beta?

A

Assuming the company has only Equity and Debt:

Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 - Tax Rate))

Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 - Tax Rate))

  • you use a “1+” in front of Debt / Equity Ratio * (1 - Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta
  • and you multiply the Debt / Equity Ratio by (1 - Tax Rate) because the tax-deductibility of interest reduces the risk of Debt

The formulas REDUCE Levered Beta to represent the removal of risk from leverage, but they INCREASE Unlevered Beta to represent the addition of risk from leverage

74
Q

How do convertible bonds factor into the WACC calculation?

A

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula.

But if the bonds are not currently convertible, you count them as Debt and use the coupon rate (or YTM, or another method) to calculate their Cost.

75
Q

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

A

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors

As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt

76
Q

In those formulas, you’re not factoring in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.

A
77
Q

How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

A

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rate doesn’t matter because there’s no tax benefit to interest paid on Debt.

If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt, and WACC.

It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher rate always reduces the after-tax cost.

But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower.

However, the Implied Value from a DCF will also be lower because the higher tax rate reduces FCF and the company’s Terminal Value. Those changes outweigh a lower WACC.

The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and WACC are all higher, and the Implied Value is also higher.

78
Q

Can you walk me through how you use Public Comps and Precedent Transactions in a valuation?

A

1) Select the companies and transactions based on criteria such as industry, size, and geography (and time for the transactions)
2) Then, you determine the appropriate metrics and multiples for each set – for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples - and you calculate them for all the companies and transactions
3) Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum or each valuation multiple in the set
4) Finally, apply these numbers to the financial metrics of the company you’re analyzing to estimate its Implied Value

79
Q

What other valuation methods are there?

A
  1. Liquidation Valuation
  2. Replacement Value
  3. LBO Analysis
  4. Sum of the Parts
  5. M&A Premiums Analysis
  6. Future Share Price Analysis
80
Q

When would you use SOTP?

A
  • company has completely different, unrelated divisions - a conglomerate like General Electric, for example
  • use comps for each different division
81
Q

When would you use an LBO valuation?

A

Used to establish how much a private equity firm could pay, which is usually lower than what strategic buyers will pay.

It is often used to set a “floor” on a possible Valuation for company.

82
Q

What are the most common multiples used in Valuation?

A
  1. EV/Revenue
  2. EV/EBITDA
  3. EV/EBIT
  4. P/E (Share Price / EPS)
  5. P/BV (Share Price / Book Value).
83
Q

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

A

if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it’s doing well.

84
Q

DCF versus public comps / pres trx?

A

Instead of projecting and analyzing a company’s cash flows, you are comparing the company to other, similar companies, and use valuation multiples from those companies to value the one you’re looking at

85
Q

Problems with pres trx

A

Often, pres trx produce higher multiples than public comps because of the control premium built into M&A deals

Also, M&A deals can be structured in different ways, creating problems for this valuation method (e.g. some deals include earn outs, where a portion of purchase price is paid out several years into the future)

86
Q

The tradeoffs of the different methodologies

A
87
Q

When would you not use a DCF in a Valuation?

A

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.

88
Q

What would yield a higher valuation: LBO or DCF?

A

in most cases, LBO will give lower valuation

with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value.

With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher.

89
Q

How would you value an apple tree?

A

The same way you would value a company: Comparables and DCF / by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation).

The Discount Rate would be based on your opportunity cost – what you might be able to earn
each year by investing in other, similar apple trees.

Yes, you could do a DCF for anything – even an apple tree.

90
Q

Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

A

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.

You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet.

This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

91
Q

You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

A

It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead.

92
Q

What are the flaws with public company comparables?

A

• No company is 100% comparable to another company.
• The stock market is “emotional” – your multiples might be dramatically higher
or lower on certain dates depending on the market’s movements.
• Share prices for small companies with thinly-traded stocks may not reflect their
full value.

93
Q

How do you value a private company?

A

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:
• You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.
• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
• A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.

94
Q

Can you use private companies as part of your valuation?

A

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

95
Q

When are Public Comps or Precedent Transactions more useful than the DCF?

A

If the company you’re valuing is early-stage, and it is impossible to estimate its future cash flows, or if the company has no path to positive cash flows, you have to rely on the other methodologies.

These other methodologies can also be more useful when you run into problems in the DCF, such as an inability to estimate the Discount Rate or extremely volatile cash flows.

96
Q

Which one should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?

Assume the growth rates, margins, and all other financial stats are the same.

A

In all likelihood, the healthcare company will be worth more because healthcare is a less asset-intensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA) as a result.

Healthcare, at least in some sectors, also tends to be more of a “growth industry” than
industrials.

The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates would likely make up for that.

However, this answer is an extreme generalization, so you would need more information to make a real decision.

97
Q

Walk me through a DCF

A

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value.

You start by projecting the company’s Free Cash Flows over the next 5-10 years (by making assumptions for revenue growth, margins, Working Capital, and CapEx).

Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost
of Capital, and sum up everything.

Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity.

You then discount the Terminal Value to Present Value using the Discount Rate and add it to
the sum of the company’s discounted cash flows.

Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.

98
Q

What are some items you exclude from Unlevered FCF?

A

Unlevered FCF must capture the company’s core, recurring line items that are available to ALL investor groups (bc it corresponds to TEV)

So, exclude

  • Net Interest Expense – Only available to Debt investors.
  • Other Income / (Expense) – Corresponds to non-core-business Assets.
  • Most non-cash adjustments besides D&A – They’re non-recurring.
  • All Items in Cash Flow from Financing – They’re only available to certain investors.
  • Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.
99
Q

What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?x

A

If you include an income or expense line item in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you exclude).

For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher.

This rule also explains why you factor in Cash and Debt when moving to the Implied Equity Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

100
Q

How does the Pension Expense factor into Free Cash Flow?

A
101
Q

What does Cost of Equity mean intuitively?

A

It tells you the average percentage a company’s stock “should” return each year, over the very
long term, factoring in both stock-price appreciation and dividends.
In a valuation, it represents the percentage an Equity investor might earn each year (averaged
over decades).
To a company, the Cost of Equity represents the cost of funding its operations by issuing
additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting
existing investors (thereby giving up stock-price appreciation potential).

102
Q

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

A

The biggest issue is that EBITDA ignores CapEx. Two companies with similar EV / EBITDA
multiples might have very different Free Cash Flow and FCF growth figures. As a result, their
Implied Values might differ significantly even if they have similar EV / EBITDA multiples.
You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those
multiples create other issues, such as less comparability across peer companies.

103
Q
  1. If there’s a Precedent Transaction where the buyer acquired 80% of the seller, how do you
    calculate the valuation multiples?
A

The multiples are always based on 100% of the Seller’s value

So, if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value would be $500 million / 80% = $625 million.

And then you would calculate the Purchase Enterprise Value based on that figure plus the usual adjustments.

You would then calculate the valuation multiples based on those figures and the financial stats for 100% of the seller.

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