Valuation

Question 1

Could you explain the concept of present value and how it relates to company valuations?

Answer 1

The present value concept is based on the premise that “a dollar in the present is worth more than a dollar in the future” due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today. For intrinsic valuation methods, the value of a company will be equal to the sum of the
present value of all the future cash flows it generates. Therefore, a company with a high
valuation would imply it receives high returns on its invested capital by investing in positive net present value (“NPV”) projects consistently while having low risk associated with its cash flows.

Question 2

What is equity value and how is it calculated?

Answer 2

Often used interchangeably with the term market capitalization (“market cap”), equity value represents a company’s value to its equity shareholders. A company’s equity value is calculated by multiplying its latest closing share price by its total diluted shares outstanding, as shown below:
Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding

Question 3

How do you calculate the fully diluted number of shares outstanding?

Answer 3

The treasury stock method (“TSM”) is used to calculate the fully diluted number of shares outstanding based on the options, warrants, and other dilutive securities that are currently “in-the-money” (i.e., profitable to exercise).
The TSM involves summing up the number of in-the-money (“ITM”) options and warrants and then adding that figure to the number of basic shares outstanding.
In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact.

Question 4

What is enterprise value and how do you calculate it?

Answer 4

Conceptually, enterprise value (“EV”) represents the value of the operations of a company to all stakeholders including common shareholders, preferred shareholders, and debt lenders.
Thus, enterprise value is considered capital structure neutral, unlike equity value, which is affected by financing decisions.
Enterprise value is calculated by taking the company’s equity value and adding net debt, preferred stock, and minority interest.
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest

Question 5

How do you calculate equity value from enterprise value?

Answer 5

To get to equity value from enterprise value, you would first subtract net debt, where net debt equals the company’s gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets.
Equity Value = Enterprise Value – Net Debt – Preferred Stock – Minority Interest

Question 6

Which line items are included in the calculation of net debt?

Answer 6

The calculation of net debt accounts for all interest-bearing debt, such as short-term and long-term loans and bonds, as well as non-equity financial claims such as preferred stock and non-controlling interests. From this gross debt amount, cash and other non-operating assets such as short-term investments and equity investments are subtracted to arrive at net debt.
Net Debt = Total Debt – Cash & Equivalents

Question 7

When calculating enterprise value, why do we add net debt?

Answer 7

The underlying idea of net debt is that the cash on a company’s balance sheet could pay down the outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company’s debt, and many leverage ratios use net debt rather than the gross amount.

Question 8

What is the difference between enterprise value and equity value?

Answer 8

Enterprise value represents all stakeholders in a business, including equity shareholders, debt lenders, and preferred stock owners. Therefore, it’s independent of the capital structure. In addition, enterprise value is closer to the actual value of the business since it accounts for all ownership stakes (as opposed to just equity owners).

Question 9

Could a company have a negative net debt balance and have an enterprise value lower than its equity value?

Answer 9

Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies will have enterprise values lower than their equity value.
If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value represents the value of a company’s operations, which excludes any non-operating assets. When you think about it this way, it should come as no surprise that companies with much cash (which is treated as a non-operating asset) will have a higher equity value than enterprise value.

Question 10

Can the enterprise value of a company turn negative?

Answer 10

While negative enterprise values are a rare occurrence, it does happen from time to time. A negative enterprise value means a company has a net cash balance (total cash less total debt) that exceeds its equity value.

Question 11

If a company raises $250 million in additional debt, how would its enterprise value change?

Answer 11

Theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised shouldn’t impact the enterprise value, as the cash and debt balance would increase and offset the other entry.
However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact the company’s profitability and lead to a lower valuation from the higher cost of debt.

Question 12

Why do we add minority interest to equity value in the calculation of enterprise value?

Answer 12

Minority interest represents the portion of a subsidiary in which the parent company doesn’t own. Under US GAAP, if a company has ownership over 50% of another company but below 100% (called a “minority interest” or “non-controlling investment”), it must include 100% of the subsidiary’s financials in their financial statements despite not owning 100%.
When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest must be added to enterprise value for the multiple to be compatible (i.e., no mismatch between the numerator and denominator).

Question 13

How are convertible bonds and preferred equity with a convertible feature accounted for when calculating enterprise value?

Answer 13

If the convertible bonds and the preferred equities are “in-the-money” as of the valuation date (i.e., the current stock price is greater than their strike price), then the treatment will be the same as additional dilution from equity. However, if they’re “out-of-the-money,” they would be treated as a financial liability (similar to debt).

Question 14

What are the two main approaches to valuation?

Answer 14

1. Intrinsic Valuation: For an intrinsic valuation, the value of a business is arrived at by looking at the business’s ability to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and is based on the notion that a business’s value equals the present value of its future free cash flows.
2. Relative Valuation: In relative valuation, a business’s value is arrived at by
   looking at comparable companies and applying the average or median multiples
   derived from the peer group – often EV/EBITDA, P/E, or some other relevant
   multiple to value the target. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called “trading comps,” or by looking at the multiples of comparable companies recently acquired, which is called “transaction comps.”

Question 15

What are the most common valuation methods used in finance?

Answer 15

Trading comps value a company based on how similar publicly-traded companies are currently being valued at by the market. DCFs value a company based on the premise that its value is a function of its projected cash flows, discounted at an appropriate rate that reflects the risk of those cash flows. An LBO will look at a potential acquisition target under a highly leveraged scenario to determine the maximum purchase price the firm would be willing to pay.

Question 16

Among the DCF, comparable companies analysis, and transaction comps, which approach yields the highest valuation?

Answer 16

Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factor in control premiums. Control premiums can often be quite significant and as high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.

Question 17

Which of the valuation methodologies is the most variable in terms of output?

Answer 17

Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of the different valuation methodologies. Relative valuation methodologies such as trading and transaction comps are based on the actual prices paid for similar companies. While there’ll be some discretion involved, the valuations derived from comps deviate to a lesser extent than DCF models.

Question 18

How can you determine which valuation method to use?

Answer 18

Each valuation method has its shortcomings; therefore, a combination of different valuation techniques should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more defensible approximation and sanity-check your assumptions.
The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa).

Question 19

Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals?

Answer 19

That could be argued as an inaccurate statement. While a comps analysis often yields different valuations from a DCF, that’s only because of inconsistent implicit assumptions across both approaches. If the implicit
assumptions of the comps analysis were entirely consistent with the explicit assumptions of the DCF analysis, the valuations using both approaches would theoretically be equal. When you apply a peer-derived multiple to value a business, you’re still implicitly making assumptions about future cash flows, cost of capital, and returns that you would make explicitly when building a DCF. The difference is, you’re relying on the assumptions used by others in the market.

Question 20

What does free cash flow (FCF) represent?

Answer 20

Free cash flow (“FCF”) represents a company’s discretionary cash flow, meaning the cash flow remaining after accounting for the recurring expenditures to continue operating.
The simplest calculation of FCF is shown below:
Free Cash Flow (FCF) = Cash from Operations – Capex
The cash from investing section, other than capex, and the financing section are excluded because these activities are optional and discretionary decisions up to management.

Question 21

Why are periodic acquisitions excluded from the calculation of FCF?

Answer 21

The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and a normal part of operations (i.e., capex is required for a business to continue operating).

Question 22

Explain the importance of excluding non-operating income/(expenses) for valuations.

Answer 22

For both DCF analysis or comps analysis, the intent is to value the operations of the business, which requires you to set apart the core operations to normalize the figures.
When performing a DCF analysis, the cash flows projected should be strictly from the business’s recurring operations, which would come from the sale of goods and services provided. A few examples of non- operating income to exclude would be income from investments, dividends, or an asset sale. Each example represents income that’s non-recurring and from a discretionary decision unrelated to the core operations. When performing comps, the core operations of the target and its comparables are benchmarked. To make the comparison as close to “apples to apples” as possible, non-core operating income/(expenses) and any non-recurring items should be excluded.

Question 23

Define free cash flow yield and compare it to dividend yield and P/E ratios.

Answer 23

The free cash flow yield (“FCFY”) is calculated as the FCF per share divided by the current share price. For this calculation, FCF will be defined as cash from operations less capex.
Free Cash Flow Yield (FCFY) = Free Cash Flow Per/ Share Current Share Price

Question 24

Could you define what the capital structure of a company represents?

Answer 24

The capital structure is how a company funds its ongoing operations and growth plans. Most companies’ capital structure consists of a mixture of debt and equity, as each source of capital comes with its advantages and disadvantages. As companies mature and build a track record of profitability, they can usually get debt financing easier and at more favorable rates since their default risk has decreased. Thus, it’s ordinary to see leverage ratios increase in proportion with the company’s maturity.

Question 25

Why would a company issue equity vs. debt (and vice versa)? - Equity

Answer 25

Advantages - No required payments, unlike debt, giving management more flexibility around repayment.
Dividends to equity shareholders can be issued, but the timing and magnitude are at the board and management’s discretion. Another advantage of equity is that it gives companies access to a vast investor base and network.
disadvantages - Issuing equity dilutes ownership, and equity is a high cost of capital.
Public equity comes with more regulatory requirements, scrutiny from shareholders and equity analysts, and full disclosures of their financial statements.
The management team could lose control over their company and be voted out by shareholders if the company underperforms.

Question 26

Why would a company issue equity vs. debt (and vice versa)? - Debt

Answer 26

Advantages - The interest expense on debt is tax- deductible, unlike dividends to equity shareholders (although recent tax reform rules limit the deduction for highly levered companies).
Debt results in no ownership dilution for equity shareholders and has a lower cost of capital.
Increased leverage forces discipline on management, resulting in risk-averse decision-making as a side benefit.
Disadvantages - Required interest and principal payments that introduce the risk of default.
Loss of flexibility from restrictive debt covenants prevents management from undertaking a variety of activities such as raising more debt, issuing a dividend, or making an acquisition.
Less room for errors in decision-making, therefore poor decisions by management come with more severe consequences.

Question 27

What are share buybacks and under which circumstances would they be most appropriate?

Answer 27

A stock repurchase (or buyback program) is when a company uses its cash-on-hand to buy back some of its shares, either through a tender offer (directly approach shareholders) or in the open market. The repurchase will be shown as a cash outflow on the cash flow statement and be reflected on in the treasury stock line items on the balance sheet.
Ideally, the right time for a share repurchase to be done should be when the company believes the market is undervaluing its shares. The impact is the reduced number of shares in circulation, which immediately leads to a higher EPS and potentially a higher P/E ratio. The buyback can also be interpreted as a positive signal by the market that the management is optimistic about future earnings growth.

Question 28

Why would a company repurchase shares? What would the impact on the share price and financial statements be?

Answer 28

A company buys back shares primarily to move cash from the company’s balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash as with dividends, a share repurchase removes shareholders. The impact on share price is theoretically neutral – as long as shares are priced correctly, a share buyback shouldn’t lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can positively or negatively affect share price movement, depending on how the market perceives the signal. Conversely, if shareholders view the buyback as a signal that the company’s investment prospects are not great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash, lower perceived growth and investment prospects).

Question 29

Why might a company prefer to repurchase shares over the issuance of a dividend?

Answer 29

The so-called “double taxation” when a company issues a dividend, in which the same income is taxed at the corporate level (dividends are not tax-deductible) and then again at the shareholder level.
Share repurchases will artificially increase EPS by reducing the number of shares outstanding and can potentially increase the company’s share price.
Many companies increasingly pay employees using stock-based compensation to conserve cash, thus share buybacks can help counteract the dilutive impact of those shares.
Share buybacks imply a company’s management believes their shares are currently undervalued, making the repurchase a potential positive signal to the market.
Share repurchases can be one-time events unless stated otherwise, whereas dividends are typically meant to be long-term payouts indicating a transition internally within a company.
Cutting a dividend can be interpreted very negatively by the market, as investors will assume the worst and expect future profits to decrease (hence, dividends are rarely cut once implemented).

Question 30

When would it be most appropriate for a company to distribute dividends?

Answer 30

Companies that distribute dividends are usually low-growth with fewer profitable projects in their pipeline. Therefore, the management opts to pay out dividends to signal the company is confident in its long-term profitability and appeal to a different shareholder base (more specifically, long-term dividend investors).

Question 31

What is CAGR and how do you calculate it?

Answer 31

The compound annual growth rate (“CAGR”) is the rate of return required for an investment to grow from its beginning balance to its ending balance. Put another way, CAGR is the annualized average growth rate.

Question 32

What is the difference between CAGR and IRR?

Answer 32

The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the return on an investment. However, the calculation of CAGR involves only three inputs: the investment’s beginning and ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can handle more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the multiple cash flows) accounted for, rather than just smoothing out the investment returns.
CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making.

Question 33

When would it be appropriate to use a sum-of-the-parts approach to valuing a company?

Answer 33

In a sum-of-the-parts (“SOTP”) analysis, each division of a company will have its unique risk/return profile and need to be broken up to value the entire company more accurately as a whole. Thus, a different discount rate will value each segment, and there’ll be distinct peer groups for the trading and transaction comps. Upon completing each division’s valuation, the ending values would be summed up to arrive at the total value.
An example of when SOTP analysis (or break-up analysis) would be used is when the company being valued has many operating divisions in unrelated industries, each with differing risk-profiles (e.g., conglomerate).

Question 34

How does valuing a private company differ from valuing a public company?

Answer 34

The main difference between valuing a private and public company is the availability of data. Private companies are not required to make their financial statements public. If you’re provided private company financials, the process is similar to public companies, except that private company financial disclosures are often less complete, standardized, and reliable. In addition, private companies are less liquid and should thus be valued lower to reflect an illiquidity discount (usually ranges between ~10-30%).

Question 35

What is an illiquidity discount?

Answer 35

The illiquidity discount used when valuing private companies is related to being unable to exit an investment quickly. Most investors will pay a premium for an otherwise similar asset if there’s the optionality to sell their investment in the market at their discretion. Therefore, a discount should be applied when performing trading comps since shares in a public company include a premium for being sold in the public markets with ease (called the “liquidity premium”).