Valuation

Question 1

Why do you need to add the Noncontrolling Interest to Enterprise Value?

Answer 1

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn’t own 100%, it reports 100% of the majority-owned subsidiary’s financial performance. In keeping with the “apples-to-apples” theme, you must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Question 2

How do you calculate fully diluted shares?

Answer 2

Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt or convertible preferred stock. To calculate the dilutive effect of options, you use the Treasury Stock Method (detail on this below).

Question 3

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

Answer 3

The “official” reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to “pay” to acquire another company. It’s not always accurate because technically you should be subtracting only excess cash – the amount of cash a company has above the minimum cash it requires to operate.

Question 4

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

Answer 4

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller’s debt, so it is accurate to say that any debt “adds” to the purchase price. However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I’ve personally never seen it, but once again “never say never” applies.

Question 5

Why do we add Preferred Stock to get to Enterprise Value?

Answer 5

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

Question 6

Are there any problems with the Enterprise Value formula you just gave me?

Answer 6

Yes – it’s too simple. There are lots of other things you need to add into the formula with real companies:

-) Net Operating Losses – Should be valued and arguably added in, similar to cash.
-) Long-Term Investments – These should be counted, similar to cash.
-) Equity Investments – Any investments in other companies should also be added in, similar to cash (though they might be discounted).
-) Capital Leases – Like debt, these have interest payments – so they should be added in like debt.
-) (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well.
-) Unfunded Pension Obligations – Sometimes these are counted as debt as well.
So a more “correct” formula would be:

Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest – NOLs – LT and Equity Investments + Capital Leases + Unfunded Pension Obligations

In interviews, usually you can get away with saying “Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest” I mention this here because in more advanced interviews you might get questions on this topic.

Question 7

When would you not use a DCF in a Valuation?

Answer 7

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.

Question 8

What other Valuation methodologies are there?

Answer 8

Other methodologies include:

1. Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
2. Replacement Value – Valuing a company based on the cost of replacing its assets
3. LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
4. Sum of the Parts – Valuing each division of a company separately and adding them together at the end
5. M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth
6. Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value

Question 9

When would you use a Liquidation Valuation?

Answer 9

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it’s better to sell off assets separately or to try and sell the entire company.

Question 10

When would you use Sum of the Parts?

Answer 10

This is most often used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Question 11

When do you use an LBO Analysis as part of your Valuation?

Answer 11

Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a “floor” on a possible Valuation for the company you’re looking at.

Question 12

What are some examples of industry-specific multiples?

Answer 12

Technology (Internet): EV / Unique Visitors, EV / Pageviews Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations) Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize (a portion of) their exploration expenses and s4ome expense them. You add back the exploration expense to normalize the numbers. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.

Question 13

When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?

Answer 13

You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.

Question 14

Would an LBO or DCF give a higher valuation?

Answer 14

Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here’s the easiest way to think about it: 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. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Question 15

When would a Liquidation Valuation produce the highest value?

Answer 15

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Question 16

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

Answer 16

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!

Question 17

What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?

Answer 17

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered FCF already includes the effects of the Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors. Debt investors have already “been paid” with the interest payments and principal re payments they received.

Question 18

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

Answer 18

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. You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the nonfinancial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

Question 19

How do you select Comparable Companies / Precedent Transactions?

Answer 19

The 3 main ways to select companies and transactions:

1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in revenue

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue

Precedent Transaction Screen: Retail M&A transactions over the past year

Question 20

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

Answer 20

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

Question 21

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

Answer 21

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. In practice you rarely do all of the above – these are just possibilities.

But 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.

Question 22

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?

Answer 22

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. For the most part this generalization is true but there are exceptions to almost every “rule” in finance.

Question 23

Two companies have the exact same financial profiles 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?

Answer 23

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.

Question 24

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 24

Warren Buffett once famously said, “Does management think the tooth fairy pays for capital expenditures?” He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises 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. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

Question 25

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?

Answer 25

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).

Question 26

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.

Answer 26

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.

Question 27

How do you value banks and financial institutions differently from other companies?

Answer 27

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:

• You screen based on assets or deposits in addition to the normal criteria.
  You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.
• You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.
  Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:
• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.
• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations.
  You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps.

Question 28

Walk me through an IPO valuation for a company that’s about to go public.

Answer 28

1. Unlike normal valuations, in an IPO valuation we only care about public company comparables.
2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company’s Enterprise Value based on that.
3. Once we have the Enterprise Value, we work backward to get to Equity Value and also subtract the IPO proceeds because this is “new” cash.
4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say “An IPO priced at…” this is what they’re referring to.

If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.

Question 29

I’m looking at financial data for a public company comparable, and it’s April (Q2) right now. Walk me through how you would “calendarize” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year

Answer 29

The “formula” to calendarize financial statements is as follows: TTM = Most Recent Fiscal Year + New Partial Period – Old Partial Period So in the example above, we would take the company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year. For US companies you can find these quarterly numbers in the 10-Q; for international companies they’re in the interim reports.

Question 30

Walk me through an M&A premiums analysis.

Answer 30

The purpose of this analysis is to look at similar transactions and see the premiums that buyers have paid to sellers’ share prices when acquiring them.

For example, if a company is trading at $10.00/share and the buyer acquires it for $15.00/share, that’s a 50% premium.

1. First, select the precedent transactions based on industry, date (past 2-3 years for example), and size (example: over $1 billion market cap).
2. For each transaction, get the seller’s share price 1 day, 20 days, and 60 days before the transaction was announced (you can also look at even longer intervals, or 30 days, 45 days, etc.).
3. Then, calculate the 1-day premium, 20-day premium, etc. by dividing the per share purchase price by the appropriate share prices on each day.
4. Get the medians for each set, and then apply them to your company’s current share price, share price 20 days ago, etc. to estimate how much of a premium a buyer might pay for it.

Note that you only use this analysis when valuing public companies because private companies don’t have share prices. Sometimes the set of companies here is exactly the same as your set of precedent transactions but typically it is broader.

Question 31

Walk me through a future share price analysis.

Answer 31

The purpose of this analysis is to project what a company’s share price might be 1 or 2 years from now and then discount it back to its present value.

1. Get the median historical (usually TTM) P / E of your public company comparables.
2. Apply this P / E multiple to your company’s 1-year forward or 2-year forward projected EPS to get its implied future share price.
3. Then, discount this back to its present value by using a discount rate in-line with the company’s Cost of Equity figures.
   You normally look at a range of P / E multiples as well as a range of discount rates for this type of analysis, and make a sensitivity table with these as inputs.

Question 32

Both M&A premiums analysis and precedent transactions involve looking at previous M&A transactions. What’s the difference in how we select them?

Answer 32

1. All the sellers in the M&A premiums analysis must be public.
2. Usually we use a broader set of transactions for M&A premiums – we might use fewer than 10 precedent transactions but we might have dozens of M&A premiums. The industry and financial screens are usually less stringent.
3. Aside from those, the screening criteria is similar – financial, industry, geography, and date.

Question 33

Walk me through a Sum-of-the-Parts analysis.

Answer 33

Example: We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA and a consumer goods division with $75 million EBITDA. We’ve selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods. Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company’s total value.

Question 34

I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?

Answer 34

This varies by bank and group, but two common methods:

1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range.

Note that you do not pick reports based on which bank they’re coming from. So if you’re at Goldman Sachs, you would not pick all Goldman Sachs equity research – in fact that would be bad because then your valuation would not be objective.

Question 35

I have a set of precedent transactions but I’m missing information like EBITDA for a lot of the companies – how can I find it if it’s not available via public sources?

Answer 35

1. Search online and see if you can find press releases or articles in the financial press with these numbers.
2. Failing that, look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller’s numbers.
3. Also look on online sources like Capital IQ and FactSet and see if any of them disclose numbers or give estimates.

Question 36

How far back and forward do we usually go for public company comparable and precedent transaction multiples?

Answer 36

-) Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years.
-) You’re more likely to look backward more than 1 year and go forward more than 2 years for public company comparables
-) For precedent transactions it’s odd to go forward more than 1 year because your information is more limited.

Question 37

I have one company with a 40% EBITDA margin trading at 8x EBITDA, and another company with a 10% EBITDA margin trading at 16x EBITDA. What’s the problem with comparing these two valuations directly?

Answer 37

There’s no “rule” that says this is wrong or not allowed, but it can be misleading to compare companies with dramatically different margins.

Due to basic arithmetic, the 40% margin company will usually have a lower multiple – whether or not its actual value is lower.

In this situation, we might consider screening based on margins and remove the outliers – you would never try to “normalize” the EBITDA multiples based on margins.

Question 38

Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.

Answer 38

Public comps and precedent transactions are similar, but:
1. You might screen based on metrics like Proved Reserves or Daily Production.
2. You would look at the above metrics as well as R/P (Proved Reserves / Last Year’s Production), EBITDAX, and other industry-specific ones, and use matching multiples.
3. You could use a standard Unlevered DCF to value an oil & gas company as well
4. But it’s also common to see a NAV (Net Asset Value) Model where you take the company’s Proved Reserves, assume they produce revenue until depletion, assign a cost to the production in each year, and take the present value of those to value the company.

• • There are also a host of other complications: oil & gas companies are cyclical and have no control over the prices they receive, companies use either “full-cost accounting” or “successful efforts accounting” and treat the exploration expense differently, and so on.*

Question 39

Walk me through how we would value a REIT (Real Estate Investment Trust) and how it differs from a “normal” company.

Answer 39

Similar to energy, real estate is asset-intensive and a company’s value depends on how much cash flow specific properties generate.

1. You look at Price / FFO per Share (Funds From Operations) and Price / AFFO per Share (Adjusted Funds From Operations), which add back Depreciation and subtract gains on property sales.
2. A Net Asset Value (NAV) model is the most common intrinsic valuation methodology; you assign a cap rate to the company’s forward NOI and multiply to get the value of its real estate, adjust and add its other assets, subtract liabilities and divide by its share count to get NAV per Share, and then compare that to its current share price.
3. You value properties by dividing Net Operating Income (NOI) (Property’s Gross Income – Operating Expenses and Property Taxes) by the capitalization rate (based on market data).
4. Replacement Valuation is more common because you can actually estimate the cost of buying new land and building new properties.
5. A DCF is still a DCF, but it flows from specific properties and it might be useless depending on what kind of company you’re valuing.

Question 40

What is P/E ratio, why use it? What drives it quantitatively and qualitatively? Difference between two companies with identical earnings but different multiples?

Answer 40

• The P/E multiple is used to compare the relative attractiveness of stocks in the same industry.
• It gives investors an idea of how much the market is paying for $1 of a company’s earning generating capability. The higher the P/E, the more investors are paying for one unit of earnings, and therefore the more earnings growth is expected to take place in the future. A P/E multiple above 20x generally implies high growth.
• Quantitatively, P/E is moved by changes in the amount of shares outstanding and net profits.
• Qualitatively, P/E is affected by perception of earnings risk, market expectations, growth, quality of earnings (margins expansion or contraction), and general investor confidence.

Question 41

What is the CAPM model?

Answer 41

• CAPM is a model designed to find the expected return on an investment and therefore the appropriate discount rate for a company’s cash flows.
• CAPM tries to figure how much should an investor be compensated to hold a asset given a world where risk free securities (government treasury bills) exist. The model divides the risk of holding risky assets into systematic and specific risk. According to CAPM, the marketplace compensates investors for taking systematic risk, but not for taking specific risk.
• CAPM is a simple model and there are other more complicated model with other variables attaches. In CAPM All investors have identical investment horizons, identical perceptions regarding the expected returns and volatilities and correlations of available risky investments.

Question 42

What are the 3 traditional reasons for doing an IPO?

Answer 42

• Capital constrained (need the money to keep current operations running)e.g. start up company needs additional “runway”
• Opportunity constrained (need additional funds to grow or develop new products or finance an acquisition)
• Human resource constrained (need the money to keep / attract talent

Question 43

In a perfect (tax free) word, if you have a company with an Enterprise Value of $5BN and you take out $2BN in debt, what is the new Enterprise Value? What is the Enterprise Value if you subsequently use the $2BN to pay out a dividend? What is the Enterprise Value if instead of paying out the dividend you invest the $2BN in a new project with an NPV of $3BN?

Answer 43

• Issuing $2bn in debt will essentially increases current cash balance by $2bn but also increases debt by $2bn. The cash(asset)and debt(liability) will net out each other to balance out the balance sheet. Thus firm value remains the same at $5bn.
• Then paying out a dividend of $2bn will reduce the cash balance on the balance sheet by $2bn,hence ,reducing $2bn ineffective equity value. Thus, firm value remains the same at $5bnenterprise value.
• However, if the $2bn were to be invested in a project with an NPV of $3bn would increases the enterprise value of the firm by the investment amount ($2bn) and the investment’s NPV ($3bn). Thus firm value is $10bn(2+3+5)

Question 44

Calculation for EPS? Does that include preferred stock and convertible bonds?

Answer 44

• Net Earnings-Per-Share (EPS) is calculated by dividing net income by common shares outstanding adjusted for the assumed conversion of all potentially dilutive securities (does not include preferred stock)
• Securities having a dilutive effect may include convertible debentures, warrants, options, and convertible preferred stock

Question 45

How do you calculate fully diluted shares in order to calculate fully diluted EPS?

Answer 45

• Fully diluted EPS is net income / fully diluted shares. Fully diluted shares include convertible debt, outstanding options, warrants or stock appreciation rights. As covered above
• Bankers would normally use the Treasury Stock Method “TSM” to calculate fully diluted shares in our financial models.
• TSM assumes that the proceeds from options and warrants exercised are used to repurchase outstanding ordinary shares in order to mitigate dilution

Question 46

What is cash EPS? Why is it used in some industries?

Answer 46

• Cash EPS is simply replacing the net income over shares outstanding with operating cash flow overdiluted shares outstanding. It is a measure of financial performance that looks at the cash flow generated by a company instead of net income which is subject to non-cash adjustments.
• Cash EPS is used in mature industries which have a lot of options and diluted shares could materially affect the EPS figures. As a result, Net Income is decreased by a non-cash expense which is adjusted under Cash EPS.

Question 47

Credit Ratios

Answer 47

• Interest coverage ratio is EBIT/net interest expenses which will give you an indication of how much would the company struggle to make debt interest payments.
• EBITDA/net interest expenses is commonly used when deciding to extend credit or during an LBO transaction. Creditors are risk adverse and want to make sure that the company can easily make interest payments without incurring any difficulty.
• Other ratios include Net debt / EBITDA and debt-to-equity ratio
• Another very important ratio specially in PP&E intensive industry is the debt service coverage ratio (DSCR) which tracks cash available for debt servicing to interest, principal and lease payments on assets.
• DSCR = (Annual Net Income + interest expenses + Amortization/Depreciation + other non-cash and discretionary items (such as changes in net working capital, net Capex investment) + additional debt) / (Principal Repayments + Interest payments + Lease payments)

Question 48

Why might a company be trading at a lower EV/EBITDA multiple than it’s competitors of the same size in the same industry?

Answer 48

• Different growth expectation based on company profile e.g. a company has won a new contract
• Differences in cash affecting regimes in the EBITDA line e.g. different inventory and depreciation schedule which will affect the tax regimes
• Crowded short: sometimes a lot of hedge funds will initiate a short position on a stock because other hedge funds have done it which will decrease the share price
• Multiple contraction or expansion: the industry might expect a contraction and it is affecting some more then others temporarily
• Potential M&A takeover rumour have created a premium
• Management instability will cause traders to review the growth outlook

Question 49

Issuing a bond at par, discount or premium

Answer 49

• When issuing a bond at par the coupon rate equals the market rate.
• When issuing below par i.e. a discount, when the coupon rate is lower than the market rate (yield). The price of the bonds will decrease because investors will be receiving an inferior rate.
• When issuing at a premium when the coupon rate is greater than the market rate (yield), this will raise the price of the bond.

Question 50

The 2 traditional methods to value an option? What factors are considered?

Answer 50

The two methods are Black-Scholes and the binomial model. The inputs are:
o Current Share Price
o Exercise Price
o Time to Maturity
o Risk Free Rate
o Variance of Return on the Stock

Question 51

What is a primary and a secondary market?

Answer 51

• The primary market is where an investment bank sells new securities(think IPO)before they go to market. With an IPO or bond issuance, the majority of these buyers are institutional investors (Pensions funds, Funds Managements etc.) who purchase large amounts of the security.
• The secondary market is the market on which a stock or bond trades after the primary offering—the New York Stock Exchange, London Stock Exchange etc.

Question 52

How would you calculate your present value? What is your Beta? What rate would you use to discount yourself? Give me an idea of the projections for your cash flows

Answer 52

• Start with projecting your future earnings until retirement age. Take you expected salary, growing faster until 45-50 which slowly starts to flat line as your income becomes mature and you become a senior.
• Discount rate: based on your “riskiness”. If you work for government, take the risk free rate as your earnings are basically guaranteed. Working for a bank, add a premium.
• Terminal value: take the average life expectancy and discount those cash flows from retirement age to expected death age. Since earnings are guaranteed by the government, used the risk free rate.

Question 53

How would you value a supermarket?

Answer 53

Multiples of other supermarket companies: key issue is to adjust for potential difference of leasing vs owning the supermarkets (use EBITDAR multiples, not EBITDA)

Question 54

How would you value an asset management company?

Answer 54

Multiples: an asset management company is not a manufacturing business and EBITDA is less meaningful. Typically asset management companies earn fees or the size of assets they manage so a multiple of assets under management would make sense

Question 55

Describe a company’s typical capital structure

Answer 55

A company’s capital structure is made up of a mixture of debt and equity, and there may be multiple levels of each. If we take a look at debt first, in the event of bankruptcy there are seniority in the kinds of debt which can be senior, mezzanine, or subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior debt is most secure and will be paid off first in bankruptcy, it offers the lowest interest rate (low risk). The most senior debt is bank loans; the rest is bonds,which can be issued to the general public. Equity is either preferred or common stock. Preferred stock comes with dividends and combines some features of both debt and equity: it can appreciate in value, but it has very little or no rights in a bankruptcy. Common stock is traded on the exchanges, if the company is public. In the event of bankruptcy, common stockholders have the least claim to assets in the event of liquidation, and therefore they bear the highest level of risk and earn the highest return on investment. Commonshareholders are the company’s owners and are entitled to profits, which may be reinvested in the business or paid as dividends.

Question 56

How would you spend a week valuing XYZ business?

Answer 56

• A week is a good amount of time to really get to know a business and the industry it operates in.
• First, read sell-side reports to understand the company, capital structure and get a good sense of the industry position , read company filings for more detail, read competitors and the filings of competition, examine the industry via industry research reports, examine the company with a SWOT analysis, build a financial model to get a better understanding of the companies’ financials, build a DCF, comps and precedent transaction analysis to see the value of the business.

Question 57

Discuss the use of relative or fundamental valuation method for a supermarket. What are the pros/cons of each?

Answer 57

SAMPLE ANSWER: Supermarkets are a highly saturated industry with leading brands like Walmart, Tesco.. competing with smaller regional chains which are often private. The industry has seen a shift recently to more healthier organic options, an increase in eating out, willingness to order groceries online for delivery, new entrance like Amazon Prime, Amazon Fresh, Instacart, etc. are causing disruption to supply chains.
In terms of valuation, relative valuation would identify which is the best performing supermarket or supermarket chain, but fail to include private supermarkets. On the other hand, fundamental driven valuation models like a DCF will be to identify which is the best super market and explain the type of details you would not get from relative valuation such as; margins, returns on capital employed, and how much free cash flow is being generated by each super market. The fundamental approach will be better at identifying a stand along investment opportunity. Relative valuation will only show which is the best performing supermarket.

Question 58

How is valuing a resource company (e.g., oil and gas, a mining company, etc.) different from valuing a standard company?

Answer 58

First, you need to project the prices of commodities and the company’s reserves. Rather than a standard DCF, you use a Net Asset Value (NAV) model. The NAV model is similar, but everything flows from the company’s reserves rather than a simple revenue growth / EBITDA margin projection. You also look at industry-specific multiples such as P / NAV in addition to the standard multiples.

Question 59

What is the APV method?

Answer 59

Adjusted Present Value values firm on 100% equity basis and debt effect to see both effects separately. (=unlevered value (discounted using COE) + PV of debt financing)

Question 60

How would you calculate TV for copper mine that is used until 2070?

Answer 60

Two possible ways:

• Negative g in GGM that approaches zero in 2070
• No TV at all and just continue degressive model until 2070

Question 61

What is Asset Beta?

Answer 61

Risk of all assets in Company. If 100% of company is equity, then Asset β = equity β

Question 62

Does debt have a β?

Answer 62

Usually, debt has β of zero as it is always paid regardless of market. For less solid companies that don’t pay all of their interest payments it can, however, vary.

Question 63

What is Adjusted β?

Answer 63

Usually weighted average of 2/3 “raw” β (historical) and 1/3 a β of 1 (mean reversion):

beta_a = 2/3 * beta_raw + 1/3

Question 64

Are taxes in DCF higher, lower or the same as the real taxes?

Answer 64

Higher or at least as high as you subtract them from EBIT instead of EBT.

Question 65

What is NOPLAT?

Answer 65

• Same as NOPAT. Fictional P&L metric used in DCF after subtracting taxes from EBIT.
• Zusätzlich berücksichtigt der NOPLAT noch, dass auf dem Zinsaufwand keine Steuern bezahlt werden. Der NOPLAT wird gelegentlich auch als Earnings before Interest (EBI) bezeichnet.

Question 66

Why do we assume taxes on entire EBIT for DCF?

Answer 66

Central point in DCF to value company on basis of UFCF assuming 100% equity financing.

Question 67

Why is tax shield effect included in WACC formula?

Answer 67

Because tax benefits are not reflected in FCF in DCF and it therefore has to be included in WACC and therefore reduces the interest costs.

Question 68

What is an APV valuation?

Answer 68

The Adjusted Present Value valuation. Like DCF but looks isolated at value drivers from capital structure. In DCF we include cap structure in WACC. APV valued (fictionally) debt-free company by discounting FCF to Firm with COE (assuming 100% equity). Effects of tax shield are separately reflected and added to unlevered company value.

Question 69

What are pros and cons of APV?

Answer 69

Same as DCF but beyond that, APV reflects changes in capital structure. Con of APV that it is rarely used in practice.

Question 70

When you do an APV valuation, would you discount tax shield with COE or COD?

Answer 70

It depends. One could assume COD as tax shield results directly form debt. However, it not only depends on debt. If a company operates at a loss, it doesn’t pay taxes, so tax shield is eliminated. Therefore, tax shield is dependent on EBT and would be discounted with COE. In practice you would look at how stable profits are and decide form there.

Question 71

What’s the difference between IRR and CAGR?

Answer 71

Nothing!

Question 72

What is the EVA method and how is it calculated?

Answer 72

EVA (Economic Value Added) calculates the value of a company above a required return rate (WACC)

EVA = NOPAT – WACC * CE (where CE = Total Assets – Short-term liabilities – Cash)

Question 73

How do you value a private company?

Answer 73

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:

1. • 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.
2. • You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
3. • Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
4. • 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.

Question 74

Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

Answer 74

There’s no discount because with precedent transactions, you’re acquiring the entire company – and once it’s acquired, the shares immediately become illiquid.

But shares – the ability to buy individual “pieces” of a company rather than the whole thing – can be either liquid (if it’s public) or illiquid (if it’s private). Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Question 75

Can you use private companies as part of your valuation?

Answer 75

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.