Valuation

Question 1

What are the 3 major valuation methodologies?

Answer 1

Public Company Comparables (Public Comps), Precedent Transactions and the
Discounted Cash Flow Analysis.

Public Comps and Precedent Transactions are examples of relative valuation (based on market values), while the DCF is intrinsic valuation (based on cash flows).

Question 2

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

Answer 2

First, you select the companies and transactions based on criteria such as
industry, financial metrics, geography, and timing (for precedent transactions).

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.

Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set.

Finally, you apply those numbers to the financial metrics for the company you’re analyzing to estimate the potential range for its valuation. For example, if the company you’re valuing has $100 million in EBITDA and the
median EBITDA multiple of the set is 7x, its implied Enterprise Value is $700
million based on that. You would then calculate its value at other multiples in
this range.

Question 3

How do you select Comparable Companies or Precedent Transactions?

Answer 3

The 3 main criteria for selecting companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography
For Precedent Transactions, you also limit the set based on date and often focus
on 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 4

For Public Comps, you calculate Equity Value and Enterprise Value for use
in multiples based on companies’ share prices and share counts… but what about for Precedent Transactions? How do you calculate multiples there?

Answer 4

They should be based on the purchase price of the company at the time of the
deal announcement.

For example, a seller’s current share price is $40.00 and it has 10 million shares
outstanding. The buyer announces that it will pay $50.00 per share for the seller.

The seller’s Equity Value in this case, in the context of the transaction, would be
$50.00 * 10 million shares, or $500 million. And then you would calculate its
Enterprise Value the normal way: subtract cash, add debt, and so on.
You only care about what the offer price was at the initial deal announcement.
You never look at the company’s value prior to the deal being announced.

Question 5

How would you value an apple tree?

Answer 5

The same way you would value a company: by looking at what comparable
apple trees are worth (relative valuation) and the present value of the apple
tree’s cash flows (intrinsic valuation). Yes, you could build a DCF for anything –
even an apple tree.

Question 6

When is a DCF useful? When is it not so useful?

Answer 6

A DCF is best when the
1) company is large, mature
2) has stable and predictable cash flows (think: Fortune 500 companies in “boring” industries). Your far-inthe-future assumptions will generally be more accurate there
3) DCF is less subject to market price variations

A DCF is not as useful if the company has unstable or unpredictable cash flows
(tech start-up) or when Debt and Operating Assets and Liabilities serve
fundamentally different roles (ex: Banks and Insurance Firms – see the industry specific guides for more).

Question 7

What other Valuation methodologies are there?

Answer 7

• 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.
• LBO Analysis –Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range.
• Sum of the Parts – Valuing each division of a company separately and
  adding them together at the end.
• 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.
• Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables and then discounting
  it back to its present value.

Question 8

When is a Liquidation Valuation useful?

Answer 8

It’s most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company’s Liabilities have been paid off with the proceeds from selling all its Assets. It is often used to advise struggling businesses on whether it’s better to sell off Assets separately or to sell 100% of the company.

Question 9

Enterprise Value/EBIT used for? means?

Answer 9

Profitability multiple

Used for: many types of companies, especially those where CapEx is more important because includes impact from D&A

Means: ~co. value (prop) income from business operations

Question 10

TEV/EBITDA used for? means?

Answer 10

Profitability Multiple

Used for: many companies, most useful when CapEx and D&A not as important

Means: ~ co. value (prop) operational cash flow

Question 11

P/E? Used for? Means?

Answer 11

Profitability Multiple

Used for: many types of companies, most relevant for banks and financial institutions bc distorted by non-cash charges, capital structure, tax rates

Means: ~ co. value (prop) after tax earnings

Question 12

Equity Value / Levered FCF? Used for? Means?

Answer 12

Profitability Multiple

Used for: not very common bc complicated to calculate and may produce wildly different numbers depending on capital structure

Means: most accurate measure of co. value (prop) true cash flow

Question 13

TEV / FCF used for? Means?

Answer 13

Profitability Multiple

Used for: when CapEx or changes in Operational Assets and Liabilities (ex: Deferred Revenue) have a big impact, critical in DCFs

Means: co. value (prop) true cash flow while capital structure neutral

Question 14

Public Comps Advantages/Disadvantages?

Answer 14

Advantages:
- based on real data opposed to future assumptions

Disadvantages:
- there may not be true comparable companies
- less accurate for thinly traded stocks or volatile companies

Question 15

Precedent Transactions Advantages/Disadvantages?

Answer 15

Advantages:
- based on what real companies have actually paid for other companies (not based on future assumptions)

Disadvantages:
- there may not be true comparable transactions
- data can be spotty, especially for private transactions

Question 16

DCF Advantages/Disadvantages?

Answer 16

Advantages:
- not subject to market fluctuations
- theoretically sound since it’s based on ability to generate cash flow

Disadvantages:
- subject to far in the future assumptions
- less useful for fast-growing, unpredictable companies

Question 17

What multiples would you use for a company that is not profitable?

Answer 17

TEV/Revenue
TEV/EBITDA
Price/Sales = current stock price/sales per share (sales per share = total sales/outstanding shares)

Question 18

You have 500 EBITDA, trading at 12x EBITDA, you made 50 in interest payments, 50% tax, 10% interest. What’s the EV? Whats the Eq?

Answer 18

TBD, my answer not sure it’s right

Equity Value = 500 EBITDA * 12 = 6000

Enterprise Value =
Equity Value
+ Debt
- Cash
= 6000 + 500 debt
= 6500

Question 19

Discuss a hypothetical subscription company with a lot of deferred revenue. How does that impact the valuation (acknowledged there is no correct answer. They just wanted to see your thinking process and your view

Answer 19

TBD

Question 20

You’re advising a client on a buy-side deal. What kind of analysis do you need to conduct on targets?

Answer 20

Trying to get you to say both quantitative valuation analysis and also qualitative (does the deal make sense)

Question 21

Why would two comparable companies be trading at 10x EBITDA versus 20x EBITDA multiples?

Answer 21

TBD

market mismatch to EBITDA multiples

• one company could have just had an earnings call where they beat analysts’ expectations, increasing their share price and Equity Value
• one company could have internally developed assets like patents that can’t be included on their book value, but are factored in by the market with an increased Equity Value

Question 22

What is an LBO high level and why is it consider the floor valuation?

Answer 22

You assume a PE company acquires a company and needs to generate an internal rate of return (IRR) such as 15-30%, and work backwards to calculate how much they could potentially pay to achieve that return. It’s a variation of DCF analysis because you still value the firm via its future cash flows, but those cash flows are used to pay off leverage.

It’s considered a floor valuation because it’s the minimum a PE firm will pay for a company - they are incentivized to minimize their entry multiple to maximize their IRR.

Question 23

If they are more accurate, why are Free Cash Flow multiples less common than EBIT and EBITDA multiples?

Answer 23

1) FCF multiples take more time to calculate, and you have to go through the company’s financial statements in detail.
2) they may not be standardized because companies include very different items in the Cash Flow from Operations section of their CF.

EBIT/EBITDA multiples are more common for
1) convenience
2) comparability

Question 24

When would you use a Sum of the Parts (SOTP) valuation?

Answer 24

This is typically used with conglomerates like General Electric, companies that have completely different, unrelated divisions.

If you have a plastics, entertainment, and energy 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, then add the individual valuations together for a Total Value.

Question 25

When do you use an LBO analysis as part of your valuation?

Answer 25

You use this whenever you’re analyzing a Leveraged Buyout, but it is used to “set a floor” on the company’s value and determine the minimum amount a PE firm could pay to achieve its targeted returns.

You often see it used when both strategics (normal companies) and financial sponsors (PE firms) are competing to buy the same company, and you want to determine the potential price if a PE firm were to acquire a company.

Question 26

How do you apply valuation methodologies to value a company?

Answer 26

You present valuation in a “Football Field” graph with a range of minimum to maximum, showing the interquartile range and median of each set (2-3 years of comps and the transactions, for each different multiple used) and then multiply by the relevant metrics for the company you’re analyzing.

For public companies, you will also work backwards to calculate the Equity Value and implied share price.

Question 27

What are EBIT and EBITDA, and how do you calculate them? How are they different?

Answer 27

EBIT is a company’s Operating Income on its IS. It includes COGS, Operating Expenses, and non-cash expenses like D&A and therefore indirectly reflects a company’s CapEx.

EBITDA is EBIT + D&A. The idea of EBITDA is to move closer to a company’s “cash flow” by including D&A impact, but an issue bc you’re ignoring CapEx.

Question 28

How do you calculated Unlevered FCF and Levered FCF?

Answer 28

Unlevered FCF =
EBIT * (1-Tax Rate)
+ D&A
- Change in Operating Working Capital
- CapEx

Unlevered FCF excludes net income expense, and mandatory debt repayments.

Levered FCF =
Net Income
+ D&A
- Change in Operating Working Capital
- CapEx
- Mandatory Repayments

Question 29

What are the most common valuation multiples? What do they mean?

Answer 29

1) TEV/Revenue = how valuable a company is to its overall sales
2) TEV/EBITDA = how valuable a company is relative to its approximate cash flow
3) TEV/EBIT = how valuable a company is relative to its operating income (pre-tax profit it receives from business operations)
4) P/E = price per share/earnings per share, how valuable a company is relative to its after-tax profits, inclusive of net income expense and other non-core business activities

Other multiples include
* P/BV = price per share / book value per share, not terribly meaningful for most companies
* EV/Unlevered FCF = closer to true cash flow than EV/EBITDA but harder to calculate
* EqV/Levered FCF = even closer to true cash flow but influenced by capital structure and time-consuming

Question 30

How are the key operating metrics and valuation metrics correlated? In other words, what might explain a higher or lower EV/EBITDA multiple?

Answer 30

1) Usually there is a correlation between growth and valuation multiples. If one company is growing revenue or EBITDA more quickly, its multiples may be higher as well.

2) Math component = actual numerator or denominator differences.

3) real world factors.

Question 31

Why can’t you use EqV/EBITDA as a multiple rather than TEV/EBITDA?

Answer 31

If a profitability metric includes net interest expense, it is only available to Equity Investors. Excluding this impact means the metric is available to ALL investors in the company.

Equity Value is available to only equity investors, while EBITDA is available to all investors, so it’s an apple-to-oranges comparison.

Question 32

What would you use with FCF multiples, EV or EqV?

Answer 32

Unlevered FCF = EV
Levered FCF = EqV

Question 33

Why does Warren Buffet prefer EBIT multiples to EBITDA multiples?

Answer 33

Dislikes EBITDA because it hides the impact of CapEx and disguises how much cash they truly require to operate.

EBIT doesn’t directly show CapEx, but includes D which is linked to CapEx.

Question 34

What are some problems with EBITDA and EBITDA multiples? If there are so many problems, why do we still use it?

Answer 34

Problems with EBITDA approximation of cash flow
1) hides debt principal and interest
2) hides CapEx and D&A impact
3) ignores working capital requirements (which can be large)
4) companies are inconsistent with what they “add back”, so comparability is warped

Used
1) for convenience, has become a standard over time
2) for comparability, better for comparing than other metrics

Question 35

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

Answer 35

P/E depends on capital structure, while EV/EBIT and EV/EBITDA do not.

You can use P/E in industries where the capital structure is similar, like banks or insurance.

EV/EBIT includes D&A impact, while EV/EBITDA does not. EBIT multiples more common in industries with high D&A, where CapEx and fixed assets are important (like Industrials). EBITDA multiples are more common where D&A is low and CapEx/fixed assets are less important (tech companies).

Question 36

Could EV/EBITDA ever be higher than EV/EBIT

Answer 36

No.

D&A is always zero or positive. Therefore EBIT will always be equal or smaller than EBITDA. An EBITDA multiple with the same EV will always be equal or smaller than the corresponding EBIT multiple.

Question 37

Examples of industry-specific multiples?

Answer 37

Industrials example:
EV/EBITDAR for Airlines (+Rental expense)

Oil & Gas:
EV/EBITDAX (+Exploration expense)

Tech:
EV/Unique Visitors

Question 38

Would an LBO or DCF produce a higher valuation?

Answer 38

Technically it could go either way, but in most cases an LBO will give you a lower valuation.

With an LBO you receive no cash flows between Year 1 and the final year – you only get value out of its final year.

With a DCF, by contrast, you include FCF during the period and the terminal value, so values tend to be higher.

Note: unlike a DCF, a LBO model does not give a specific valuation. Instead you set a desired IRR and back-solve for how much you could pay for the company (the valuation) based on that.

Question 39

When would a Liquidation Valuation produce the highest value?

Answer 39

This is unusual, but could happen if a company has substantial hard assets but the market is severely undervaluing it (such as earnings miss of cyclicality).

As a result, the Comps and Precedent Transaction would likely produce lower values.

Question 40

Why are Public Comps and Precedent Transactions sometimes viewed as “more reliable” than a DCF?

Answer 40

Because they’re based on real market data, as opposed to far-in-the-future assumptions.

However, even in Public Comps & Precedent Transactions you do use future assumptions for immediate forward years.

Also , you might not have good or comparable data for these, in which case a DCF might produce better results.

Question 41

Flaws of Public Company Comparables?

Answer 41

1) no company is 100% comparable to another company
2) the stock market is “emotional” - your multiples may be dramatically higher or lower depending on the market’s movements
3) share prices for small companies with thinly traded stocks may not reflect their full value

Question 42

What is a situation in which Precedent Transactions actually give a lower valuation than Comparable Companies?

Answer 42

This would be unusual, but could happen if there is a substantial mismatch between the M&A market and public market. This could happen if no public companies have been acquired recently, or lots of private companies have been acquired for smaller valuations.

Question 43

What are flaws of Precedent Transactions?

Answer 43

1) past transactions are rarely 100% comparable (transaction structure, size of company, and market sentiment all make a huge impact)
2) data on precedent transactions is generally more difficult to find than for public company comparables, especially for small private companies

Question 44

How would you present valuation methodologies to a company or its investors? What do you use it for?

Answer 44

You would present valuation as a Football Field charge with an implied range with each methodology.

You could use valuation for
1) Pitch Books & Client Presentations - telling companies what you think they’re worth, updates to clients
2) Parts of Other Models (Defense analyses, merger models, DCF, LBO)
3) Fairness Opinions - right before a deal with a public seller closes, a financial advisor creates a “Fairness Opinion” that justifies the acquisition price and directly estimates the company’s valuation

Question 45

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

Answer 45

Multiple Reasons
1) company reported earnings well above analyst expectations and stock price has risen in response
2) has some type of competitive advantage not reflected in its financials, such as key patent or IP
3) just won a favorable ruling in a lawsuit
4) market leader in its industry (greater market share than its competitors)

Question 46

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

Answer 46

1) Highlight a 75% percentile or higher multiple rather than the median
2) add in a premium to multiples
3) use more aggressive projections for company

Question 47

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

Answer 47

Nope, in fact you always use a range. You can make the median the center of that range, but you could also use 25th or 75th percentile if the company is under or overperforming for some reason.

Question 48

Two companies have the exact same financial profiles (revenue, growth, profits) and are purchased by the same acquirer, but the EBITDA multiple of one transaction is twice that of the other transaction – how could this happen?

Answer 48

1) One process was more competitive, and that competitive tension increased the purchase price
2) one company recently had bad news or a depressed stock price so it was acquired at a discount
3) two industries with different median multiples
4) two different accounting standards, different adding back into EBITDA. Multiples are not truly comparable.

Question 49

If you were buying a vending machine business, would you pay a higher EBITDA multiple for a business that owned the machines and depreciated normally, or ones where the machines are leased? The Depreciation expense and lease expense are the same dollar amounts and everything else is held constant.

Answer 49

Owning the machines means EBITDA would be higher than leasing, where the leasing expense would decrease pre-tax income. Therefore, the EBITDA multiple in owning would be smaller.

Question 50

How would you value a company that has no profit and no revenue?

Answer 50

1) use Comps or Precedent Transactions to look at more “creative” multiples like EV/Unique Visitors or EV/Pageviews rather than Revenue or EBITDA denominators (more common in tech)
2) use far-in-the-future DCF and project a company’s financials out until it actually earns revenue and profit (more common biotech & pharma companies)

Question 51

The S&P 500 index has a median P/E multiple of 20x. A manufacturing company you’re analyzing has earnings of $1m. How much is the company worth?

Answer 51

It depends on how it’s performing relative to the index, and relative to companies in its own industry.

If it has higher growth/margins, you could assign a higher multiple to it – say 25x or 30x, making EqV 25m or 30m

If it’s on par with everyone else, maybe 20m

It’s it’s underperforming, perhaps even lower than that.

Question 52

A company’s current stock price is $20/share, P/E = 20x, EPS = $1. It has 10m shares outstanding.

Now it does a 2-for-1 stock split – how does P/E multiple and valuation change?

Answer 52

Theoretically hey don’t.

Stock split doubles the number of shares and halves their price and EPS = same Equity Value and P/E.

In practice however, a stock split is seen as a good sign and might spike the share price, increasing Equity Value and P/E.

Question 53

Let’s say you’re comparing a company with a strong brand name, like Coca-Cola, to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins.

Which one will have the higher EV/EBITDA multiple?

Answer 53

In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name.

However, this valuation is not a science but an art – valuation is often based not just on strict financial criteria, but other factors such as brand name, perceived “trendiness”, etc.

Question 54

Why would relative and intrinsic valuation be different?

Answer 54

In theory, intrinsic valuation like DCF should equal relative valuation like a Comps analysis.

Possible reasons
1) Comps = maybe the given cash flows have different growth prospects, or relative riskiness
2) DCF = maybe too aggressive/conservative with forecasts than what the market values the peer group

Question 55

Tax rate drops from 20% to 15% would the EBITDA multiple increase or decrease?

Answer 55

My answer: it would increase the multiple.

TEV / EBITDA

EBITDA wouldn’t change = earnings before interest, taxes, depreciation, amortization.

Total Enterprise Value = might increase because this would increase NOPAT, increasing UFCF in a DCF.

Question 56

What are 6 reasons that 2 companies with same revenues and same industry would trade at different multiples

Answer 56

TBD

Question 57

Would capital structure cause a difference on all multiples (when comparing two different companies with same revenues and industry)?

Answer 57

TBD

Question 58

(Advanced)

Walk me through an M&A Premiums analysis.

Answer 58

The purpose of this analysis is to look through precedent transactions and calculate the premiums that buyers have paid over PUBLIC sellers’ share prices when acquiring them. For example, if a company is trading at $10/share and the buyer acquires it for $15/share, that’s a 50% premium.

You ONLY use this analysis when valuing a PUBLIC company, bc a private company doesn’t have a share price. Sometimes the set of companies here is exactly the same as Precedent Transactions, but typically it’s broader.

1) select precedent transactions based on industry, date, and size
2) for each transaction, get the seller’s share price at different intervals before the transaction was announced (1 day, 20, 30, 90)
3) calculate the premium for each of those intervals by dividing the per-share purchase price with the share price of that day
4) get the medians for each set and apply to your company’s share price at the same time intervals

Question 59

(Advanced) Both M&A Premiums and Precedent Transactions involve analyzing previous M&A transactions. What’s the difference in how we select them?

Answer 59

1) all the sellers in a M&A premiums analysis must be PUBLIC
2) Usually we use a broader set of transactions in M&A Premiums bc industry and financial screens are less stringent

Aside from those screening criteria is similar (financial metrics, geography, date)

Question 60

(Advanced) Walk me through a future share price analysis.

Answer 60

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

1) get the median historical (usually Trailing Twelve Months TTM) P/E multiple of the public company comparables
2) Apply this P/E multiple to your company’s 1-year forward or 2-year forward projected EPS to get to its implied future share price.
3) Then, discount this share price back to its present value by using a discount rate in-line with the company’s COE.

You normally look at a range of P/E multiples as well as a range of discount rates for this type of analysis, and create sensitivity tables with these as inputs. Technically you could use other multiples but P/E is most common.

Question 61

(Advanced) Walk me through a Sum-of-the-Parts Analysis

Answer 61

In a Sum-of-the-Parts analysis, you value each division of the company using separate Comparables and Precedent Transactions, get to separate multiples, then add each division’s value to get the total of the company.

Once again, picking a RANGE of multiples is crucial and you would never say a single value.

Question 62

(Advanced) How do you value NOL (Net Operating Losses) and take them into account in a valuation?

Answer 62

You determine how much the NOLs will save the company in taxes in the future years, then calculate the net present value of the total future tax savings.

Question 63

Looking at Precedent Transactions, why might Sponsor transactions carry higher multiples than strategic transactions - aren’t strategics willing to pay more?

Answer 63

TBD

Question 64

Say analyst miscalculated D&A - it’s 50% too low - how would that correction affect value?

Answer 64

This would artificially increase Net Income. EqVal/Net Income multiples would increase.

Question 65

What gives lowest and highest valuation?

Answer 65

Precedent Transactions – typically highest valuation because of purchase premium to transfer
ownership Good
 LBO – typically the floor, calculated backwards from target IRR, PE firm will pay less than
strategic buyer due to lack of synergies Good

Question 66

What’s the point of valuation? WHY do you value a company?

Answer 66

You value a company to determine its Implied Value according to your views.
If this Implied Value is very different from the company’s Current Value, you might be able to
invest in the company and make money if its value changes.
If you are advising a client company, you might value it to tell management the price that it
might receive if the company sells, which is often different from its Current Value.

Question 67

But public companies already have Market Caps and Share Prices. Why bother valuing
them?

Answer 67

Because a company’s Market Cap and Share Price reflect its Current Value according to “the
market as a whole” – but the market might be wrong!
You value companies to see if the market’s views are correct or incorrect.

Question 68

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

Answer 68

Public Comps are useful because they’re based on real market data, are quick to calculate and
explain, 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.

Question 69

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

Answer 69

This is a trick question because almost any methodology could produce the highest Implied
Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps because of
the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF compares because it’s far more dependent on your
assumptions.
The safest 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.”

Question 70

When is a DCF more useful than Public Comps or Precedent Transactions?

Answer 70

You should pretty much always build a DCF since it is valuation – the other methodologies are
supplemental. But it’s especially useful when the company you’re valuing is mature and has stable, predictable
cash flows or when you lack good Public Comps and Precedent Transactions.

Question 71

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

Answer 71

If the company you’re valuing is early-stage and you cannot estimate its future cash flows, or if
the company has no path to positive cash flows, you must rely on the other methodologies.
These other methodologies can also be more useful when you run into problems in the DCF,
such as the inability to estimate the Discount Rate.

Question 72

Which one should be worth more: a $500 million EBITDA healthcare company or a $500
million EBITDA industrials company? Assume the growth rates and margins are the same.

Answer 72

In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive 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).
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 need more information to give a
detailed answer.

Question 73

How do you value an apple tree?

Answer 73

The same way you value a company: comparable apple trees and a DCF. You’d look at what
similar apple trees have sold for and calculate the expected future cash flows from this tree.
You would then discount these cash flows to Present Value, discount the Terminal Value to PV,
and add everything to determine the apple tree’s Implied Value.
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.

Question 74

People say that the DCF is intrinsic valuation, while Public Comps and Precedent
Transactions are relative valuation. Is that correct?

Answer 74

No, not exactly. The DCF is based on the company’s expected future cash flows, so in that
sense, it is “intrinsic valuation.”
But the Discount Rate used in the DCF is usually linked to peer companies (market data), and if
you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer
companies.
The DCF depends less on the market than the other methodologies, but there is still some
dependency.
It’s more accurate to say that the DCF depends more on your views of the company’s long-term
prospects and less on market data than the other methodologies.

Question 75

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

Answer 75

First, you select the companies and transactions based on industry, size, and geography (and
time for the transactions).
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.
Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for
each valuation multiple in the set.
Finally, you apply these numbers to the financial metrics of the company you’re analyzing to
estimate its Implied Value.
For example, if the company you’re valuing has $100 million in LTM EBITDA, and the median
LTM TEV / EBITDA multiple in a set of comparable companies is 7x, then the company’s implied
Enterprise Value is $700 million.
You then calculate its Implied Value for all the other multiples to get a range of possible values.

Question 76

Why is it important to select Public Comps and Precedent Transactions that are similar?

Answer 76

Because the comparable companies and transactions should have similar Discount Rates and
Free Cash Flow figures (in theory…).
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 In practice, it’s almost impossible to find multiple companies with “similar” FCF figures, so this
exercise is more important for getting similar Discount Rates.

Question 77

How do you select Comparable Public Companies and Precedent Transactions?

Answer 77

You screen based on geography, industry, and size, and also time for Precedent Transactions.
Here are a few example screens:
* Comparable Company Screen: U.S.-based steel manufacturing companies with over
$500 million in revenue.
* Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA.
* Precedent Transaction Screen: Latin American M&A transactions over the past 3 years
involving consumer/retail sellers with over $1 billion USD in revenue.
* Precedent Transaction Screen: Australian M&A transactions over the past 2 years
involving infrastructure sellers with over $200 million AUD in revenue.

Question 78

Are there any screens you should AVOID when selecting Comparable Companies and
Precedent Transactions?

Answer 78

You should not screen by both financial metrics and Equity Value or Enterprise Value.
For example, you should NOT use this screen: “Companies with revenue below $1 billion and
Enterprise Values above $2 billion.”
If you use that screen, you artificially constrain the multiples because TEV / Revenue must be
above 2x for every company in the set.

Question 79

Public Comps and Precedent Transactions seem similar. What are the main differences?

Answer 79

The idea is similar – you use Current valuation multiples from similar companies or deals to
value a company – but the execution is different.
Here are the differences for Precedent Transactions:
Screening Criteria: In addition to industry, size, and geography, you also use time
because you only want transactions from a specific period, which could be the past few
years or even as long as 10-15 years ago. You might also use Transaction Size, and you
may use broader screening criteria in general.
* Metrics and Multiples: You focus on historical metrics and multiples, especially LTM
revenue and EBITDA, because it’s difficult to find projections as of the deal
announcement date.
* Calculations: All the multiples are based on the purchase price as of the announcement
date of the deal.
* Output: The multiples produced tend to be higher than those from Public Comps
because of the control premium. But the multiples also tend to span wider ranges
because deals can be done for many different reasons.

Question 80

Can you walk me through the process of finding the market and financial information for
the Public Comps?

Answer 80

You start by finding each company’s most recent annual and interim (quarterly or half-year)
filings. You calculate its diluted share count and Current Equity Value and Current Enterprise
Value based on the information there and its most recent Balance Sheet.
Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent
annual results, adding the results from the most recent partial period, and subtracting the
results from the same partial period the last year.
For the projected figures, you look in equity research or find consensus figures on Bloomberg,
Capital IQ, Finviz, Google/Yahoo, etc. And then, you calculate all the multiples by dividing
Current Equity Value or Current Enterprise Value by the appropriate metric

Question 81

Can you walk me through the process of finding the market and financial information for
the Precedent Transactions?

Answer 81

You find the acquired company’s filings from just before the deal was announced, and you
calculate the LTM financial metrics using those.

To calculate the company’s Transaction Equity Value and Enterprise Value, you use the
purchase price the acquirer paid, and you move from Equity Value to Enterprise Value in the
same way you usually do, using the company’s most recent Balance Sheet as of the
announcement date.
You calculate all the valuation multiples the same way, using Transaction Equity Value or
Transaction Enterprise Value as appropriate.

Question 82

How do you decide which metrics and multiples to use in these methodologies?

Answer 82

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitabilitybased metrics and their multiples. For example, you might use Revenue, EBITDA, and Net
Income, and the corresponding multiples: TEV / Revenue, TEV / EBITDA, and P / E.
You do this because you want to value a company in relation to how much it sells and how
much it keeps of those sales.
Sometimes, you’ll drop the sales-based multiples and focus on the profitability or cash flowbased ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Question 83

Why do you look at BOTH historical and projected metrics and multiples in these methodologies?

Answer 83

Historical metrics are useful because they’re based on what happened in real life, but they can
also be deceptive if there were non-recurring items or if the company made acquisitions or
divestitures.

Projected metrics are useful because they assume the company will operate in a “steady state,”
without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because
they’re based on future predictions.

Question 84

When you calculate the forward multiples for the comparable companies, should you use
each company’s Current Equity Value or Current Enterprise Value, or should you project them
to get the Year 1 or Year 2 values?

Answer 84

You always use the Current Equity Value or Current Enterprise Value. NEVER “project” either
one. A company’s share price, and, therefore, both of these metrics, reflects past performance and
future expectations.
So, to “project” these metrics, you’d have to jump into the future and see what future
expectations are at that point in the future and then jump back to the present.

Question 85

What should you do if some companies in your set of Public Comps have fiscal years that
end on June 30th and others have fiscal years that end on December 31st?

Answer 85

You have to “calendarize” by adjusting the companies’ fiscal years so that they match up.
For example, to make everything match a December 31st year-end date, you take each
company with a June 30th fiscal-year end and do the following:
* Start with the company’s full June 30th fiscal-year results.
* Add the June 30th – December 31st results from this year.
* Subtract the June 30th – December 31st results from the previous year.
Normally, you calendarize to match the fiscal year of the company you’re valuing.
But you might pick another date if, for example, all the comparable companies have December
31st fiscal years but your company’s ends on June 30th

Question 86

How do you interpret the Public Comps? What does it mean if the median multiples are
above or below the ones of the company you’re valuing?

Answer 86

The interpretation depends on how the growth rates and margins of your company compare to
those of the comparable companies.
Public Comps are most meaningful when the growth rates and margins are similar, but the
multiples are different. This could mean that the company you’re valuing is mispriced and that
there’s an opportunity to invest and make money.
For example, maybe all the companies are growing their revenues at 10-15% and their EBITDA
at 15-20%, and they all have EBITDA margins of 10-15%. Your company also has growth rates
and margins in these ranges.
However, your company trades at TEV / EBITDA multiples of 6x to 8x, while the comparable
companies all trade at multiples of 10x to 12x. This result could indicate that your company is undervalued since its multiples are lower, but its
growth rates, margins, industry, and size are comparable.
If the growth rates and margins are very different, it’s harder to draw conclusions.

Question 87

Is it valid to include both announced and closed deals in your set of Precedent
Transactions?

Answer 87

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed
yet, the simple announcement of the deal reflects what one company believes another is worth.
Note that you base all the metrics and multiples on the financial information as of the
announcement dates.

Question 88

Why do Precedent Transactions often result in more “random” data than Public Comps?

Answer 88

The problem is that the circumstances surrounding each deal might be very different.
For example, one company might have sold itself because it was distressed and about to enter
bankruptcy – but another company might have sold itself because the acquirer desperately
needed it and was willing to pay a high price.
Some deals are competitive and include multiple acquirers bidding against each other, while
others are targeted and involve no auction processes.

Question 89

How do you factor in earn-outs and expected synergies in Precedent Transactions?

Answer 89

You generally don’t factor in expected synergies because they’re quite speculative. If you do
include them, you might increase the sellers’ projected revenue or EBITDA figures so that the
valuation multiples end up being lower – assuming that you’re using projected metrics.
Opinions differ about earn-outs, but you could assume they have a 50% chance of being paid
out, multiply the earn-out amounts by 50%, and add them to the purchase prices.
Other people ignore earn-outs or add the full earn-out amounts to the Purchase Equity Value
and Purchase Enterprise Value

Question 90

Are there any rules about filtering out deals for less than 100% of companies or about
stock vs. cash deals in Precedent Transactions?

Answer 90

Ideally, your set of Precedent Transactions will include only 100% acquisition deals.
However, you may need to go beyond that and also include majority-stake deals (ones where
the acquirer buys more than 50% but less than 100% of the seller).
You can include those because the dynamics are similar, but you should not include minoritystake deals because acquiring 10% or 20% of a company is quite different.
Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically
include all deals regardless of the form of consideration. However, you may note whether each
deal was cash, stock, or a mix of both.

Question 91

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

Answer 91

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

Question 92

Why do you use median multiples rather than average multiples or other percentiles?

Answer 92

Median multiples are better than average multiples because of outliers.
If there are 5 companies in your set with multiples of 8x, 10x, 9x, 8x, and 25x, you don’t want
the 25x multiple to push up the average when it’s clearly an outlier.
However, there’s no “rule” that you have to use the median rather than other percentiles, so
you could make an argument for using the 25th percentile or 75th percentile.
For example, you could argue that your company’s growth rates and margins are in-line with
those of companies in the 75th percentile of your set and that the 75th percentile multiples are,
therefore, most applicable to your company.

Question 93

What is a Liquidation Valuation, and when is it useful and not so useful?

Answer 93

In a Liquidation Valuation, you value a company by determining the market values of all its
Assets, adding them up, and subtracting its Liabilities (i.e., full repayment of all Liabilities).
It gives you the company’s Implied Equity Value because you’re valuing the company’s Net
Assets, not its Net Operating Assets.
This methodology is useful for distressed companies because it tells you how much they might
be worth if they liquidate and shut down and how much different lender groups might receive.
It’s less useful for healthy, growing companies because it tends to undervalue them
significantly; assets like Net PP&E are always worth more to “going concern” companies.

Question 94

How does a Dividend Discount Model (DDM) differ from a DCF?

Answer 94

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually
based on a per-share figure or a percentage of Net Income. You then discount the Dividends to
their Present Value using the Cost of Equity and add them up.
To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E, and you
discount it to its Present Value using the Cost of Equity.
You add the PV of the Terminal Value to the PV of Dividends o calculate the company’s Implied
Equity Value at the end rather than its Implied Enterprise Value – there’s no “bridge” – and you
divide it by the diluted share count to get the company’s Implied Share Price.
The DDM is essential in some industries, such as commercial banks and insurance, useful for
other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so useful for most others because it takes more time and effort to set up and tends to undervalue
companies that do not distribute high percentages of their cash flows.

Question 95

Why might you use an M&A Premiums analysis to value a company?

Answer 95

The M&A Premiums analysis applies only to public companies because you look at acquisitions
of similar public companies and calculate the “premium” each buyer paid for each seller.
For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00
per share, that represents a 25% premium.
You then use these percentages to value your company. If the median premium in a set of deals
is 20%, and your company’s share price is $10.00, it’s worth $12.00 per share.
This analysis is typically a supplement to Precedent Transactions and gives you another way to
value your company besides just the standard multiples. But it’s also a bit limited because M&A
Premiums cannot indicate that a company is currently undervalued.

Question 96

How do you build a Future Share Price Analysis? When is it useful?

Answer 96

The idea is to project a company’s stock-price appreciation and its Dividends between today
and some future date, discount them to Present Value, and add them up (since these are the
two “returns sources” if you buy a company’s shares).
The Dividend projections are based on Net Income or per-share figures; to project a company’s
future stock price, you normally take the company’s current NTM multiple, the median from
the comps, or something similar, and apply it to a future figure, such as its EBITDA in Year 3.
You then back into the future Implied Equity Value based on this future Implied Enterprise
Value and divide by the share count on that date to get the “future share price,” which you
discount to PV using the Cost of Equity. You then compare this to the current share price.
This analysis adds little over traditional Public Comps, but it can be useful if a company wants to
assess the valuation impact of changing its capital structure or Dividend policy.

Question 97

What are the advantages and disadvantages of a Sum-of-the-Parts Valuation?

Answer 97

The Sum-of-the-Parts methodology, in which you value each division of a company separately
and add them up to determine the company’s Implied Value, works well for conglomerates that
have very different divisions (e.g., retail vs. transportation vs. digital media).
The divisions operate in such different industries that it would be meaningless to value the
company as a whole – no other public company would be comparable.
But Sum of the Parts also takes far more time and effort to set up because you have to find
comparable companies and transactions for each division, build a separate DCF for each
division, and so on.
Also, you may not have enough information to use it; companies sometimes don’t disclose EBIT,
CapEx, or Working Capital by division, and they may not disclose the corporate overhead
expenses that you must factor in at the end of the analysis.

Question 98

How do you set up an LBO valuation, and when is it useful?

Answer 98

You set up the LBO valuation by creating a leveraged buyout model in which a private equity
firm acquires a company using Debt and Equity, holds it for several years, and then sells it for a
certain multiple of EBITDA.
Most private equity firms target an internal rate of return (IRR) in a specific range, so you work
backward and determine the maximum price the PE firm could pay to achieve a targeted IRR.
You could use the “Goal Seek” function in Excel to do this, and you solve for the purchase price
based on constraints for the IRR, exit multiple, and Debt / Equity split.
This methodology is most useful as a way to screen LBO candidates and see which ones might
warrant further attention; it can also be useful for helping a company compare its options and
see what different types of acquirers (e.g., PE firms vs. normal companies) might pay.

Question 99

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

Answer 99

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.

PV = (CF) / (1 + r)^t

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 100

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

Answer 100

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 101

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

Answer 101

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 102

What are the two main approaches to valuation?

Answer 102

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.

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 103

Advantages/Disadvantages of DCF vs Comparable Companies analysis?

Answer 103

DCF
DCF Advantages
* The DCF values a company based on the company’s forecasted cash flows. This approach is viewed as the most direct and academically rigorous way to measure value.
* Considered to be independent of the market and instead based on the fundamentals of the company

DCF Disadvantages
* The DCF suffers from several drawbacks; most notably, it’s very sensitive to assumptions.
* Forecasting the financial performance of a company is challenging, especially if the forecast period is extended.
* Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around three- quarters of the implied valuation.

Comparable Companies
CC Advantages
* Trading comps value a company by looking at how the market values similar businesses. Thus, comps relies much more heavily on market pricing to determine the value of a company (i.e., the most recent, actual prices paid in the public markets). = Good, real data. Bad, dependent on market
* In reality, there are very few truly comparable companies, so in effect, it’s always an “apples and oranges” comparison.

CC Disadvantages
* While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced, it’s vulnerable to how the market is not always right. Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company’s fundamentals.
* Comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF).

Question 104

What does free cash flow (FCF) represent?

Answer 104

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.

Extra info:
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 105

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

Answer 105

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 106

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

Answer 106

EQUITY
Equity 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.
* gives companies access to a vast investor base and network.

Equity 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.

DEBT
Debt 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 ofcapital.
* Increased leverage forces discipline on management, resulting in risk-averse decision-making as a side benefit.

Debt 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 107

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

Answer 107

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.

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 108

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

Answer 108

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.

Question 109

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

Answer 109

1) 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.

2) 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.

3) Share buybacks imply a company’s management believes their shares are currently undervalued, making the repurchase a potential positive signal to the market.

4) 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 110

FLAGGED

A company with $100 million in net income and a P/E multiple of 15x is considering raising $200 million in debt to pay out a one-time cash dividend. How would you decide if this is a good idea?

Answer 110

If we assume that the P/E multiple stays the same after the dividend and a cost of debt of 5%, the impact to shareholders is as follows:

Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million]

Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million)

Although there’s a tax impact since interest is mostly deductible, it can be ignored for interviewing purposes.

That’s a $150 million drop in equity value.

However, shareholders are immediately getting $200 million. So ignoring any tax impact, there’s a net benefit of $50 million ($200 million - $150 million) to shareholders.

The assumptions we made about taxes, the cost of debt and the multiple staying the same all affect the result. If any of those variables were different - for example, if the cost of debt was higher - the equity value might be wiped out in light of this move.

A key assumption in getting the answer here was that P/E ratios would remain the same at 15x. A company’s P/E multiple is a function of its growth prospects, ROE, and cost of equity. Hence, borrowing more with no compensatory increase in investment or growth raises the cost of equity via a higher beta, which will pressure the P/E multiple down. While it appears based on our assumptions that this is a decent idea, it could easily be a bad idea given a different set of assumptions. It’s possible that borrowing for the sake of issuing dividends is unsustainable indefinitely because eventually, debt levels will rise to a point where the cost of capital and P/E ratios are adversely affected. Broadly, debt should support investments and activities that will lead to firm and shareholder value creation rather than extract cash from the business.

Question 111

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

Answer 111

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 112

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

Answer 112

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 113

What is an illiquidity discount?

Answer 113

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”).