Valuation Flashcards
What is equity value and how is it calculated?
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Could you explain the concept of present value and how it relates to company valuations?
45
How do you calculate the fully diluted number of shares outstanding?
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What is enterprise value and how do you calculate it?
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How do you calculate equity value from enterprise value?
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Which line items are included in the calculation of net debt?
46
When calculating enterprise value, why do we add net debt?
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What is the difference between enterprise value and equity value?
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Could a company have a negative net debt balance and have an enterprise value lower than its
equity value?
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Can the enterprise value of a company turn negative?
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If a company raises $250 million in additional debt, how would its enterprise value change?
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Why do we add minority interest to equity value in the calculation of enterprise value?
47
How are convertible bonds and preferred equity with a convertible feature accounted for when
calculating enterprise value?
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What are the two main approaches to valuation?
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What are the most common valuation methods used in finance?
47
Among the DCF, comparable companies analysis, and transaction comps, which approach yields
the highest valuation?
48
Which of the valuation methodologies is the most variable in terms of output?
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Contrast the discounted cash flow (DCF) approach to the trading comps approach.
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How can you determine which valuation method to use?
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Would you agree with the statement that relative valuation relies less on the discretionary
assumptions of individuals?
49
What does free cash flow (FCF) represent?
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Why are periodic acquisitions excluded from the calculation of FCF?
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Explain the importance of excluding non-operating income/(expenses) for valuations.
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Define free cash flow yield and compare it to dividend yield and P/E ratios.
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Could you define what the capital structure of a company represents?
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Why would a company issue equity vs. debt (and vice versa)?
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What are share buybacks and under which circumstances would they be most appropriate?
51
Why would a company repurchase shares? What would the impact on the share price and financial
statements be?
51
Why might a company prefer to repurchase shares over the issuance of a dividend?
51
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?
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When would it be most appropriate for a company to distribute dividends?
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).
What is CAGR and how do you calculate it?
The compound annual growth rate (“CAGR”) is the rate of return required for an investment to grow from its
beginning balance to its ending balance. Put another way, CAGR is the annualized average growth rate.
What is the difference between CAGR and IRR?
The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the
return on an investment. However, the calculation of CAGR involves only three inputs: the investment’s
beginning and ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can handle
more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the multiple
cash flows) accounted for, rather than just smoothing out the investment returns.
CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for
investment decision-making.
How would you evaluate the buy vs. rent decision in NYC?
First, I would have to make assumptions to allow for a proper comparison, such as having enough upfront
capital to make a down payment and the investment period being ten years.
Under the 1st option, I assume I buy and will have to pay the monthly mortgage, real estate tax, and
maintenance fees (which will be offset by some tax deductions on interest and depreciation) during this
investment period. Then, I’ll assume that I could sell the property at a price that reflects the historical
growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow
due to a sale, I can calculate my IRR and compare this IRR to the IRR from renting.
For the 2nd option, I would start by estimating the rental cost of comparable properties, factoring in rent
escalations over ten years. Since there’s no initial down-payment required, I would put that money to work
elsewhere, such as an investment in the stock market, in which I would assume an annual return over the
ten years consistent with the long-term historical return on the stock market (5-7%). I could then compute
an IRR based on the inflows/(outflows) and compare the two IRRs to make an informed decision.
I would keep in mind that this comparison is not precisely “apples to apples.” For example, investing in an
NYC property is riskier than investing in the stock market due to the leverage and lower liquidity. NYC real
estate is liquid, but not as liquid as public stocks. If the two IRRs were identical, I would probably go with
renting as it does not appear that I am being compensated for the added risk.
How would you value a painting?
A painting has no intrinsic value, generates no cash flows, and cannot be valued in the traditional sense. The
pricing of the painting is a function of what someone will pay for it in the market, rather than being anchored
by its fundamentals. To determine the approximate price, you would have to analyze comparable transactions
to see the amount others paid to purchase similar paintings in the past.
When would it be appropriate to use a sum-of-the-parts approach to valuing a company?
In a sum-of-the-parts (“SOTP”) analysis, each division of a company will have its unique risk/return profile and
need to be broken up to value the entire company more accurately as a whole. Thus, a different discount rate
will value each segment, and there’ll be distinct peer groups for the trading and transaction comps. Upon
completing each division’s valuation, the ending values would be summed up to arrive at the total value.
An example of when SOTP analysis (or break-up analysis) would be used is when the company being valued
has many operating divisions in unrelated industries, each with differing risk-profiles (e.g., conglomerate).
How does valuing a private company differ from valuing a public company?
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%).
What is an illiquidity discount?
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”).
Walk me through a DCF.
- Forecast Unlevered Free Cash Flows (“FCFF” or “UFCF”): First, unlevered free
cash flows, which represent cash flows to the firm before the impact of leverage,
should be forecast explicitly for a 5 to 10 year period. - Calculate Terminal Value (“TV”): Next, the value of all unlevered FCFs beyond
the initial forecast period needs to be calculated – this is called the terminal value.
The two most common approaches for estimating this value are the growth in perpetuity approach and
the exit multiple approach. - Discount Stage 1 & 2 CFs to Present Value (“PV”): Since we are valuing the company at the current
date, both the initial forecast period and terminal value need to be discounted to the present using the
weighted average cost of capital (“WACC”). - Move from Enterprise Value Equity Value: To get to equity value from enterprise value, we would
need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the
value of non-operating assets such as cash or investments and subtract debt. Then, we would account for
any other non-equity claims such as minority interest. - Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value
by diluted shares outstanding as of the valuation date. For public companies, the equity value per share
that our DCF just calculated can be compared to the current share price. - Sensitivity Analysis: Given the DCF’s sensitivity to the assumptions used, the last step is to create
sensitivity tables to see how the assumptions used will impact the implied price per share.
Conceptually, what does the discount rate represent?
The discount rate represents the expected return on an investment based on its risk profile (meaning, the
discount rate is a function of the riskiness of the cash flows). Put another way, the discount rate is the minimum
return threshold of an investment based on comparable investments with similar risks. A higher discount rate
makes a company’s cash flows less valuable, as it implies the investment carries a greater amount of risk, and
therefore should be expected to yield a higher return (and vice versa).
What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?
Unlevered FCF: FCFF represents cash flows a company generates from its core
operations after accounting for all operating expenses and investments. To
calculate FCFF, you start with EBIT, which is an unlevered measure of profit
because it excludes interest and any other payments to lenders. You’ll then tax
effect EBIT, add back non-cash items, make working capital adjustments, and
subtract capital expenditures to arrive at FCFF. Tax-affected EBIT is often referred
to as Net Operating Profit After Taxes (“NOPAT”) or Earnings Before Interest After
Taxes (“EBIAT”). (see 54 for formula)
Levered FCF: FCFE represents cash flows that remain after payments to lenders since interest expense
and debt paydown are deducted. These are the residual cash flows that belong to equity owners. Instead of
tax-affected EBIT, you start with net income, add back non-cash items, adjust for changes in working
capital, subtract capex, and add cash inflows/(outflows) from new borrowings, net of debt paydowns. (see 55 for formula)
What is the difference between the unlevered DCF and the levered DCF?
Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive
directly at enterprise value. When you have a present value, add any non-operating
assets such as cash and subtract any financing-related liabilities such as debt to get
to the equity value. The appropriate discount rate for the unlevered DCF is the
weighted average cost of capital (WACC) because the rate should reflect the
riskiness to both debt and equity capital providers since UFCFs are cash flows that
belong to debt and equity providers.
Levered DCF: The levered DCF approach, on the other hand, arrives at equity
value directly. First, the levered FCFs are forecasted and discounted, which gets you to equity value directly.
The appropriate discount rate on LFCFs is the cost of equity since these cash flows belong solely to equity
owners and should thus reflect the risk of equity capital. If you wanted to get to enterprise value, you
would add back net debt.
The levered and unlevered DCF method should theoretically lead to the same enterprise value and equity value,
but in practice, it’s very difficult to get them to be precisely equal.
What is the appropriate cost of capital when doing an unlevered DCF?
When doing an unlevered DCF, the weighted average cost of capital (WACC) is the correct cost of capital to use
because it reflects the cost of capital to all providers of capital.
However, the cost of equity would be the right cost of capital to use for levered DCFs.
What is the formula to calculate the weighted average cost of capital (WACC)?
see 55
If a company carries no debt, what is its WACC?
If a company has no debt on its capital structure, its WACC will be equivalent to its cost of equity. Most mature
companies will take on a moderate amount of leverage once their operating performance stabilizes because
they can raise cheaper financing from lenders.
How is the cost of equity calculated?
The cost of equity is most commonly estimated using the capital asset pricing model (“CAPM”), which links the
expected return on a security to its sensitivity to the overall market (most often S&P 500 is used as the proxy). (see 55)