Valuation Flashcards
What is the appropriate numerator for a revenue multiple?
Enterprise Value
When should you value a company using a revenue multiple vs. EBITDA?
When a company has a negative profit
Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk. Company A is trading at a 15 P/E multiple, while Company B trades at 10 P/E. Which would you prefer as an investment?
Company B because it would cheaper to acquire
What its working capital
Current Liabilities - Current Assets
How is it possible for a company to show positive net income but go bankrupt?
This happens by deteriorating working capital and financial tactics
How is the income statement linked to the balance sheet?
The income statement links to the balance sheet through retained earnings, which reflects the company’s cumulative profits. Each period, net income from the income statement flows into retained earnings on the balance sheet, minus any dividends paid out. Also, interest expense on the income statement depends on debt from the balance sheet, and depreciation reduces the balance of fixed assets on the balance sheet, showing how costs and asset values connect across statements.
If the cost of equity is higher than the cost of debt, why not finance using entirely debt?
Using only debt can get risky because high debt means higher interest payments and default risk, which raises borrowing costs and makes investors demand higher returns, increasing overall financing costs.
Is it possible for a company to show positive cash flows but be in grave trouble?
Yes. One possible reason for a company to have positive cash flows but still be in trouble is that the cash may be coming from non-operational activities. For example, the company may have sold off assets or taken out loans to generate cash.Another reason for a company to have positive cash flows but still be in trouble is that the cash may be tied up in inventory or accounts receivable. While these assets may look good on paper, they do not necessarily translate into cash in the bank.
How would a $10 increase in depreciation impact the three statements?
- Income Statement: A $10 depreciation expense is recognized on the income statement, which reduces operating income (EBIT) by $10. Assuming a 20% tax rate, net income would decrease by $8 [$10 – (1 – 20%)].
- Cash Flow Statement: The $8 decrease in net income flows into the top of the cash flow statement, where the $10 depreciation expense is then added back to the cash flow from operations since it is a non-cash expense. Thus, the ending cash balance increases by $2.
- Balance Sheet: The $2 increase in cash flows to the top of the balance sheet, but PP&E is decreased by $10 due to depreciation, so the assets side declines by $8. The $8 decrease in assets is matched by the $8 decrease in retained earnings due to net income decreasing by that amount, thereby the two sides remain in balance.
I buy a piece of equipment, walk me through the impact on the 3 financial statements.
A: Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement)
Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement).
Why are increases in accounts receivable a cash reduction on the cash flow statement?
Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds.
How to book the accounts of subsidiaries and associates?
For subsidiaries (over 50% ownership), use consolidation—combine all accounts with the parent. For associates (20-50% ownership), use the equity method—record the investment as an asset and adjust for the parent’s share of profits or losses.
Is a business with depreciation = capex viable?
Yes, a business with depreciation equal to capital expenditures (CapEx) can be viable. This balance means the company is reinvesting enough to maintain its current asset base without expanding. While this suggests stability, long-term growth may be limited unless additional investments are made beyond just replacing assets.
How to go from EBITDA to Unlevered Free Cash Flow
Unlevered Free Cash Flow = (EBITDA – A&D)*(1-tax) + Depreciation and Amortization – Increase in Net Working Capital (NWC) – Capital Expenditures
