Valuation Flashcards
What is Free Cash Flow?
A company generates cash flows from its operations by selling goods or services. Some of its cash goes back into the business to renew fixed assets and for working capital requirement. Free cash flow to firm is the excess cash generated over and above these expenses. Free cash flow to firm goes to the debt holders and the equity holders. Is used in the DCF model
Formula:
Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure
Walk me through a Discounted Cash Flow?
Discounted cash flow (DCF) is one of the most respected techniques in the financial world to
value companies. DCF values a company based on the Present value (PV) of the future free
cash flows that a company will generate until eternity.
If the financial model has five years of forecast, the total value of the business is derived by
adding the company’s present value of free cash flows to equity over the next five years and
the PV of its terminal value (TV).
What is the Difference between Enterprise value and equity value?
This is one of the most basic interview question on valuation. Straightforward answer –
Enterprise Value = Market value of operating assets
Equity Value = Market value of shareholders’ equity
EV = Equity Value + Debt + (Preferred Stock + Minority Interest - Cash)
Equity Value is the market value and Shareholders’ Equity is the book value. Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be any value. For healthy companies,
Equity Value usually far exceeds Shareholders’ Equity.
Why do we look at both Enterprise Value and Equity Value?
Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.
What are the 3 major valuation methodologies?
- Comparable Companies (Multiples)
- Precedent Transactions
- Discounted Cash Flow Analysis.
What is a WACC?
WACC is the weighted average cost of capital of a company.
WACC captures the cost of capital for the entire company given its capital structure and the
underlying risk attached to the underlying cash flows.
WACC is the minimum rate of return a company should earn given its capital structure.
WACC = [Cost of debt * (% of debt * (1- Tax rate)] + [cost of equity * % of equity)]
% of debt = Total Debt/ (Debt + Equity)
% of Equity = Book value equity/ (Debt + Equity)
What is cost of debt?
Cost of debt is the after-tax interest expense that the company pays on its debt. It can also be calculated by using the current market yield of the company’s long-term bonds.
What are the most common multiples used in valuation?
- EV to EBIT
- Price to Cash Flow
- Enterprise Value to Sales
- EV to EBITDA!!!
- PEG Ratio
- Price to Book Value
- PE Ratio
what is the difference between levered and unlevered free cash flow?
The difference between levered and unlevered free cash flow is expenses. Levered cash flow is the amount of cash a business has after it has met its financial obligations. Unlevered free cash flow is the money the business has before paying its financial obligations. Operating expenses and interest payments are examples of financial obligations that are paid from levered free cash flow.
What other Valuation methodologies are there?
- 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
- Replacement Value – Valuing a company based on the cost of replacing its assets
- 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
What is terminal value (TV) in a DCF?
You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity. The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).
What is ROE?
Return on Equity is calculated by dividing the net income of the company by the average book value of its equity. Return on equity allows analyst to read into the efficiency of management.
Why do analysts use EBITDA versus net income to value a company?
EBITDA = Sales – COGS – SG&A – R&D
EBITDA is a popular measure of profitability amongst investors and analysts.
It is widely used to value companies for public comparables.
Allows for comparability of profitabilits across sectors.
Since EBITDA is income before Interest Tax, Depreciation and Amortisation - it ignores
financing, taxation and capital decisions of the company and projects the true operating profitability of the company.
Companies with different capital structures i.e. capital light such as software and IT versus capital heavy such as autos are not differentiated when comparing EBITDA.
Also ignores the tax structure of the company. If a company has tax advantages such as REIT versus normal companies which are paying taxes, will be considered equal when comparing EBITDA across the companies in these sectors.
Another important ratio includes EBITDA margins or EBITDA/Sales.
EBITDA can also be used in debt related ratios such as Debt/EBITDA and EBITDA/Interest (interest coverage ratio) to convey riskiness of a company’s leverage.
What Is Earnings Before Interest, Taxes, Depreciation, and Amortization – EBITDA?
EBITDA=Net Income+Interest+Taxes+Depreciation+Amortization
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to simple earnings or net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.
The earnings, tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then add back depreciation and amortization.
At times EBITDA is used as a quick and dirty proxy of the firm’s free cash flow.
What Is Earnings Before Interest, Taxes – EBIT?
Earnings before interest and taxes (EBIT) is a company’s net income before income tax expense and interest expense have been deducted. EBIT is used to analyze the performance of a company’s core operations without tax expenses and the costs of the capital structure influencing profit.
The following formula is used to calculate EBIT:
EBIT=Net Income + Interest Expense + Tax Expense
EBIT is often referred to as operating income since they both exclude taxes and interest expenses in their calculations. However, there are times when operating income can differ from EBIT.
