Valuation (Other)

Question 1

1. What IS a valuation multiple?

Answer 1

A valuation multiple is shorthand for a company’s value based on its cash flows, cash flow
growth rate, and Discount Rate. Normally, you value a company with this formula:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate)
Instead of providing all that information, you can use a number like “10x” and express it in a
condensed way.
You can also think of valuation multiples as “per-square-foot” or “per-square-meter” values
when buying a house: They help you compare houses, or companies, of different sizes and see
how expensive or cheap similar houses, or companies, are.

Question 2

4. Suppose that you graph the EV / EBITDA multiples for a set of similar companies along with
   the revenue growth rates, EBITDA margins, and EBITDA growth rates.
   Which operational metric will MOST LIKELY have the strongest correlation with the EV /
   EBITDA multiples?

Answer 2

Since a company’s value depends on its cash flow, cash flow growth rate, and Discount Rate,
the EV/EBITDA multiples are most likely to be correlated with the EBITDA growth rates.
While EBITDA, Cash Flow, and Free Cash Flow are very different metrics, EBITDA growth is still
closer to cash flow growth than revenue growth is.
EBITDA margins don’t make much of an impact unless they are changing – only changing
margins will produce different growth rates.
There might be some correlation between revenue growth rates and EV/EBITDA multiples, but
the correlation will be stronger for revenue growth and EV / Revenue multiples.

Question 3

5. Despite this principle, why do valuation multiples and growth rates often NOT display as
   much correlation as you might expect?

Answer 3

First, EBITDA growth and FCF growth are very different since FCF includes taxes, the Change in
Working Capital, and the full CapEx amount, whereas EBITDA excludes these.
Company valuation is ultimately based on cash flow growth, so growth rates in revenue,
EBITDA, EBIT, and Net Income are, at best, rough approximations of cash flow growth.
Also, not every comparable company necessarily has the same Discount Rate; perhaps the
company you’re analyzing is a lot riskier, or a lot less risky than the others.

Finally, non-financial factors could easily affect multiples. For example, if the company reported
recent legal troubles, announced the development of a new product, or recruited a key
executive, all those changes could affect its stock price and therefore its multiples.

Question 4

8. Could a valuation multiple such as P / E or EV / EBITDA ever be negative? What would it
   mean?

Answer 4

Yes, it’s possible for any valuation multiple to be negative (except for ones based on Revenue,
which could be $0 but couldn’t be negative).
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If a company has a negative Net Income or negative EBITDA, the multiples will turn negative.
It means that this particular multiple is not meaningful for valuing the company, so you’ll have
to use other multiples or methodologies to value it.

Question 5

8. Could a valuation multiple such as P / E or EV / EBITDA ever be negative? What would it
   mean?

Answer 5

Yes, it’s possible for any valuation multiple to be negative (except for ones based on Revenue,
which could be $0 but couldn’t be negative).
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If a company has a negative Net Income or negative EBITDA, the multiples will turn negative.
It means that this particular multiple is not meaningful for valuing the company, so you’ll have
to use other multiples or methodologies to value it.

Question 6

9. If a company has both Debt and Preferred Stock, why is it NOT valid to use Net Income
   rather than Net Income to Common when calculating its P / E multiple?

Answer 6

You can use Equity Value or Enterprise Value in multiples, but you shouldn’t create “halfpregnant” multiples that are based on metrics in between Equity Value and Enterprise Value.
Also remember that if you do not include an expense in the denominator of a multiple, you
have to include the Balance Sheet item corresponding to that expense in the numerator (and
vice versa).
So if you use Net Income rather than Net Income to Common in this case, you’ll have to use a
modified version of Equity Value that adds Preferred Stock, but none of the other items that
you typically add when calculating Enterprise Value.
This numerator will confuse anyone looking at your analysis, so you should stick with the
standard Equity Value calculation and pair it with Net Income to Common.

Question 7

10. If a company’s cash flow matters most, why do you use metrics like EBIT and EBITDA in
    valuation multiples rather than CFO or FCF?

Answer 7

Mostly for convenience and comparability. CFO and FCF measure a company’s cash flows more
accurately, but they also take more time to calculate since you need a full or partial Cash Flow
Statement for them.
Also, the individual items within CFO and FCF vary a lot between companies, and vastly
different figures for Deferred Taxes, Stock-Based Compensation, and the Change in Working
Capital make it difficult to create meaningful comparisons.

Question 8

11. What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E?

Answer 8

But the interviewer will probably be annoying and press you on this point, so you can say that
with EV / EBITDA vs. EV / EBIT, EV / EBITDA is better in cases when you want to completely
exclude the company’s CapEx, Depreciation, and capital structure.
EV / EBIT is better when you want to exclude capital structure, but partially factor in CapEx and
Depreciation. It is common in industries, such as manufacturing, where those items are key
value drivers for companies.
The P / E multiple is not terribly useful in most cases because it’s affected by different tax rates,
capital structures, non-core business activities, and more – so you use it primarily to be
“complete” and ensure that you’ve covered all the common multiples.
Also, sometimes it is more relevant and important in certain industries, such as commercial
banks and insurance firms, where you do want to factor in the interest income and expense.

Question 9

12. What are the advantages and disadvantages of FCF vs. Unlevered FCF vs. Levered FCF?

Answer 9

The main advantage of Unlevered FCF is that it’s capital structure-neutral, so a company’s cash
flow will be the same regardless of its Cash, Debt, and Preferred Stock. It’s also easier and faster
to calculate than the others.
You’d use FCF or Levered FCF if you want to take into account the company’s capital structure,
and you’d use Levered FCF to be slightly more accurate since it includes (Mandatory?) Debt
Principal Repayments.
You almost always use Unlevered FCF in a DCF analysis to value a company; FCF is more
common for standalone financial statement analysis; and Levered FCF is rare, partially because
no one agrees on how to calculate it.
You can create a DCF analysis based on Levered FCF as well, but we strongly recommend
against doing this because it’s less reliable and harder to set up.

Question 10

14. Could Levered FCF ever be higher than Unlevered FCF?

Answer 10

Yes. Levered FCF includes Net Interest Expense, so if the company had a negative value for that
figure, i.e. it earned more in Interest Income than it spent on Interest Expense, and it also had
minimal Debt principal repayments, then Levered FCF might be higher than Unlevered FCF.
This scenario is highly unusual, but it is possible.

Question 11

15. If EBITDA decreases, how do Unlevered and Levered FCF change?

Answer 11

Think of what EBITDA includes: Only Revenue, COGS, and Operating Expenses. Unlevered FCF
and Levered FCF also include all those items, plus more.
So if EBITDA decreases, it means that Revenue has decreased, or that COGS or Operating
Expenses have increased.
If any of those happens, then both Levered FCF and Unlevered FCF should also decrease since
the Operating Income that flows into both of them will also be lower.
Technically, the FCF figures might stay the same if the D&A, Working Capital, or CapEx change in
such a way that the change offsets the drop in Operating Income.
But that’s not the main point of the question; it’s just an edge case.

Question 12

19. Two companies have the same P / E multiples but different EV / EBITDA multiples. How
    can you tell which one has more Debt?

Answer 12

You might be tempted to say, “The one with the higher EV / EBITDA multiple,” but that’s
wrong. You can’t answer this question because the companies could be very different sizes.
For example, if they both have P / E multiples of 15x, but one company has Net Income of $10
and one has Net Income of $100, the one with Net Income of $100 is likely to have more Debt –
even if its EV / EBITDA multiple is lower.
If you assume that both companies have the same Net Income and the same EBITDA, then you
can “kind of” answer this question.
In that case, the companies have the same Equity Value, so the company with the higher EV /
EBITDA multiple must have a higher Enterprise Value.
Most likely, that means that it has more Debt.
HOWEVER, remember that other items factor into the calculation. Perhaps both companies
have the same amount of Debt, but the one with the higher EV / EBITDA multiple has less Cash.
Or the company with the higher multiple has a higher Unfunded Pension or Preferred Stock
balance.
But as originally stated, this question is too vague to answer unless you get more information.

Question 13

22. Two companies have the same amount of Debt, but one company has Convertible Debt,
    and the other has traditional Debt.
    Both companies have the same Operating Income, Tax Rate, and Equity Value. Which
    company will have a higher P / E multiple?

Answer 13

Since the interest rates on Convertible Debt are lower than the rates on traditional Debt, the
company with Convertible Debt will have a lower interest expense and therefore a higher Net
Income.
As a result, its P / E multiple will be lower. So the company with Convertible Debt will have a
lower P / E multiple, and the company with traditional Debt will have a higher P / E multiple.
Advanced Note: Technically, you may have to reflect on the Income Statement the
“Amortization of the Convertible Bond Discount,” which is a number that reflects how the
Liability component of a Convertible Bond is worth less than a normal Bond because of the
lower interest rate. If you do this, then the Net Incomes of both companies will be much closer,
and the P / E multiples may be almost the same.

Question 14

23. A company is currently trading at 10x EV / EBITDA. It wants to sell an Asset for 2x the
    Asset’s EBITDA. Will that sale increase or decrease the company’s Enterprise Value?

Answer 14

It depends on what type of Asset it is. Assuming that it is a core-business Asset, then the sale
will reduce the company’s Enterprise Value because the company is trading away the Asset for
Cash, which is a non-core-business Asset.
If it’s not a core-business Asset, then the company’s Enterprise Value won’t change.
Even though the company’s Enterprise Value decreases in the first case, its EV / EBITDA
multiple increases because the Asset’s multiple was lower than the multiple for the entire
company.
Pretend that the company’s total EBITDA was $100, and this Asset contributed $20 of that
EBITDA. The company’s Enterprise Value before the sale was, therefore, $1,000.
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The company now sells the Asset for $40. After the sale, the company’s Enterprise Value falls by
$40, and its EBITDA falls by $20. So its new EV / EBITDA is $960 / $80, or 12x.
This is why companies often sell under-performing divisions: To boost their valuation multiples
and increase their stock prices.

Question 15

1. Is it accurate to subtract 100% of the Cash balance when moving from Equity Value to
   Enterprise Value?

Answer 15

No, but everyone does it anyway. The reasoning is that a portion of any company’s Cash
balance is a “core-business Asset” because the company needs a certain minimum amount of
Cash to continue running its business.
So technically, you should subtract only the Excess Cash, i.e. the portion of the Cash balance
above this number. For example, if the company has $1,000 in Cash but needs only $200 to run
its business, you should subtract $800 rather than $1,000 when calculating Enterprise Value.
However, companies rarely disclose this number, and it is almost impossible to determine on
your own, so in practice, everyone just subtracts the entire Cash balance.

Question 16

2. Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value?
   The company doesn’t need it to continue operating its business.

Answer 16

Goodwill is a core-business Asset, so you should NOT subtract it when moving to Enterprise
Value.
Remember that Goodwill reflects the premiums paid for companies that the company
previously acquired – if you subtracted it, you’d be saying, “Those previous acquisitions are not
a part of this company’s core business anymore.”
And that’s true only if the company has shut down or sold those companies, in which case it
removes all Assets and Liabilities associated with them.

Question 17

3. Why might you subtract only part of a company’s Deferred Tax Assets (DTAs) when
   calculating Enterprise Value?

Answer 17

Deferred Tax Assets can contain many different items, some of which are related to simple
timing differences or tax credits for operational items.
But you should subtract ONLY the Net Operating Losses (NOLs) that are in the DTA because
those are non-operational in nature.
There is some controversy on exactly which figure to subtract since NOLs are off-Balance Sheet
Assets with a small presence (roughly, NOLs * Tax Rate) within the DTA.
So some people argue that you should use the off-BS figure, some argue that it should be the
on-BS figure, and some argue for other approaches, such as calculating the PV of tax savings
from the NOL and subtracting that.
Don’t mention all of this in interviews – just acknowledge that you subtract NOLs when moving
from Equity Value to Enterprise Value.

Question 18

4. Why might someone argue that you should NOT add capital leases when moving from
   Equity Value to Enterprise Value?

Answer 18

Some people argue that capital leases are operational items since owning vs. renting buildings
(or planes, stores, etc.) is an operational decision, not a financial one.
If capital leases are “operational liabilities” and they do not represent another investor group,
you should not add them in this calculation.
We disagree with this view because, in our opinion, all leases are financial in nature – they’re
similar to Debt since they require fixed payments for many years under non-cancelable
contracts.
So we treat capital leases as a Debt-like item, and we recommend capitalizing operating leases,
especially in industries where some companies rent and others own property.

Question 19

5. How do you factor in Working Capital when moving from Equity Value to Enterprise Value?

Answer 19

You don’t. Remember that Equity Value represents the value of ALL the company’s Assets but
only to equity investors.
So you subtract items only if they’re non-core-business Assets, and you add Liability and Equity
line items only if they represent different investor groups.

The Assets that comprise Working Capital all count as core-business Assets (e.g., Inventory,
Accounts Receivable, Prepaid Expenses, etc.), and the Liabilities in Working Capital are all
operational items that do not represent other investor groups (e.g., Accrued Expenses,
Deferred Revenue, etc.).
So there’s no reason to add or subtract Working Capital, as both Equity Value and Enterprise
Value reflect it implicitly.

Question 20

12. A company has 10,000 shares outstanding and a current share price of $20.00. It has 100
    options outstanding at an exercise price of $10.00.
    It also has 50 Restricted Stock Units (RSUs) outstanding.
    Finally, it also has 100 convertible bonds outstanding at a conversion price of $10.00 and par
    value of $100.
    What is its Diluted Equity Value?

Answer 20

Since the options are in-the-money, you assume that they get exercised, so 100 new shares are
created.
The company receives 100 * $10.00, or $1,000, in proceeds. Its share price is $20.00, so it can
repurchase 50 shares with these proceeds. There are now 50 additional shares outstanding
(100 new shares – 50 repurchased).
You add the 50 RSUs as if they were common shares, so now there’s a total of 100 additional
shares outstanding.
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The company’s share price of $20.00 exceeds the conversion price of $10.00, so the convertible
bonds can convert into shares.
Divide the par value by the conversion price to determine the shares per bond:
$100 / $10.00 = 10 new shares per bond
There are 100 convertible bonds outstanding, so you get 1,000 new shares (100 convertible
bonds * 10 new shares per bond).
All of these changes create 1,100 additional shares outstanding, so the diluted share count is
now 11,100, and the Diluted Equity Value is 11,100 * $20.00, or $222,000.