Valuations Flashcards
What is the order of the reorganized balance sheet
Operating capital:
Operating fixed assets
NWC
Operating liabilities
Non operating assets
Non operating liabilities
INVESTED CAPITAL
Adjusted group Equity
Financial liabilities
What are the steps in DCF?
Enterprise value formula?
MV of equity + Net debt + Debt equivalents ((i.e., pension deficits & assoc. DTLs)
What is part of Operating fixed assets
PPE
Intangible assets
Operating leases right of use assets
(e.g., patents, trademarks,
goodwill)
Operating NWC
- Op. cash, trade receivables, inventory, prepaid expenses
(Accounts payable, accrued expenses)
Operating liabilities examples
- Long term financing from customers
- Income taxes payable (accrued)
- Deferred tax liabilities (net of deferred tax assets) assoc. with operating assets/NWC
- Operating provisions (e.g., warranties, product
-returns; bad debt)
Three types of expenses
- Operating expenses (current period)
- Capital expenses (Multiple periods)
- Financial expenses (nonequity capital raised by the firm)
What falls under the invested capital?
+ Operating capital
+ Non operating assets
- non operating liabilities
What falls under the Operating Capital?
+ Operating fixed assets
+ Operating net working capital
- operating liabilities
How do you calculate unlevered beta
Beta_Unlevered = Beta_Levered/(1+((D/E)*(1-tax rate)))
we want to take out of the total equity risk -> the business risk
NOPAT formula?
ebit * (1-tax rate)
Growth rate formula
Ronic * reinvestmentrate
RONIC formula
(new year nopat 24 - old year nopat 23) / new investments 23
Non operating assets
Excess cash
Investments in securities
Investments in associates & JVs
Deferred tax assets assoc. with
tax loss carryforwards
Overfunded pension assets
Assets held for sale
Loans to other companies
Customer financing subsidiaries
Discontinued operations
Excess real estate
Value of non-operating / financing
derivatives
Any other contingent assets not included
in op. assets/NWC
Non-operating liabilities
- Unfunded employee benefits
- Unfunded pension liabilities
- Deferred tax liabilities (net of deferred tax assets) assoc. with non-operating items.
-Non-operating provisions - Liabilities associated with assets held for sale
- Any other contingent liabilities not included in op. liabilities
How do we classify deferred tax assets & liabilities
Classification of DTAs and DTLs:
- Treat any DTLs (net of any DTAs associated with operating assets) such as PPE,
intangibles, operating provisions as operating liabilities.
- Treat all other DTAs such tax loss carryforwards (also known as “net operating losses NOLs”, DTAs associated with financing etc. as non-operating assets.
- Treat all other DTLs (e.g., DTLs associates with pension/employee benefits or financing etc.) as non-operating liabilities / debt-equivalents
How are R&D expenses treated under IFRS and US GAAP?
Under IFRS, research costs are expensed and development costs are capitalized, meaning no adjustments are needed. Under U.S. GAAP, all R&D costs are expensed, which means they should be capitalized for financial analysis purposes.
What is the impact of expensing R&D costs on ROIC calculation?
Expensing R&D costs will understate (or overstate) the ROIC for R&D-intensive firms in early (or later) years. This is because R&D expenses reduce current profitability on the income statement and are not reflected as an asset on the balance sheet.
What is the consequence of capitalizing R&D expenses on financial statements?
Capitalizing R&D expenses means the value of intangible assets created as a result of R&D spending is recorded on the balance sheet. This increases the invested capital figure and can provide a more accurate measure of ROIC over time. It also reduces the scope for earnings management.
Why might the capitalization of R&D expenses be important for technology-intensive companies?
For technology-intensive companies like Apple, which experience substantial year-on-year variation in R&D spending, capitalizing R&D expenses ensures that the investment in future technology is reflected in the financial statements.
-This practice affects the balance sheet by showing higher intangible assets
- impacts the income statement by spreading out the expense over the useful life of the research, rather than taking the full hit in the year the expense occurs.
“holds them accountable”
What are the implications of expensing versus capitalizing R&D costs for ROIC?
Answer: Expensing
R&D costs immediately decreases the operating income for the period, which can lower ROIC in the short term. However, if R&D costs are capitalized, they are amortized over time, leading to a more even distribution of costs and potentially a higher ROIC in the short term. Over time, as the capitalized R&D is amortized, the ROIC will reflect the true returns on these investments.
How does the treatment of R&D expenses influence the reported invested capital on the balance sheet?
If R&D expenses are expensed as incurred (as per U.S. GAAP), they are not recorded as assets on the balance sheet, thereby understating invested capital. If they are capitalized (as permitted under IFRS for development costs), they increase the asset base and consequently show a higher invested capital, which may affect the ROIC calculation.
What does capitalizing R&D expenses imply for earnings management?
Capitalizing R&D expenses reduces the ability of management to manipulate earnings since the R&D costs are spread over several periods rather than affecting profits in just one period. This leads to a smoother earnings pattern and can give a more accurate picture of a company’s long-term profitability and investment efficiency.
What is the goal of adjustments for non-recurring items and which ones do you do?
What do you do with income from minority holdings?
dividends (as well as portion of net income is) shown as part of operating income -> Exclude
How do you know whether you have to do a WACC or APV?
“Although it is not mentioned anywhere that you have to use APV in this example, it should be clear to you given that debt levels and not D/E ratios are specified”
New investments formula:
NOPAT - FCFF
Why is a negative working capital good?
It is a sign of quality business. It means the business has a lot of bargaining power with suppliers.
What is ROIC
ROIC measures how well a company generates cash flow relative to the capital it has invested in its business. It’s calculated as Net Operating Profit After Taxes (NOPAT) divided by the invested capital.
It is a measure of the efficiency and profitability of a company’s capital investments. A higher ROIC indicates that the company is using its capital effectively to generate profits. ROIC is a measure of how much profit a company generates for every dollar invested in the company.
What is the relationship between ROIC and WACC?
Return on invested capital: returns generated for all the capital providers with the operating capital invested in the firm.
If:
- ROIC > WACC -> growth adds value
If a company’s ROIC is greater than its WACC, it means the company is generating a return on its investments that is higher than the average cost of financing those investments. This implies that the company is creating value for its shareholders because it is earning more on its investments than it costs to fund those investments.
- ROIC = WACC -> growth does not add value
- ROIC < WACC -> growth destroys value
If a company’s ROIC is less than its WACC, it indicates that the company is not generating enough return from its invested capital to cover the cost of the capital it has used. Essentially, it’s earning less on its investments than what it pays for financing them.
Under perfect competition: ROIC in steady state = WACC
What drives ROIC?
What is Goodwill?
Goodwill (= price paid in an acquisition – FV of assets) is a part of intangible assets
Why are reinvestments important and what types are there?
Types: Capital reinvestment strategies: Build (i.e., organic) vs. Buy (i.e., M&A).
-> Organic vs. acquired growth typically tend to be complementary
When determining the discount rate, what perspective should you take and what do you base the discount rate on?
The pricing of risk in markets is done from the perspective of a marginal risk-averse investor who holds a well diversified portfolio:
-> Risk averse, investor seeks compensation in excess of the risk-free rate (which is the compensation for deferring consumption) for holding the risky asset.
-> Well diversified portfolio è porfolio carries only nondiversifiable risk (since all firm-specific risk has been
diversified away).
-> Since the marginal investor holds a well diversified portfolio -> (s)he will seek compensation only for the nondiversifiable risk which (s)he holds in his portfolio.
Your choice of discount rate depends on which cash flows you are valuing (their riskiness)
Which assumptions are violated in determining the Cost of equity of privately held firms?
i. Diversified investors: Marginal investor holds a fully diversified portfolios and
hence expected to be rewarded for undiversifiable risk.
ii. Liquid market: Investments are liquid. Trading is easy, instantaneous and
costless.
iii. Powerful stockholders: As the owners of companies, stockholders exercise
power over managers, who seek mightily to maximize stockholder wealth.
In other words, there are no owner-manager with majority control of the
voting rights of the firm, who may subvert firm value for their private
interests.
How do you need to adjust the beta when calculating it for a private firm?
- Discount for lack of diversification
- Illiquidity discount
- The shareholder(s) controlling a majority stake in the firm control the direction of the
firm and hence its outcomes (i.e., value).
When is it better to use APV
DCF with WACC does not reflect changing capital structure
* In theory, it should. In practice, people do not make the required adjustments
(not just d/e”)
* What happens when a firm is expected to have negative cash flows for
many years?
* What happens when we have limited information about a firm?
Given the frequent failure to adjust WACC based calculations for capital structure,
APV has obvious theoretical appeal
* APV also allows for explicit modeling of the costs of financial distress
* … and valuation of private companies without measurable D/E ratio
What are the downsides of APV
However, APV requires a lot of uncertain inputs that make practical implementation
poor
* Synthetic credit rating
* E(COFD)
* Rate to discount tax shields with
* Other effects of leverage on value besides the tax shield
When does a PE ratio grow?
➢ P/E ratio is increases with increase in:
▪ Payout ratio, expected growth rate, ROE.
➢ P/E ratio is decrease with increase in:
▪ riskiness through increase in the cost of equity
