WSO - Accounting, Finance, & Valuation

Question 1

What are the three main financial statements?

Answer 1

Income Statement, Balance Sheet, and Statement of Cash Flows

Question 2

What is the Income Statement equation?

Answer 2

Revenue - COGS - Expenses = Net Income

Question 3

What is the Balance Sheet equation?

Answer 3

Assets = Liabilities + Shareholder’s Equity

Question 4

What is the Statement of Cash Flows equation?

Answer 4

Beginning Cash + CF from Operations + CF from Investing + CF from Financing = Ending Cash

Question 5

How are the three main financial statements connected?

Answer 5

Net Income from the Income Statement is added to Cash Flow from Operations on the Statement of Cash Flows. The Beginning Cash Balance on the Statement of Cash Flows is taken from Cash from the Balance Sheet in the prior period. After making adjustments to Net Income for Non-Cash items, the Cash Flow from Operations, Investing, and Financing; the Ending Cash Balance becomes the Cash for the current period’s Balance Sheet under Assets. Lastly, Net Income (minus any dividends paid) flows from the Income Statement onto the Retained Earnings column (Shareholder’s Equity) of the Balance Sheet, allowing the Balance Sheet to balance.

Question 6

Walk me through the major line items of an Income Statement.

Answer 6

Revenues - COGS = Gross Margin
Gross Margin - Operating Expenses = Operating Income
Operating Income - Other Expenses - Income Taxes = Net Income
“The first line of the Income Statement is Revenues or sales. From that you subtract out the Cost of Good Sold. This leaves you with the Gross Margin. From there, you subtract out the Operating Expenses, leaving you with the Operating Income. From here, you subtract out any Other Expenses and Income Taxes. This leaves you with Net Income.

Question 7

What are the three components of the Statement of Cash Flows?

Answer 7

The three components of the Statement of Cash Flows are Cash from Operations, Cash from Investing, and Cash from Financing.

Question 8

What is EBITDA?

Answer 8

EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization and is an indicator of a company’s financial performance. It is a good way of comparing the performance of different companies because it removes the effects of financing and accounting decisions like Interest and Depreciation. It is also considered a rough estimate of Free Cash Flow.

Question 9

What is Enterprise Value?

Answer 9

Enterprise Value is the value of a firm as a whole, to both debt and equity holders. In order to calculate Enterprise Value you take the market value of equity (AKA the company’s Market Cap), add the debt, add the value of the outstanding preferred stock, add the value of any minority interests the company owns and then subtract the cash the company currently holds.

Question 10

What is the Enterprise Value equation?

Answer 10

Enterprise Value = Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash

Question 11

If the Enterprise Value is 150, and Equity Value is 100, what is Net Debt?

Answer 11

Net Debt is 50

Question 12

Why do you subtract cash from Enterprise Value?

Answer 12

There are a few reasons for subtracting Cash from Enterprise Value. First, Cash is already accounted for within the Market Value of Equity. You also subtract cash because you can either use that cash to pay off some of the debt, or pay yourself a dividend, which is effectively reducing the purchase price of the company.

Question 13

What is Valuation?

Answer 13

Valuation is the procedure of calculating the worth of an asset, security, company, etc.

Question 14

What are some ways you can value a company?

Answer 14

• Comparable Companies/Multiples Analysis (To calculate either Enterprise Value or Equity Value)
• Market Valuation/Market Capitalization
• Precedent Transactions
• DCF (Discounted Cash Flow) Analysis
• LBO Valuation
  “There are a number of ways to value a company. The most simple would be the market valuation, which is just the equity value of the company based on the public markets - this is simply the market capitalization of the company plus the net debt on its books to get to total enterprise value. You can also use comparable company analysis, precedent transactions analysis, discounted cash flow analysis as well as a leverage buyout valuation.

Question 15

Which of the valuation methodologies will result in the highest valuation?

Answer 15

Of the four main valuation techniques (Market Value, Market Comps, Precedent Transactions and DCF) the highest valuation will normally be a DCF because those building the DCF models tend to be optimistic in their projections. Precedent Transactions will normally give the next highest valuation simply because a company will pay a control premium for the projected synergies coming from the merger. Market Comps and Market Value will normally give the lowest valuation.

Question 16

What does spreading comps mean?

Answer 16

Spreading comps is the process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis/comparison.

Question 17

Walk me through a DCF model.

Answer 17

To begin we would project the Free Cash Flows of the company for about 5 years. Free Cash Flow is EBIT times 1 minus the Tax Rate, plus Depreciation and Amortization, minus CapEx (Capital Expenditures), minus the Change in Net Working Capital. Then you must predict the Free Cash Flows beyond 5 years which is done either using a Terminal Value Multiple or the using of the Perpetuity Method. To calculate the Perpetuity you must establish a Terminal growth rate (which is usually around the rate of inflation or GDP growth {low single digits}). Then multiply the year 5 Cash Flow by 1 plus the Growth Rate and divide it by your Discount Rate minus the Growth Rate. Now, in order to do this you must have an established Discount Rate. For a Discounted Cash Flow you use WACC as the Discount Rate. You discount all Cash Flows back to year zero using that rate. The sum of the Present Values of all those Cash Flows is the Estimated Present Value of the Firm.

Question 18

How do you calculate a firm’s Terminal Value?

Answer 18

There are two ways to calculate Terminal Value. The first is the Terminal Multiple Method. To use this method, you choose an operation metric (most common is EBITDA) and apply a comparable company’s multiple to that number from the final year of projections. The second method is the Perpetuity Growth Method. To use this method you choose a modest Growth Rate, usually just a bit higher than the Inflation Rate or GDP Growth Rate, in order to assume that the company can grow at this rate infinitely. We then multiply the FCF from the Final Year by 1 plus the Growth Rate, and divide that number by the Discount Rate (WACC) minus the assumed Growth Rate.

Question 19

What is WACC and how do you calculate it?

Answer 19

WACC is the percentage of Equity in the capital structure times the Cost of Equity (which is calculated using CAPM) plus the percentage of Debt in the capital structure times one minus the Corporate Tax Rate times the Cost of Debt (which is the current yield on their outstanding debt) plus the percentage of Preferred Stock in their capital structure times the Cost of Preferred Stock (if there is any preferred stock outstanding).

Question 20

How do you calculate Free Cash Flow?

Answer 20

Free Cash Flow is EBIT (Earnings before Interest and Taxes) times 1 minus the Tax Rate plus Depreciation and Amortization minus CapEx (Capital Expenditures) minus the Change in Net Working Capital.

Question 21

Why do you project out Free Cash Flows for the DCF model?

Answer 21

The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.

Question 22

What is Net Working Capital?

Answer 22

Net Working Capital is equal to Current Assets minus Current Liabilities. It is a measure of whether a company is able to pay off its short term liabilities with its short-term assets. A positive number means they can cover their short term liabilities with their short-term assets. If the number is negative, the company may run into trouble paying off their creditors which could result in bankruptcy if their cash reserves are low enough.

Question 23

What happens to Free Cash Flow if Net Working Capital increases?

Answer 23

Since you subtract the change in Net Working Capital in the calculation of Free Cash Flow, if Net Working Capital increases, your Free Cash Flow will decrease.

Question 24

What are the components of each of the items on the statement of Cash Flows?

Answer 24

Cash Flow from Operations is the cash generated from the normal operations of a company. The cash flow from investing is the change in cash due to outside occurrences such as the purchase or sale of PPE or any other investments. Cash Flow from Financing involves the increase or decrease in cash due to the issuance or repurchase/repayment of equity and debt.

Question 25

What is the difference between the Income Statement and Statement of Cash Flows?

Answer 25

A company’s sales and expenses are recorded on their Income Statement. The statement of Cash Flows records what cash is actually being used and where it is being spent by the company during that time period. Some additional items included on the Cash Flow Statement could be issuance or repurchase of debt or equity, capital expenditures or other investments. Amortization and Depreciation will be reflected on the Balance Sheet, but will be added back to Net Income on the Cash Flow Statement since they are Expenses, but not actually a use of cash.

Question 26

What is the link between the Balance Sheet and the Income Statement?

Answer 26

There are many links between the Balance Sheet and the Income Statement. The major link is that any Net Income from the Income Statement, after the payment of any Dividends, is added to Retained Earnings. In addition, debt on the balance sheet is used to calculate the Interest Expense on the Income Statement, and PPE will be used to calculate any Depreciation Expense.

Question 27

What is the link between the Balance Sheet and the Statement of Cash Flows?

Answer 27

Well, the beginning cash on the Statement of Cash Flows comes from the previous period’s Balance Sheet. The Cash from Operations is impacted by the change in Net Working Capital which is Current Assets minus Current Liabilities. Depreciation comes from PPE which effects cash from operations. Any change in PPE due to the purchase or sale of that equipment will affect cash from investing. Finally, ending cash balance from the Cash Flow Statement is the Cash Balance on the Balance Sheet.

Question 28

Why might there be multiple valuations of a single company?

Answer 28

Each method of valuation will each give a different value of a given company. The reason for these differences is due to different assumptions, different multiples, or different comparable companies and/or transactions. Generally, the Precedent Transaction methodology and DCF methodology will give a higher valuation than the comparable companies analysis or market valuation. This is because a prior transaction will include a “Control Premium” over the company’s market value to entice shareholders to sell, and will account for the “synergies” that may occur when the two companies become one. The DCF will also normally produce a higher valuation than the comparable companies due to the fact that when an analyst makes their projections and assumptions for a company’s future cash flows, they are usually somewhat optimistic.

Question 29

How do you determine which of the valuation methodologies to use?

Answer 29

The best way to determine the value of a company is to use a combination of all the methodologies and zero in on an appropriate valuation. If you have a precedent transaction you feel is extremely accurate, you may give that more weight, if you are extremely confident in your DCF you may give that more weight. Valuing a company is as much an art as it is a science.

Question 30

What is an IPO?

Answer 30

An IPO occurs the first time a company sells shares of stock to the public market. Most times the company will either go public to raise capital in order to grow the business, or to allow the original owners and investors to cash out some of their investment.

Question 31

What is a Primary Market and what is a Secondary Market?

Answer 31

The Primary Market is the market that a firm sells a new stock or bond issuance to the first time it comes to market. The Secondary Market is the market that the security will trade on after its IPO.

Question 32

What is the Capital Assets Pricing Model?

Answer 32

The CAPM is used to calculate the required return on Equity or the Cost of Equity. The Return on Equity is equal to the Risk Free Rate (which is usually the yield on a 10-year U.S. Gov’t Bond) plus the company’s beta (which is a measure of how volatile the stock is in relation to the stock market) times the Market Risk Premium.

Question 33

Where do you find the Risk Free Rate?

Answer 33

The Risk Free Rate is usually the current yield on the 10yr Gov’t Treasury which can be found the front page of the Wall Street Journal or Yahoo Finance.

Question 34

What is Beta?

Answer 34

Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a Beta of 1, while investments that are more volatile than the market have a Beta greater than 1 and those that are less volatile have a Beta of less than 1.

Question 35

What sectors tend to have a Beta less than 1?

Answer 35

Consumer Staple, Healthcare, Utilities, Tobacco, and Petroleum Production

Question 36

What sectors tend to have a Beta greater than 1?

Answer 36

Wireless Networking, Biotechnology, Computer Software/Services/Hardware, E-Commerce, Entertainment Technology.

Question 37

From the three main financial statements, if you have to choose two, which would you choose and why?

Answer 37

If I had to choose two financial statements, I would choose the Balance Sheet and the Income Statement. As long as I had the Balance Sheets from the beginning and end of the period, as well as the end of period Income Statement, I would be able to generate a Cash Flow Statement.

Question 38

How would a $10 increase in Depreciation Expense affect the three financial statements?

Answer 38

Starting with the Income Statement, the $10 increase in Depreciation will be an expense, and will therefore reduce Net Income by $10 times (1-T). Assuming a 40% Tax Rate, this will mean a reduction in Net Income of $6. This will flow to Cash from Operations where Net Income will be reduced by $6, but Depreciation increases by $10, resulting in an increase of Ending Cash by $4. Cash then flows onto the Balance Sheet. Where cash increases by $4, PPE decreases by $10, and Retained Earnings decreases by $6, causing everything to balance.

Question 39

How would you calculate the Discount Rate for an all Equity Firm?

Answer 39

If a firm is all equity, then you would use CAPM to calculate the Cost of Equity, and that would be the Discount Rate.

Question 40

What is the Market Risk Premium?

Answer 40

The Market Risk Premium is the required return that investors require for investing in stocks over investing in “risk-free” securities. It is calculated as the Avg. Return on the market minus the Risk Free Rate (current yield on a 10-yr Treasury).

Question 41

What kind of an investment would have a negative beta?

Answer 41

Gold is a type of investment that would have a negative beta. When the stock market goes up, the price of gold typically drops as people flee from the “safe haven” of gold. The opposite happens when the market goes down, implying a negative correlation.

Question 42

How much would you pay for a company with $50 million in revenue and $5 million in profit?

Answer 42

Since you have no information about historical or projected performance, as well as no details about the firm’s capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm’s industry, and can identify a group of comparable companies, your best bet would be to do a multiples analysis using the ratios from those comparable companies that are most relevant to the given industry.

Question 43

How would you value a company with no revenue?

Answer 43

In order to value a company with no revenue, such as a startup, you must project the company’s cash flows for future years and then construct a DCF of those cash flows using an appropriate Discount Rate. Alternatively, you could use other operating metrics to value the company as well. If you took a start-up website with 50,000 subscribers, but no revenue, you could look at a similar website’s value per subscriber and apply that multiple to the website you are valuing.

Question 44

What is the difference between APV and WACC?

Answer 44

• WACC incorporates effect of interest tax shields into the discount rate; Typically calculated from actual data from Balance Sheets and used for a company with a consistent capital structure over the period of the valuation.
• APV adds present value of financing effects to NPV assuming all-equity value; Useful where costs of financing are complex and if capital structure is changing; Use for Leveraged Buyouts

Question 45

Describe a company’s typical capital structure.

Answer 45

A company’s capital structure is made up of debt and equity, but there may be multiple levels of each. Debt can be broken down into senior, mezzanine and subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior is paid off first, it will have a lower interest rate. Debt may consist of bank loans (which are normally most senior in the capital structure) and/or bonds which can be issued to the general public. Equity can also be broken down into preferred stock and common stock. Preferred stock is like a combination of debt and equity in that it has the opportunity for some appreciation in value, but more importantly pays out a consistent dividend that is not tied to the market price of the stock. Common stock is the final piece of the capital structure, and is the stock that is traded on the exchanges if the company is public. In the event of bankruptcy, the common stockholders will have the last right to assets in the event of liquidation, and therefore are bearing the highest level of risk. Due to this they will demand the highest return on their investment. Those shareholders are the owners of the company and have the rights to the firm’s profits, which may be paid out in the form of dividends or reinvested back into the business.

Question 46

When should a company issue equity rather than debt to fund its operations?

Answer 46

There are a number of reasons a company may issue stock rather than debt to fund its operations. First, if it believes its stock price is inflated, it can issue stock and raise a relatively significant amount of capital for the ownership sold. If the projects for which the money is being raised may not generate predictable cash flows in the immediate future, the company may have a difficult time paying the consistent coupon payments required by the issuance of debt. The company could also choose to issue stock if they want to adjust the debt/equity ratio of their capital structure.

Question 47

When should an investor buy preferred stock?

Answer 47

An investor should buy preferred who wants the upside of potential of equity, but wants to limit risk and provide themselves with the stability of current income in the form of a dividend. The investor would receive steady interest-like payments (dividends) that are more secure than the dividends from common stock. Preferred Stock owners also get a superior right to the company’s assets should the company go bankrupt (although less rights than debtholders).

Question 48

Why would a company distribute its earnings through dividends to common stockholders?

Answer 48

The distribution of a dividend signals to the public that a company is healthy and profitable and it can also attract more investors, potentially driving up the company’s stock price.

Question 49

What is Operating Leverage?

Answer 49

Operating Leverage is the relationship between a company’s fixed and variable costs. A company whose costs are mostly fixed has a high level of operating leverage.

Question 50

How would a $10 increase in Depreciation in yr4 affect the DCF valuation of a company?

Answer 50

A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT (1-T) by $10 (1-T). Assuming a Tax Rate of 40%, it drops EBIT (1-T) by $6, but you must add back the $10 Depreciation in the calculation of FCF. Therefore your FCF increases by $4 and your valuation will increase by the present value of that $4.

Question 51

If you have two companies that are exactly the same in terms of revenue, growth, risk, etc. but one is Private and one is Public, which company’s shares would be higher priced?

Answer 51

The public company will likely be priced higher for a few reasons. The main reason is the Liquidity Premium an investor would be willing to pay for the ability to quickly and easily trade their stock on the public exchanges. A second reason would be a sort of “Transparency Premium” an investor would pay since the public company is required to file their financial documents publicly.

Question 52

What could a company do with excess cash on its Balance Sheet?

Answer 52

While at first it may seem that having a lot of cash on hand would be a good thing, especially in a recession, there is an opportunity cost to holding cash on the Balance Sheet. A company should have enough cash to protect itself from Bankruptcy in a downturn, but above that level the cash should be used in one way or another. The main ways a company could use its cash would be to either reinvest into the firm (whether it be equipment, employees, marketing, etc) or the company could pay out the excess earnins/cash in the form of a dividend to its equity holders. A growing company will tend to reinvest rather than paying a dividend. Other ways the cash could be spent would include paying off debt, repurchasing equity, or buying out a competitor/supplier/distributor.

Question 53

What is Goodwill and how does it affect Net Income?

Answer 53

Goodwill is an Intangible Asset found on a company’s Balance Sheet. Goodwill may include things like Intellectual Property rights, a Brand Name, etc. Usually Goodwill is acquired when purchasing a firm, in that the acquirer pays a higher amount for the firm than the book value of its assets. If an event occurs that diminishes the value of these intangible assets, the assets must be “written down” in a process much like depreciation. Goodwill is then subtracted as a non-cash expense and therefore reduces Net Income.

Question 54

How/Why do you Lever/Unlever Beta?

Answer 54

By Unlevering the Beta, you are removing the financial effects from leverage (debt in the capital structure). This Unlevered Beta shows you how much risk a firm’s equity has compared to the market. Comparing Unlevered Betas allows an investor to see how much risk they will be taking by investing in a company’s equity (i.e. buying stock in the public market). When you have a Company A that doesn’t have a beta, you can find comparable Company B, take their Levered Beta, unlever it, and then relever it using the Company A’s capital structure to come up with their Beta.

Question 55

How would you calculate an Equity Beta?

Answer 55

In order to calculate an Equity Beta you must perform a regression of the return of the stock versus the return of the market as a whole (the S&P 500). The slope of the regression line is the beta.