Accounting, Finance & Valuation (Chapter 2)
Days Payable Outstanding (DPO)
(Accounts Payable/Cost of Goods Sold) x 365 - measures the number of days it takes a company to make payment on its outstanding purchases of goods and services. An increase in Accounts Payable is a source of cash, so companies should aspire to maximize their DPO as to increase short-term liquidity.
Days Sales Outstanding (DSO)
(Accounts Receivable/Sales) x 365 - provides a gauge of how well a company is managing the collection of its receivables by measuring the number of days it takes to collect payment after the sale of a product or service. Minimizing DSO increases cash flow
Days Inventory Held (DIH)
(Inventory/Cost of Goods Sold) x 365 - measures the number of days it takes a company to sell its inventory. Minimizing DIH increases cash flow as a company turns it inventory as quickly as possible to minimize the amount of cash it ties up
Intangible Assets
Trademarks, patents, and other intellectual property. Similar to goodwill and is normally the result of M&A activity. Certain assets are amortizable.
What is the difference between the income statement and statement of cash flows?
A company's sales and expenses (both cash and non-cash) are recorded on its Income Statement. The Statement of Cash Flows records what cash is actually being generated and used during the reporting period and where it is being spent. Other items included on the Cash Flow Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments. Amortization and depreciation will be reflected as expenses on the Income Statement, but they will be added back to Net Income on the Cash Flow Statement since they are expenses but not actually a use of cash.
What is a deferred tax asset and why might one be created?
A deferred tax asset occurs when a company pays more in taxes to the government than they show as an expense on their income statement in a reporting period. Another reason a company may generate a deferred tax asset is through a Net Operating Loss (NOL). If a company incurs more expenses than the revenue it generates, and therefore incurs a loss from operations, that company may apply the loss generated in the period to a period(s) of future operational profitability in order to reduce future tax expenses.
Revolvers
A line of credit that has a maximum from which a company can borrow and pay of debt at any time. Typically secured by working capital assets such as A/R, inventory and prepaid assets
What is the difference between accounts receivable and deferred revenue?
Accounts receivable is revenue, which has been earned and recognized because the product has been delivered, but the customer has not yet paid the cash. Deferred revenue is cash that has been collected for products which have not yet been delivered, so the revenue has not yet been recognized. Accounts receivable is an asset on the Balance Sheet, whereas deferred revenue is a liability.
Long-Term Debt
Amount of debt the company has that matures in more than a year
Property Plant and Equipment (PP&E)
Any factories, warehouses, offices, land that has long term value (>12 Months) and contributes to the company's core business
How could a company have positive EBITDA and still go bankrupt?
Bankruptcy occurs when a company can't make its interest or debt payments. Since EBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company's EBITDA, then if they have insufficient cash on hand, they would soon default on their debt and could eventually need bankruptcy protection.
What is the difference between accounts payable and accrued expenses?
Basically they are the same thing. The main difference is usually that accounts payable is typically a one-time expense with an invoice (such as the purchase of inventory) while accrued expenses are recurring (like employee expenses). Both accounts are reflected in working capital calculations.
How do you determine which valuation methodology to use?
Because each method has unique ability to provide useful information, you don't choose just one. The best way to determine the value of a company is to use a combination of valuation techniques. For example, if you have a precedent transaction valuation that you feel is extremely accurate, you may give that result more weight. Or if you are extremely confident in your DCF analysis, you will place more emphasis on its outcome. Valuing a company is as much an art as it is a science.
When looking at the acquisition of a company, do you look at equity value or enterprise value?
Because the acquiring company must purchase both liabilities and equity in order to take over the business, the buyer will need to assess the company's Enterprise Value, which includes both the debt and the equity.
What is the link between the balance sheet and the statement of cash flows?
Beginning cash on the Statement of Cash Flows comes from the previous period's Balance Sheet. Cash from operations on the Cash Flow Statement is affected by the Balance Sheet's numbers for change in net working capital, current assets minus current liabilities. Property, plant, and equipment is another Balance Sheet item that affects the Cash Flow Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of property, plant, and equipment will affect cash from investing. Finally, the Cash Flow Statement's ending cash balance becomes the beginning cash balance on the new Balance Sheet.
Cash Flow from Investing
Capital Expenditures and cash inflows from the sale of capital assets. primarily sales and purchases of PP&E or other capital assets. This section will also show any investments in the financial markets and operating subsidiaries.
Cash Flow from Operations
Cash generated or lost through normal operations, sales, and changes in working capital. Net Income + non cash expenses (depreciation/amortization) +/- delta in working capital (increase in working capital is an outward cash flow?)
Cash Flow from Financing
Cash impact of activity with a company's investors (both debt and equity) includes debt capital raised or repaid, equity capital raised or repurchased, or dividends paid
Deferred Revenue
Cash the company has collected from customers ahead of time for services that will be delivered over that period of time
What basic tools and metrics does a financial professional use to evaluate potential projects or investments?
Cost of Capital: An individual's cost of capital, or "discount rate" represents what he or she could earn by investing in another asset (the opportunity cost). In general, if an investment is expected to generate a return in excess of an investor's cost of capital, that investor should pursue the project. In general, equities tend to have a higher discount rate because the expected potential returns are higher, and carry more risk than fixed income (higher risk and higher reward). Bonds/debt typically have a lower discount rate because the investor's compensation is primarily limited to the interest earned on the debt instrument, rather than appreciation in price of the asset. Furthermore, the risk on the investment is also generally lower since it is more senior than equity in the waterfall in the event of a default. Interest paid on debt reduces taxable income, so there is a tax deductibility benefit from having some debt.
Inventory Turns
Cost of Goods Sold / Inventory - an alternative approach for measuring a company's efficiency at selling inventory. Indicates the number of times a company turns over its inventory in a year
How can you determine activity with investors from these two statements?
Debt or equity raised reflected on the Balance Sheet during a given accounting period will be included as a cash inflow in the Cash Flow from Financing section of the Cash Flow Statement during the same accounting period. Similarly, debt or equity capital repaid/repurchased during the accounting period will be reflected as a cash outflow in the same section, as will dividends paid to shareholders.
What is deferred revenue and why is it a liability?
Deferred revenue is cash that has been collected in advance for something that hasn't yet been delivered. For example, if you pay for a monthly gym class membership a year in advance, you haven't yet received a year's worth of exercise classes; therefore the company has not yet recognized the revenue since the service hasn't been delivered. At the beginning of the year they will show the full amount of the subscription in deferred revenue, and that amount will decrease by 1/12 of the amount each month as issues are delivered. All of the cash is received up front, so the liability goes up by the amount of cash received, therefore reflecting the influx on the cash flow statement. Since no additional cash is received each month, the reduction in the liability offsets the equivalent amount of revenue recognized so it has no effect on the company's cash flows.
What is a deferred tax liability and why might one be created?
Deferred tax liability is a tax expense amount reported on a company's income statement not actually paid in cash during that accounting period, but expected to be paid in the future. This occurs when a company pays less in taxes to the government than they show as an expense on their income statement. This can be caused due to differences in depreciation expense between book reporting (GAAP) and tax reporting. This will lead to differences in tax expense reported in the financial statements and taxes payable to the government.
When projecting out depreciation and amortization, what balance sheet line items are impacted by these annual non-cash expenses?
Depreciation expense from the Income Statement (or Notes) reduces the Balance Sheet Account for Plant Property & Equipment, a non-current asset. Amortization expense, also from the Income Statement (or Notes) reduces the Balance Sheet Account for Intangible Assets. Only certain identifiable intangible assets are currently amortizable under U.S. GAAP.
What is the purpose of the changes in working capital section of the cash flow statement
Due to accrual accounting, changes in balance sheet items like accounts payable and accounts receivable are not reflected within net income, and thus there must be an adjustment to calculate cash flows
Would you be calculating Enterprise Value or Equity Value when using a multiple based on free cash flow or EBITDA?
EBITDA and free cash flow represent cash flows that are available to repay holders of a company's debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors. A multiple such as P/E ratio, based on earnings alone, represents the amount available to common shareholders after all expenses are paid, so if you used this multiple, you would be calculating the value of the firm's equity.
What is EBITDA?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's a good high-level indicator of a company's financial performance. Since it removes the effects of financing and accounting decisions such as interest and depreciation, it's a good way to compare the performance of different companies. It serves as a rough estimate of free cash flow, and is used in the EV/EBITDA multiple to quickly establish a company's high-level valuation.
Why might there be multiple valuations of a single company?
Each method of valuation will generate a different value because it is based on different assumptions, different multiples, or different comparable companies and/or transactions. Generally, the precedent transaction methodology and discounted cash flow method lead to higher valuations than comparable companies analysis or market valuation does. The precedent transaction result may be higher because the approach usually will include a "control premium" above the company's market value to entice shareholders to sell and will account for the "synergies" that are expected from the merger. The DCF approach normally produces higher valuations because analysts' projections and assumptions are usually somewhat optimistic.
What is enterprise value>
Enterprise Value is the value of an entire firm, both debt and equity, according to the equation below. This is the price that would be paid for a company in the event of an acquisition. Enterprise Value = Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash NOTE: This is a highly simplified Enterprise Value formula. When bankers working on a deal are calculating the true Enterprise Value in an acquisition, they must take into account numerous other factors such as leases, pension obligations, and NOLs.
What is the difference between enterprise value and equity value?
Equity Value represents residual value for common shareholders after the company satisfies its outstanding obligations (net debt, preferred stock, which is senior to common equity).
Prepaid Expense
Expenses the company has paid for in cash ahead of the delivery of services, but have not been recognized as expenses in the income statement yet (due to the service not being received yet)
Walk me through a discounted cash flow model
First, project the company's free cash flows for about 5 years using the standard formula. (Free cash flow is EBIT times 1 minus the tax rate, plus Depreciation and Amortization, minus Capital Expenditures, plus or minus the Change in Net Working Capital.) Next, predict free cash flows beyond 5 years using either a terminal value multiple or the perpetuity method. To calculate the perpetuity, establish a terminal growth rate, usually about the rate of inflation or GDP growth, a low single-digit percentage. Now multiply the Year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate. Your discount rate is the Weighted Average Cost of Capital, or WACC. Use that rate to discount all your cash flows back to year zero. The sum of the present values of all those cash flows is the estimated present Enterprise Value of the firm according to a discounted cash flow model.
What metrics are commonly employed when projecting net working capital in a DCF valuation?
For a company with common working capital accounts, such as accounts receivable, inventories, prepaid assets, other current assets, accounts payable, accrued expenses, deferred revenue, other current liabilities, etc., common ratios include: Days Sales Outstanding (AR/Sales) x 365 Days Inventory Held = (Inv/CoGS)x365 Inventory Turns = CoGS/Inventory Days Payable Outstanding = (Accounts Payable/CoGs) x 365
How do you calculate free cash flow?
Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital. FCF=EBIT*(1-t)+D+A-CapEx-DeltaNWC
If you couldn't use a DCF or Multiples, how would you value a company?
Generally there are three ways to value a company, market, income or assets. Income approach uses some form of discounting income or cash flows, and the market method uses comparable multiples or market value, so if you can't rely on either of those two you are left with assets. In an asset based analysis the business is worth the sum of it's parts. Assets at acquisition value net depreciation value, or the lower of this method and market value. Basically looking at the cost of an investor to go out to the open market and build the business for tangible assets. Problem with this method is that you can't really value intangible assets without knowing the enterprise value. (Theory of substitution, no investor would pay more for a business than what they would have to pay if they
What is goodwill?
Goodwill is an asset that captures what is paid for an acquisition over fair market value (or book value of shareholders equity) Here is an example: Company A buys Company B for $100 million in cash. Company B has one asset, which is a factory with a book value of $75 million, debt of $25 million, and equity of $50 million which equals the book value (assets minus liabilities).Company A's cash balance declines of $100 million to finance acquisition (cost of the acquisition)Company A's PP&E increases by $75 million (book value of Company B's factory)Company A's debt increases by $25 million (Company B's acquired debt)Company A's goodwill increases $50 million (purchase price of Company B minus book value of equity in Company B)
Capital Intensity
How much capital/cash earned that needs to be reinvested in the business and is thus tied up when determining unlevered free cash flow (UFCF). Expressed by subtracting CapEx and adding or subtracting the delta in net working capital from D+A when converting EBITDA into FCF. One of the two non-EBITDA factors in the calculation
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating. The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business. And the Balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF Statement would show.
Now assume you can choose to see two of a company's three financial statements. Which would you choose?
I would want to see the Income Statement and the Balance Sheet because one can produce an accurate expected or illustrative Cash Flow Statement with the information presented in the Income Statement and Balance Sheet. The Cash Flow Statement begins with Net Income and then adjusts for non- cash and non-operating expenses, both sourced from the Income Statement. From there, we can calculate the changes in net working capital from information on the Balance Sheet to calculate Cash Flow from Operations. Capital Expenditures in the Cash Flow from Investing section of the Cash Flow Statement could be inferred by taking the year over year change in PP&E from the Balance Sheet, plus Depreciation Expense, less any cash inflows from the sale of capital assets. Repayments of Debt on the Cash Flow from Financing section of the Cash Flow Statement can be inferred using the year over year changes in short-term and long-term debt balances, while also adjusting for any debt capital raised. Similarly, repurchases of Equity, dividends paid to equity investors and equity capital raised would be reflected on the Balance Sheet as well.
Accounts Payable
IOUs for goods that the company has received but hasn't yet paid for
Accounts Receivable
IOUs from customers due to items that were sold but haven't been paid for yet
What is an initial public offering (IPO)?
IPO is the acronym for Initial Public Offering. It is the first time a privately-held company sells shares of stock to the public market. Usually a company goes public to raise capital for growing the business or to allow the original owners and investors to cash out some of their investment.
When would you not want to use a DCF?
If you have a company that has very unpredictable cash flows, then attempting to project those cash flows and create a DCF model would not be effective or accurate. In this situation you will most likely want to use a multiples or precedent transactions analysis.
When should an expense appear on the income statement?
In order to be on the income statement, the expense must be tax deductible and must have been incurred during the period of the income statement.
Short-Term Investments
Items almost as liquid as cash but not quite, such as money market accounts, Certificates of Deposits
Inventory
Items that have already been produced, but haven't yet been sold (e.g. clothing on the shelves, video games on the racks)
Cash
Liquid currency that is readily available for the business to spend
Why has deferred revenue come under greater focus from the IRS, SEC and investor community?
Many of the high profile, publicly traded technology companies that are highly valued by investors operate with a monthly or annual license/subscription model. Investors like these businesses due to their ability to retain customers and generate repeat, recurring and contractual revenue. Therefore, it is important that investors understand the cash flow/liquidity implications of a company that has already collected cash for a product or service it has yet to deliver. The delivery of this good/service consumes resources from the business, thus reducing available working capital to grow the company.
What is net working capital?
Net Working Capital is current assets minus current liabilities. It is a measure of a company's ability 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. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient. Net Working Capital = Current Assets - Current Liabilities Working capital going up means a company must have used cash to produce the increase (so reduce cash) and vice versa, WC going down means the company didn't use cash to pay an expense, and as a result that expense needs to be added back to the CF statement
What is net debt?
Net debt is a company's total debt minus the cash it has on the balance sheet. Net debt assumes that a company pays off any debt it can with excess cash on the balance sheet. One can simplify the Enterprise Value formula above by replacing "Debt" with "Net Debt" and removing the subtraction of Cash, since that is already built into Net Debt.
Why do you subtract cash from enterprise value?
One good reason is that cash has already been accounted for within the market value of equity. You also subtract cash because it can be used either to pay a dividend or to reduce debt, effectively reducing the purchase price of the company.
Balance Sheet
One of the three main financial statements. A company's statement of financial position on a given day, typically the final day of a particular period Assets = Liabilities + Shareholder's Equity
Income Statement
One of the three main financial statements. Shows company's revenues and expenses during a particular period Revenues - Cost of Goods Sold - Expenses = Net Income
Statement of Cash Flows
One of the three main financials tatements. Shows how a company's Net Income is adjusted upwards or downwards (for non-cash and non-operating expenses) to calculate a company's Cash Flow from Operations Begging Cash + CF From Operations + CF From Investing + CF From Financing = Ending Cash
If depreciation is a non-cash expense, then how does it affect the cash balance?
Prepaid expenses are payments that have been made for products or services that will be delivered in the future. As the products or services are received they will be recognized as expenses on the income statement. Accounts payable is a liability for a good or service that has been received and recognized as an expense, but has not yet been paid for in cash.
What is the difference between accounts payable and prepaid expenses?
Prepaid expenses are payments that have been made for products or services that will be delivered in the future. As the products or services are received they will be recognized as expenses on the income statement. Accounts payable is a liability for a good or service that has been received and recognized as an expense, but has not yet been paid for in cash.
What is the difference between public equity value and book value of equity?
Public Equity Value is the market value of a company's equity; while the book value is just an accounting number. A company can have a negative book value of equity if it has been taking large cash dividends, or running at a net loss; but it can never have a negative public Equity Value, because it cannot have negative shares or a negative stock price.
If enterprise value is $150MM, and equity value is $100MM, what is net debt?
Since Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest, if we assume there is no minority interest or preferred stock, then Net Debt will be $150mm -$100mm, or $50mm.
What does the terminal value represent/why is it significant?
Since it is infeasible to project a company's FCF indefinitely, we use a terminal value to capture the value of the company beyond the projection period. The terminal value typically accounts for a substantial portion of a company's value in a DCF, sometimes three quarters or more. Therefore, it is important that the company's terminal year financial data represents a steady state level of financial performance, as opposed to a cyclical high or low.
What does spreading comps mean?
Spreading comps means calculating relevant multiples from comparable companies and summarizing them for easy analysis and comparison. It can be challenging when a company's data and financial information must be scoured to conduct the necessary research.
Deferred Tax Liability
The company has paid less cash taxes than it actually owes and will have to make it up by paying additional taxes in the future
Treasury Stock
Total value of shares that the company has repurchased from investors, at the value for which they were repurchased, NOT their current value
Retained Earnings
The company's cumulative net income minus any dividends that have been paid to equity investors
How does the process work for companies?
The decision process is similar for companies when evaluating investments and projects, but the decision is more dependent on the company's sources of funding (its investor composition). At the firm level, the WACC represents the average discount rate that a company pays its existing investors (both debt and equity), proportionally weighted by the company's capital structure (i.e. how much total funding is comprised of debt vs. equity?). A company WACC will depend on the company's size, stability, the interest rate it pays on its debt, its tax rate, and how volatile its stock is relative to the rest of the market. Internal Rate of Return (IRR): The IRR of a particular investment or asset is another type of Discount Rate, similar to WACC. It represents the effective compounded interest rate (or rate of return) on an investment. Solving for an IRR provides another way to evaluate investments or projects: does this investment opportunity present the best risk/reward? The IRR of a potential investment is not known in advance; it is an output of a particular investment analysis
Why might two companies with similar growth and profitability have different valuations?
The difference in valuation could reflect some sort of a competitive advantage that isn't represented on the financial statements. Perhaps the more valuable company is a market leader in a key region or owns uniquely valuable intellectual property or enjoys a significantly stronger management track record.
Walk me through the major line items of an income statement
The first line of the Income Statement represents revenues or sales. From that you subtract the cost of goods sold, which leaves gross profit. Subtracting operating expenses, depreciation and amortization from gross profit gives you operating income. From operating income, you subtract interest expense and any other expenses (or add other income) to get pre-tax income. Then subtract tax payments and what's left is net income.
Common Stock and Additional Paid in Capital
The market value of the shares of stock when they were issued by the company (NOT current market value)
Goodwill
The premium paid for a company over it's book value of shareholders' equity. No longer amortizable but is tested annually for impairment.
What is a primary market and what is a secondary market?
The primary market is where an investment bank sells new securities before they go to market. With an IPO or bond issuance, the majority of these buyers are institutional investors who purchase large amounts of the security. The secondary market is the market on which a stock or bond trades after the primary offering—the New York Stock Exchange, American Stock Exchange, or Nasdaq, in the United States. The primary market is the market where a new stock or bond is sold the first time it comes to market. The secondary market is where the security will trade after its initial public offering (NYSE, Nasdaq).
Why do you project out free cash flows for the DCF model?
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.
What are the three main financial statements?
The three main financial statements are the Income Statement, the Balance Sheet, and the Statement of Cash Flows. The Income Statement shows a company's revenues, costs, and expenses, which together yield net income. The Balance Sheet shows a company's assets, liabilities, and equity and is a representation of the company's financial health/position on one particular day in time. The Cash Flow Statement starts with net income from the Income Statement; then it shows adjustments for noncash expenses, non-expense purchases such as capital expenditures, changes in working capital, or debt repayment and issuance to calculate the company's ending cash balance.
How are the three main financial statements connected?
The three main financial statements show separate views, and together they create a whole picture of a company's financial health. For example, the Income Statement closes with a net income figure that appears on the Cash Flow Statement as an addition to cash flow from operations. The Cash Flow Statement's beginning cash balance comes from the Balance Sheet for the prior period. The Cash Flow Statement's ending cash balance becomes the cash asset on the current period's Balance Sheet.
Equity Value
The value of the company to the owners of the business. Equity Value = Enterprise Value - Debt + Cash
Enterprise Value
The value of the entire business, both debt and equity. Can also be substituted as the purchase price. Enterprise Value = Equity Value + Debt - Cash
What are some ways you can value a company?
There are a number of ways I can think of to value a company, and I'm sure you know even more. The simplest is probably market valuation, which is just the public Equity Value of a company based on the public markets. To get the Enterprise Value, you add the net debt on its books, preferred stock, and any minority interest. A few other ways to value a company include comparable company analysis, precedent transactions, discounted cash flow, leveraged buyout valuation, and liquidation valuation. Main methods: Comparable Companies, Market Valuation, Precedent Transactions, DCF Models, and LBO Valuations
What is the link between the balance sheet and the income statement?
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 property plant and equipment will be used to calculate any depreciation expense.
How do you calculate a firm's terminal value?
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 commonly 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 where you choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You 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.
When would a company collect cash from a customer and not show it as revenue? If it isn't revenue what is it?
This typically occurs when a company is paid in advance for future delivery of a good or service, such as a magazine subscription. If a customer pays for delivery of 12 months of magazines in advance, cash from that purchase goes onto the Balance Sheet as cash, but also increases deferred revenue, a liability. As each issue is delivered to the customer over the course of the year, the deferred revenue line item will go down, reducing the company's liability, while a portion of the subscription payment will be recorded as revenue.
All else equal, should the cost of equity be higher for a company with $100M of market cap or a company with $100B of market cap?
Typically, a smaller company is expected to produce greater returns than a large company, meaning the smaller company is more risky and therefore would have a higher cost of equity.
What is valuation and what is it used for?
Valuation is the procedure of calculating the worth of an asset, security, company, etc. This is one of the primary tasks that investment bankers do for their clients. Investment bankers are hired to value a company, often in the context of purchasing another company, selling itself or divesting a division or raising capital. Investment bankers use valuation analyses in pitch books and other presentations to guide clients toward what they should expect in terms of investor interest. Private equity firms, hedge funds, asset managers, and others engage in valuation techniques to determine which assets are undervalued, how much to pay for an asset, etc.
What is WACC and how do you calculate it?
WACC is the acronym for Weighted Average Cost of Capital. It is used as the discount rate in a discounted cash flow analysis to calculate the present value of a company's cash flows and terminal value. It reflects the overall cost of a company's raising new capital, which is also a representation of the riskiness of investing in the company. Mathematically, WACC is the percentage of equity in the capital structure times the cost of equity (calculated by the Capital Assets Pricing Model) plus percentage of debt in the capital structure times one minus the corporate tax rate times the cost of debt—current yield on outstanding debt—plus percentage of preferred stock in the capital structure times the cost of preferred stock if there is any preferred stock outstanding.
When calculating enterprise value, do you use the book value or the market value of equity?
When calculating a company's Enterprise Value, you use the market value of the equity because that represents the true supply-demand value of the company's equity in the open market.
What does it mean if your change in net working capital is negative on the statement of cash flow? Is negative working capital a bad thing for a company?
While negative working capital by pure definition (i.e. current liabilities > current assets) may be indicative of a solvency issue for a company, or an inability to satisfy its obligations, negative working capital is not necessarily a bad thing. If a company is making a concerted effort to stretch out its payment terms with its vendors as much as possible in order to preserve its cash position (which is not included in the calculation of working capital), this would result in negative working capital (since Accounts Payable would likely cause an excess of current liabilities over current assets). The company still has the liquidity to satisfy its obligations, but stretching out the vendor payment provides the company with the most amount of flexibility.
If I have an unknown item that belongs on the balance sheet, how would I be able to tell if it should be an asset or a liability?
Will the line item result in the company receiving cash in the future, or will it result in the company needing to spend cash in the future? If it will result in an increase in cash in the future, then it is an asset. If it will result in a decrease in cash in the future, then it is a liability.
All else equal,should the WACC be higher for a company with $100M of market cap or a company with $100B of market cap?
Without knowing more information about the companies, it is impossible to say. If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. However, if the larger company has a lot of high-interest debt, it could have a higher WACC.
Could a company have a negative book equity value?
Yes, a company could have a negative book Equity Value if the owners are taking out large cash dividends or if the company has been operating for a long time at a net loss, both of which reduce shareholders' equity.
How do you value a private company?
You can value a private company with the same techniques you would use for a public company but with a few differences that make it more difficult. Financial information will likely be harder to find and potentially less complete and less reliable. Second, you can't use a straight market valuation for a company that isn't publicly traded. In addition, a DCF can be problematic because a private company won't have an equity beta to use in the WACC calculation. Finally, if you're doing a comps analysis using publicly traded companies, a 10-15% discount may be required as a 10-15% premium is paid for the public company's relative liquidity.
How can you perform a sanity check on an assumed terminal value?
You could compare the two terminal values implied by the Exit Multiple Method and the Perpetuity Growth Method. If they are materially different, review the implied perpetuity growth rate and implied exit multiples. If the implied perpetuity growth rate, as derived from the Exit Multiple Method is too high or too low, it could be an indicator that the exit multiple assumptions are unrealistic. Similarly, if the implied exit multiple from the Perpetuity Growth Method is not in line with normalized trading multiples for the target and its comp set, the perpetuity growth rate should be revised.
What happens to free cash flow if net working capital increases?
You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa. Remember, if an asset goes up, this is a use of cash; if a liability goes up; it is a source of cash.
