M&I 400

What are examples of non-recurring charges we need to add back to a company's EBIT/EBITDA when looking at its financial statements?

-Restructuring Charges -Goodwill Impairment -Asset Write-Downs -Bad Debt Expenses -Legal Expenses -Disaster Expenses -Change in Accounting Procedures Note: To be an "add-back" or "non-recurring" charge for EBITDA/EBIT purposes, it NEEDS TO AFFECT OPERATING INCOME ON THE INCOME STATEMENT. Note: You do add back, Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA/EBIT, but that these are not "non-recurring charges" because all companies have them every year-- these are just non-cash charges.

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based. 2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation). 3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

How do the 3 statements link together?

1. The net income from the Income Statement, after the payment of any dividends, is added to retained earnings on the Balance Sheet. 2. Debt on the Balance Sheet is used to calculate the interest expense on the Income Statement. 3. PP&E will be used to calculate any depreciation expense. 4. The beginning cash on the Cash Flow Statement comes from the previous period's Balance Sheet. 5. Cash from operations on the Cash Flow Statement is affected by the Balance Sheet's numbers for changes in working capital. 6. PP&E is another Balance Sheet item that affects the CF Statement because depreciation is based on the amount of PP&E a company has. 7. Any change due to the purchase or sale of PP&E with affect cash from investing. 8. The CF Statement's ending cash balance becomes the beginning cash balance on the new Balance Sheet.

Normally Goodwill remains constant on the Balance Sheet-- why would it be impaired and what does Goodwill Impairment mean?

1. Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement. 2. It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

When would a company collect cash from a customer and NOT record it as revenue?

3 examples: 1. Web-based subscription software 2. Cell phone carriers that sell annual contracts 3. Magazine publishers that sell subscriptions Companies that agree to services in the future often collect cash upfront to ensure stable revenue-- this makes investors happy as well since they can better predict a company's performance. Per the rules of accounting, you only record revenue when you actually perform the services-- so the company would not record everything as revenue right away.

Walk me through a DCF.

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. 1. You project out a company's financials using assumptions for revenue growth, expenses and Working Capital. 2. Then you get down to Free Cash Flow for each year for about 5 years, which you then discount and sum up to a Net Present Value, based on your discount rate-- usually the Weighted Average Cost of Capital. 3. Once you have the present value of the Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC. Finally, you add the two together to determine the company's Enterprise Value.

What is the difference between the Income Statement and Cash Flow Statement?

A company's sales and expenses are recorded on its Income Statement. The Cash Flow Statement records what cash is actually being used during the reporting period and where it is being spent. Other items included on the CF Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments. Amortization & 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.

Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company because technology is viewed as a "riskier" industry than manufacturing.

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC= Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises

What's the difference between accounts receivable and deferred revenue?

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. Deferred revenue is the opposite-- money that has not yet been recorded as revenue because it was collected for goods or services not yet delivered.

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan much also be paid back now. Walk me through the 3 statements.

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. Income statement- The $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. Cash Flow Statement- Net Income is down by $48 but the write-down is a non-cash expense, so we add it back- and therefore Cash Flow from Operations INCREASES by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback- so Cash Flow from Financing falls by $100. Overall, the Net Change in Cash falls by $68. Balance Sheet- Cash is down by $68 and PP&E is down by $80, so Assets have decreased by $148 alltogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilties & Shareholders' Equity are down by $148 and both sides balance.

Why would you NOT use a DCF for a bank or other financial institution?

Banks use debt differently than other companies and do not re-invest in the business-- they use it to create their "products-- loans-- instead. Also, interest is a critical part of banks' business models and changes in working capital can be much larger than a bank's net income-- so traditional measures of cash flow don't tell you much. For financial institutions, it's more common to use a Dividend Discount Model or Residual Income Model instead of a DCF.

What is Beta?

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 (higher risk, higher reward) and those that are less volatile have a beta less than 1 (lower risk, lower reward).

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expense when cash is actually received or paid out; Accrual accounting recognizes revenue when collection is REASONABLY certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

Walk me through the major items in Shareholders' Equity.

Common items include: (5) -Common Stock: Simply the par value of however much stock the company has issued. -Retained Earnings: How much of the company's Net Income it has "saved up" over time -Additional Paid in Capital: This keep track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering. -Treasury Stock: The dollar amount of shares that the company has bought back. -Accumulated Other Comprehensive Income: This is a "catch-all" that includes other items that don't fit anywhere else, like the effect of foreign currency exchange rates changing.

What are some industries with Beta < 1?

Consumer Staples, Healthcare, Utilities, Tobacco, Petroleum Production

How do you calculate the Cost of Equity?

Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium The risk-free rate represents how much a 10-year or 20-year US Treasury should yield; Beta is calculated based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you pull the Equity Risk Premium from a publication called Ibbotson's. Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is according to its market cap or industry. Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

How can we calculate Cost of Equity WITHOUT using CAPM?

Cost of Equity= (Dividends per Share/Share Price)+Growth Rate of Dividends This is less common than the "standard" formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

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.

What types of sensitivity analyses would we look at in a DCF?

Example sensitivities: 1. Revenue Growth vs. Terminal Multiple 2. EBITDA Margin vs. Terminal Multiple 3. Terminal Multiple vs. Discount Rate 4. Long-Term Growth Rate vs. Discount Rate And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense)

What should you do if you don't believe management's projections for a DCF model?

Few different approaches (3): 1. You can create your own projections. 2. You can modify management's projections downward to make them more conservative. 3. You can show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of numbers.

How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 30-60 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.

How do you know if your DCF is too dependent on future assumptions?

If significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

How do you decide when to capitalize rather than expense a purchase?

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the I.S.). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

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 would not be effective or accurate. In this situation you will most likely want to use a multiples or precedent transactions analysis.

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's much easier to get appropriate data for exit multiples since they are based on Comparable Companies-- picking a long-term growth rate, by contrast, is always a shot in the dark. However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road.

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

In cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account-- at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would "turn into" Cash.

Why is the Income Statement not affected by changes in inventory?

In the case of inventory, the expense is only recorded when the goods associated with it ARE SOLD-- so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

What about a 1% change in revenue vs. a 1% change in the discount rate?

In this case the discount rate is likely to have a bigger impact on the valuation.

We're creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing in Year 4). Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the factory purchase, and what would our new Enterprise Value be?

In this scenario, we would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.

Let's say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

Income Statement- At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement yet. Cash Flow Statement- The additional investment in factories would show up under Cash Flow from Investing as a net REDUCTION in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an ADDITION to Cash Flow, canceling out the investment activity. So the cash number stays the same. Balance Sheet- PP&E goes up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 so both sides balance.

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Income Statement- No changes Cash Flow Statement- Inventory is an asset so that DECREASES your Cash Flow from Operations-- it goes down by $10, as does the Net Change in Cash at the bottom. Balance Sheet- Assets: Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet-- what happens to the 3 statements?

Income Statement- No changes Cash Flow Statement- Inventory is up by $10, so Cash Flow from Operations DECREASES by $10. There are no further changes, so overall Cash is down by $10. Balance Sheet- Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.

Now let's say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Income Statement- Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. Cash Flow Statement- Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPads), which is a net addition to cash flow-- so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. Balance Sheet- Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders' Equity is up by $6 and both sides balance.

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write-down of $100.

Income Statement- The $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. Cash Flow Statement- Net Income is down by $60 but the write-down is a non-cash expense, so we add it back-- and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40. Balance Sheet- Cash is now up by $40 and an asset is down by $100 (not clear which asset). Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders' Equity is also down by $60-- and both sides balance.

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. The formula is: Cost of Equity x (% Equity) + Cost of Debt x (% Debt) x (1-Tax Rate) + Cost of Preferred x (% Preferred) In all cases, the percentages refer to how much of the company's capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates. Cost of Equity= Calculate using CAPM Cost of Debt= Current Yield of Debt Cost of Preferred Stock= Interest Rate on Preferred Stock

What is the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

LIFO= Last-In, First-Out FIFO= First-In, First-Out 2 different ways of recording the value of inventory and the Cost of Goods Sold (COGS) With LIFO, you use the value of the MOST RECENT INVENTORY ADDITIONS for COGS, but with FIFO, you use the value of the OLDEST INVENTORY ADDITIONS for COGS. Example: Let's say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4. You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40*$30=$1200 for the annual revenue. The difference is that in LIFO, you would use the 40 MOST RECENT INVENTORY PURCHASE VALUES- $120+$150+$170+$200- for the Cost of Goods Sold, whereas in FIFO you would use the 40 OLDEST PURCHASE VALUES- $100+$120+$150+$170- for COGS. As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would have lower Pre-Tax Income and Net Income. The ending inventory value would by $100 higher under FIFO and $100 lower under LIFO. In general if inventory is getting more expensive to purchase, LIFO will produce higher value for COGS and lowering end inventory values and vice versa if inventory is getting cheaper to purchase.

Let's say that you use Levered Free Cash Flow rather than Unlevered FCF in your DCF-- what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

What's the relationship between debt and Cost of Equity?

More debt means the company is more risky, so the company's Levered Beta will be higher-- all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

What is Net Working Capital?

Net Working Capital= Current Assets - Current Liabilities Net Working Capital 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. An increase in net working capital is a use of cash. Ex) If you increase inventory, it is not a cost on the Income Statement, but is still a use of cash due which needs to be accounted for on the CF statement. A decrease in net working capital is a source of cash. Ex) increasing accounts payable, reducing inventory

How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Comparable Companies and pick the median of the set, or something close to it. As with almost anything in finance, you aways show a range of exit multiples and what Terminal Value looks like over that range rather than picking one specific number.

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

Normally you make very simple assumptions and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples: -Accounts Receivable: % of revenue -Deferred Revenues: % of revenue -Accounts Payable: % of COGS -Accrued Expenses: % of operating expenses or SG&A Then you either carry the same percentages across in future years or assume slight changes depending on the company.

What's the appropriate growth rate to use when calculating the Terminal Value?

Normally you use the country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed companies are growing at less than 5% per year.

What do you usually use for the discount rate?

Normally, you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you've set up the DCF.

What does negative Working Capital mean? Is that a bad sign?

Not necessarily. It depends on the type of company and the specific situation-- here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront- so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers DON'T pay quickly and upfront and the company is carrying a high debt balance).

If I'm working with a public company in a DCF, how do I calculate its per-share value?

Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock, and noncontrolling interest (and any other debt-like items) to get to Equity Value. Then, you need to use a circular calculation that takes into account the basic shares outstanding, options, warrants, convertibles and other dilutive securities. It's circular because the dilution from these depends on the per-share price-- but the per-share price depends on the number of shares outstanding, which depends on the per-share price. To resolve this, you need to enable iterative calculations in Excel so that it can cycle through to find an approximate per-share price.

What's the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement. Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt. A lease is a capital lease if any one of the following 4 conditions is true: 1. If there's a transfer of ownership at the end of the term. 2. If there's an option to purchase the asset at a bargain price at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset's fair market value.

Walk me through what flows into Retained Earnings.

Retained Earnings= Old Retained Earnings Balance + Net Income - Dividend Issued

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Several possibilities: 1. The company is spending too much on Capital Expenditures-- these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch"-- and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company. Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges-- and all of these could end up bankrupting the company.

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1-Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.

What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets/Liabilities and CapEx?

Take Cash Flow from Operations and 1. subtract CapEx and 2. mandatory debt repayments-- that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Under what circumstances would Goodwill increase?

Technically, Goodwill can increase if the company re-assesses its value and finds that it is worth more, but this is RARE. 2 scenarios: 1. The company gets acquired or bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price in an acquisition. 2. The company acquires another company and pays more than what its assets are worth-- this is then reflected in the Goodwill number.

Why do you use 5 or 10 years for DCF projections?

That's usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

What is the link between the Balance Sheet and the Cash Flow Statement?

(4) 1. Beginning cash on the CF Statement comes from the previous period's B.S. 2. Cash from Operations on the CF Statement is affected by the B.S.'s numbers for change in net working capital. 3. PP&E is another B.S. item that affects the CF Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of PP&E will affect cash from investing. 4. The CF Statement's ending cash balance becomes the beginning cash balance on the new B.S.

How do Net Operating Losses (NOLs) affect a company's 3 statements?

The "quick and dirty" way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same). The way you SHOULD do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs and then look at what you would pay in taxes WITHOUT the NOLs Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet. This method reflects the fact that you're saving on cash flow-- since the DTL, a liability is rising-- but correctly separates the NOL impact into book vs. cash taxes.

Walk me through the 3 financial statements.

The 3 major financial statements are the 1. Income Statement 2. Balance Sheet 3. Cash Flow Statement The Income Statement gives the company's revenue and expenses, and goes down to Net Income. The Balance Sheet shows the company's Assets- it's resources- such as Cash, Inventory and PP&E, as well as its Liabilities- such as Debt and Accounts Payable- and Shareholders' Equity. Assets= Liabilities+Shareholders' Equity The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash.

What is the Capital Assets Pricing Model?

The Capital Assets Pricing Model, referred to as 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 (usually the yield on a 10-year U.S. government bond) + a company's beta (a measure of the stock's volatility in relation to the stock market) x market risk premium.

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company-- which statement would I use and why?

The Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. Cash is the #1 thing you care about when analyzing the overall financial health of any business. 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.

Let's say I could only look at 2 statements to assess a company's prospects-- which 2 would I use and why?

The Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those.

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

The mechanics are the same as a DCF, but we use dividends rather than free cash flows: (7 steps) 1. Project out the company's earnings, down to earnings per share (EPS). 2. Assume a dividend payout ratio-- what percentage of the EPS actually gets paid out to shareholders in the form of dividends-- based on what the firm has done historically and how much regulatory capital it needs. 3. Use this to calculate dividends over the next 5-10 years. 4. Do a check to make sure that THE FIRM STILL MEETS ITS TARGET TIER 1 CAPITAL AND OTHER CAPITAL RATIOS-- if not, reduce dividends. 5. Discount the dividend in each year to its present value based on COST OF EQUITY-- NOT WACC-- and then sum these up. 6. Calculate terminal value based on P/BV and Book Value in the final year, and then discount this to its present value based on COST OF EQUITY. 7. Sum the present value of the terminal value and the present values of the dividends to get the company's net present per-share value.

What's the flaw with basing terminal multiples on what public company comparables are trading at?

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range. This method is particularly problematic with cyclical industries.

Two companies are exactly the same, but one has debt and one does not-- which one will have the higher WACC?

The one without debt will generally have a higher WACC because debt is "less expensive" than equity. Why? 1. Interest on debt is tax-deductible. 2. Debt is senior to equity in a company's capital structure-- debt holders would be paid first in a liquidation or bankruptcy scenario. 3.Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will. Theoretically if the company had a lot of debt, the Cost of Debt might increase and become greater than the Cost of Equity but that is extremely rare-- the company without debt has a higher WACC in 99% of all cases.

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 discount period numbers would you use for the mid-year convention if I have a stub period -- e.g. Q4 of Year 1-- in my DCF?

The rule is that you divide the stub discount period by 2, and then simply subtract 0.5 from the "normal" discount periods for the future years..125-- .75-- 1.75-- 2.75...

How should you project Depreciation and Capital Expenditures?

The simple way: project each one as a % of revenue or previous PP&E balance. The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset's useful life, and then assumes capital expenditures based on what the company has invested historically.

Walk me through how you create a revenue model for a company.

There are 2 ways you could do this: a bottoms-up build and a tops-down build. Bottoms-Up: Start with individual products/customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together. Tops-Down: Start with "big-picture" metrics like overall market size, then estimate the company's market share and how that will change in coming years, and multiple to get their revenue. Of these two methods, bottoms-up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

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

There are many links between the Balance Sheet and the Income Statement. (3) 1. The major link is that any net income from the I.S., after the payment of any dividends, is added to retained earnings. 2. In addition, debt on the B.S. is used to calculate the interest expense on the I.S. 3. PP&E will be used to calculate any depreciation expense.

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earning?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.

What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for cash purposes vs. what they can deduct for book tax purposes. Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven't expensed them on the Income Statement yet. They're most common with asset write-ups and write-downs in M&A deals-- an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset.

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you're undercounting D&A.

What about WACC-- will it be higher for a $5 billion or $500 million (of market cap) company?

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company. This is because the larger company should be less risky and therefore have a lower WACC. If the capital structure is NOT the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are. If the larger company has a lot of high-interest debt, it could have a higher WACC.

Walk me through a $100 write-down of debt-- as in OWED debt, a liability-- on a company's balance sheet and how it affects the 3 statements.

This is counter-intuitive. When a LIABILITY IS WRITTEN DOWN you record it as a gain on the Income Statement (with an asset write-down, it's a loss)-- so Pre-Tax Income goes UP by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. Cash Flow Statement- Net Income is up by $60, but we need to SUBTRACT that debt write-down-- so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. Balance Sheet- Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60-- so Liabilities & Shareholders' Equity is down by $40 and it balances.

How do you calculate WACC for a private company?

This is problematic because private companies don't have market caps or Betas. In this case, you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

What is the Statement of Shareholders' Equity and why do we use it?

This statement shows the major items that comprise the Shareholders' Equity, and how we arrive at each of them using the numbers elsewhere in the statement. You don't use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.

Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should incur an expense. Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company's internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Trick question. You don't account for this AT ALL in an Unlevered DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement-- but we only take into account EBIT x (1-Tax Rate), and then a few items from Cash Flow from Operations, and then subtract Capital Expenditures to get to Unlevered Free Cash Flow. If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off-- the mandatory debt repayments would also reduce Free Cash Flow.

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company-- but what about dividends? Shouldn't we factor dividend yield into the formula?

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole-- and those returns include dividends.

When you're calculating WACC, let's say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?

Trick question. If the convertible debt is IN-THE-MONEY then you do not count it as debt but instead assume that it contributes to dilution, so the company's Equity Value is higher. If it's out-of-the-money then you count it as debt and use the interest rate on the convertible for Cost of Debt.

Let's say we're trying to create these models but don't have enough information or the company doesn't tell us enough in its filings-- what do we do?

Use estimates. For the revenue if you don't have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years. For the expenses, if you don't have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

If cash collected is not recorded as revenue, what happens to it?

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases.

Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

What type of "bailout" is this-- debt? equity? a combination? The most common scenario here is an equity investment from the government. Income Statement- No Changes Cash Flow Statement- Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. Balance Sheet- Cash is up by $100 so Assets are up by $100. On the other side, Shareholders' Equity would go up by $100 to make it balance.

Why do you have to un-lever and re-lever Beta?

When you look up the Betas on Bloomberg (or whatever source you're using) they will be levered to reflect the debt already assumed by each company. But each company's capital structure is different and we want to look at HOW "RISKY' A COMPANY IS REGARDLESS OF WHAT % DEBT OR EQUITY IT HAS. To get that, we need to un-lever Beta each time. But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, TAKING INTO ACCOUNT ITS CAPITAL STRUCTURE THIS TIME.

How does the terminal value calculation change when we use the mid-year convention?

When you're discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or Gordon Growth Method: -Multiples Method: You add 0.5 to the final year discount number to reflect the fact that you're assuming the company gets sold at the END of the year. -Gordon Growth Method: You use the final year discount number as is because you're assuming the cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end.

What are some industries with Beta > 1?

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

What is Working Capital? How is it used?

Working Capital= Current Assets-Current Liabilities If it's positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign tells you whether or now the company is "sound". Bankers look at OPERATING WORKING CAPITAL more commonly in models, and that is defined as (Current Assets -Cash & Cash Equivalents) - (Current Liabilities-Debt). The point of Operating Working Capital is to EXCLUDE ITEMS that relate to a company's financing activities- cash and debt- from the calculation.

Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

After a year has passed, Apple must pay interest expense and must record the depreciation. Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether. Assuming a tax rate of 40%, Net Income would fall by $12. Cash Flow Statement- Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the result is that Cash Flow from Operations is down by $2. That's the only change on the Cash Flow Statement, so overall Cash is down by $2. Balance Sheet- Under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders' Equity is also down by $12 and both sides balance. Remember, the debt number under Liabilities does not change since we've assumed none of the debt is actually paid back.

If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is a non-cash expense, it is TAX-DEDUCTIBLE. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

What happens when Accrued Compensation goes up by $10?

Assuming that accrued compensation is now being recognized as an expense, Income Statement- OPERATING EXPENSES goes up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). Cash Flow Statement- Net Income goes down by $6, Accrued Compensation will INCREASE cash flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. Balance Sheet- Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance. LIABILITIES ARE POSITIVE.

Can you give examples of major line items on each of the financial statements?

Income Statement: 1. Revenue 2. COGS (cost of goods sold) 3. Gross Margin 4. Operating Expenses (R&D, SG&A) 5. Operating Income 6. Other Income and Expense 7. Pretax Income 8. Provision for Income Taxes 9. Net Income 10. Earnings per common share Balance Sheet: Assets- 1. Cash and cash equivalents 2. Short-term investments 3. Accounts receivable 4. Inventories 5. Deferred tax asset 1. PP&E 2. Goodwill 3. Acquired intangible assets (patents & copyrights) Liabilities & Shareholders' Equity- 1. Accounts payable 2. Accrued expenses 3. Non-current liabilities (debt, bonds issued, mortgage, loans) 1. Common stock 2. Retained earnings Cash Flow Statement: Cash and Cash Equivalents, beginning of the year (from B.S.) Operating Activities- Net income Non-cash expense 1. D&A (A) 2. Stock-based compensation expense 3. Provision for deferred income taxes 4. Loss on disposition of PP&E Changes in operating assets and liabilities- 1. Accounts Receivable 2. Inventories 3. Other current assets 4. Other assets 5. Accounts payable 6. Deferred revenue 7. Other liabilities CASH FLOW FROM OPERATIONS Investing Activities (CAPITAL EXPENDITURES)- 1. Purchases of short-term investments 2. Proceeds from maturities of short-term investments 3. Proceeds from sale of short-term investments 4. Purchases of long-term investments 5. Payments made in connection with business acquisitions 6. Payment for acquisition of PP&E 7. Payment for acquisition of intangible assets CASH FLOW FROM INVESTING Financing Activities (SALE/PURCHASE OF SECURITIES) - 1. Proceeds from issuance of common stock (DIVIDENDS ISSUED) CASH FLOW FROM FINANCING

Walk me through how Depreciation going up by $10 would affect the statements.

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There is no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: PP&E goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.

Where does Depreciation usually show up on the Income Statement?

It could be in a (1) separate line item, or it could be embedded in (2) COGS or (3) Operating Expenses-- every company does it differently. The end result is always the same: Depreciation always reduces PRE-TAX INCOME.

Which has a greater impact on a company's DCF evaluation-- a 10% change in revenue or a 1% change in the discount rate?

It depends, but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn't affect only the current year's revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Should Cost of Equity be higher for $5 billion or $500 million market cap company?

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be "more risky"). Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company. 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.

Which method of calculating Terminal Value will give you a higher valuation?

It's hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more VARIABLE than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common to see this in 2 scenarios: 1. Leveraged Buyouts with dividend recapitalizations-- it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. Done with the intention of paying a large cash dividend to shareholders. The company's liabilities are increased and equity is reduced. This strategy is an intentional antitakeover measure used to make the corporation less attractive to potential acquirers. 2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders' Equity. If a company has had negative net income for a long time, it would have a negative retained earnings balance, which would lead to negative shareholders equity. It doesn't "mean" anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario). Shareholders' equity never turns negative IMMEDIATELY AFTER an LBO-- it would only happen following a dividend recap or continued net losses.

How do you calculate the Terminal Value?

You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or FCF (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 x (1+Growth Rate)/(Discount Rate-Growth Rate).

How do you get to Beta in the Cost of Equity calculation?

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation. Un-Levered Beta= Levered Beta/ (1+((1-Tax Rate) x (Total Debt/Equity))) Levered Beta= Un-levered Beta x (1+((1-Tax Rate) x (Total Debt/Equity)))

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

You subtract the change in Net Working Capital when you calculate FCF, so if Net Working Capital increases, your FCF decreases.

Explain why we would use the mid-year convention in a DCF.

You use it to represent the fact that a company's cash flow does not come 100% at the end of each year-- instead, it comes in evenly throughout each year.

If I use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with Debt or Preferred Stock in this case-- we're calculating Equity Value, not Enterprise Value.