Personal Investment Banking Prep Material

How to Compute Net Income? (Simplified)

Revenue - COGS = Gross Profit; - Operating Expenses = Operating Income; - Interest Expense + Interest Income = Pre-Tax Income; - Taxes = Net Income

Relationship Between Balance Sheet and Cash Flow Statement?

The SCF is greatly affected by the change in Balance Sheet line items. When Assets on the Balance Sheet fall, Cash typically rises. For example: if "Accounts Receivable" (an Operating Current Asset on the Balance Sheet) falls, this is because a customer had paid its bill and hence Cash increases. Simultaneously, the Accounts Receivable line item decreases by the same amount. By contrast, when Liabilities and Equity rise, typically so does Cash. For example, if a company issues Debt (a Liability on the Balance Sheet), Cash will rise by the same amount as the value of the loan taken out. Similarly, if a Company repurchases common shares outstanding, Cash will decrease by the same amount as the value of the Equity being retired in the transaction.

Net Working Capital (or "Working Capital")

The difference between Current Assets and Current Liabilities on the Balance Sheet

Why are changes in Net Working Capital (NWC) subtracted to find unlevered Free Cash Flow (UFCF)?

This is subtracted out, as it represents investments in short-term net operating assets needed to fund Revenue growth. This figure represents the annual change in Current Assets minus Current Liabilities on the Balance Sheet, excluding Cash, Cash-like items, and Debt.

How do we define WACC?

WACC can be a confusing concept: - The technical definition of WACC is the required rate of return for the entire business given the risks to investors of investing in the business. - Meanwhile, the layperson's (and probably analyst's) definition of WACC is the rate used to discount projected Free Cash Flows (FCF) in a DCF model.

What happens to D&A on the Cash Flow Statement?

While Depreciation & Amortization will be reflected as expenses on the Income Statement, they will be added back to net income on the Cash Flow Statement since they are expenses but not actually a use of cash.

Calculating Present Value

http://www.streetofwalls.com/wp-content/uploads/2013/05/PV-formula.png Discount Factor = (1 + discount rate [r])^n

C.V.S. (DCF Analysis)

- Confirm historical financials for accuracy; - Validate key assumptions for projections; - Sensitize variables driving projections to build a valuation range.

Four Main Valuation Methods

- Discounted Cash Flow (DCF) - Comparable Companies ("Public Comps) - Precedent Transactions ("Comparable Transactions") - Leveraged Buyout

Operating Multiple Examples

- EV/Sales: The Enterprise value of the company divided by Sales/Revenue - EV/EBITDA: The Enterprise value of the company divided by EBITDA

Considerations to make when using Terminal Multiple Method

- Make sure the terminal year is a "normalized" year. Exclude years that are influenced cyclical factors or economic factors. - The growth rate that the EBITDA multiple implies needs to be in-line with long-term assumptions. - Be sure to use a "normalized" tax rate in the terminal year. A tax rate can be skewed by previous losses, one-time items, and a change in international mix.

Current Assets (Balance Sheet Line Item)

Assets whose value is expected to translate into Cash in the near future (generally within one year). Cash is a Current Asset. Most Current Assets besides Cash are classified as "Operating Assets," or Assets generated by the company as part of the functioning of its business operations.

Other or Long-term Assets (Balance Sheet Line Item)

Assets whose value will not translate into Cash in the near future (outside of one year). Most Long-term Assets are classified as "Operating Assets," or Assets required by the company as part of the functioning of its business operations.

How Depreciation (and Amortization) Affects the Cash Flow Statement

Because Depreciation is incorporated into Net Income, it must be added back in the SCF, because it is a non-cash expense and therefore does not decrease Cash when it is expensed.

Beta (in Context of DCF Analysis)

Beta is a measure of the relationship between changes in the prices of a company's securities and changes in the value of an overall market benchmark, such as the S&P 500 index.

Book Value

Book Value is the accounting valuation of the equity, and simply equals Total Assets - Total Liabilities. Book Value is often called "liquidation value," because it represents the expected value of a company's assets after they are used to pay off all existing liabilities. This generally assumes, of course, that the company will be ceasing operations.

Determining Cost of Equity for WACC?

CAPM (Capital Asset Pricing Model): K[Sub-E] = r[Sub-f] + Beta[b] * (r[Sub-m] - r[Sub-f]) Where: - K[Sub-E] = Cost of Equity - r[Sub-f] = Risk Free Rate - Beta[b] = risk coefficient - r[Sub-m] = expected market return rate - (r[Sub-m] - r[Sub-f]) = Risk Premium

Why must CapEx be Subtracted to get Free Cash Flow (FCF)?

CapEx must be subtracted out, because it does not appear in the Income Statement, but it is an actual Cash expense that occurred in years prior.

What is included in Cash Flow from Financing?

Cash Flow from Financing Activities (CFF) includes the Cash inflows from shareholders and lenders as well as the outflows of dividends or sales of stock. Items found in this line item will include: Dividends Paid, Cash raised via the sale of Common Stock, Cash proceeds from Borrowings (Debt), and repayment of Debt obligations.

Core Assets

Core assets are assets critical to the operating business, such as Inventory, Fixed Assets, Accounts Receivable, etc., and are used to generate profit for the business.

Why do we take out D&A and then add it back in calculating unlevered Free Cash Flow (UFCF)?

D&A needs to be taken out of EBITDA in order to calculate after-tax Operating Profit (aka EBIT). D&A is an expense for tax purposes. Thus, first we must subtract D&A in this model to calculate taxes, and then add it back after taxes.

What is Discounted Cash Flow (DCF) Analysis?

DCF analysis is a means to value a company done by projecting a company's future Free Cash Flows (FCF) and then using the Net Present Value (NPV) method to value the firm.

Diluted Shares Outstanding

Diluted shares outstanding account for the conversion of options, warrants and convertible preferred stock and prevents a possible underestimate of valuation caused by using basic shares outstanding. Diluted shares outstanding can be obtained from the EPS footnotes of a company's financials, and can also be calculated directly using footnotes to the financials that list management stock options as well as warrants and convertible preferred stock.

How to calculate EBITDA?

EBITDA = EBIT (Operating Profit) + Depreciation + Amortization

Enterprise Value (EV)

Enterprise Value = Net Debt + Minority Interest(s) + Preferred Equity (Stock) + Equity Value - Remember that Minority Interest(s) will include the entire value of the company's subsidiary(-ies), even though the Corporation itself does not own 100% of it/them!

What is Free Cash Flow (FCF; According to Street of Walls)?

Free Cash Flow refers to the cash generated by the operations of a business, irrespective of Net Debt and Minority Interest/Preferred Equity

Market Capitalization

Market Capitalization = Stock Price × Shares Outstanding

What is the Difference Between Book Value and Market Value?

Market Value is almost always larger then Book Value for three primary reasons: 1. Market Value includes future growth expectations while Book Value does not. 2. Market Value includes brand value and company intangible assets. 3. Market Value includes value accrued by the company historically through wise managerial decision making, while Book Value generally does not. In other words, Book Value is a value arrived at for a company by simply following the rules of standard accounting based on a company's past transactions and operations, while Market Value takes into account all information about a company's operations, including future expectations.

Market Value/Equity Value/Market Capitalization

Market value represents the dollar value of a company's issued shares of common equity. It is calculated by multiplying shares outstanding by the current stock price.

How Depreciation (and Amortization) Affects the Balance Sheet

Net Fixed Assets (generally Plant, Property, and Equipment) is reduced by the amount of the Depreciation. This reduces Fixed Assets. It also reduces Net Income and therefore Retained Earnings

Non-Core Assets

Non-core assets are assets not critical to the operating business such as Derivatives, Currencies, Real Estate, Commodities, Stock Options, etc. They are things owned by the business but not central to its money-generating operations.

Operating Multiples v. Equity Multiples

Operating multiples refer to the operating results of the business as a whole, while Equity multiples refer to the value created from the company that is available to equity/shareholders.

Unlevered v. Levered DCF

- An unlevered DCF analysis projects FCF before the impact of Debt and Cash. Therefore, it attempts to value the company as a whole; at the end of the unlevered DCF analysis, Net Debt and other claims can be subtracted out to arrive at the residual (Equity) value of the business. - A levered DCF projects FCF after Interest Expense (Debt) and Interest Income (Cash). A levered DCF therefore attempts to value the Equity portion of a company's capital structure directly.

What are the two types of Shares Outstanding?

- Basic Shares Outstanding - Diluted Shares Outstanding

Cons of LBO Analysis

- Con: Ignoring synergies could result in an underestimated valuation, particularly for a well-fitting strategic buyer. - Con: The valuation obtained is very sensitive to operating assumptions (growth rate, operating working capital assumptions, profit margins, etc.) and financing cost assumptions (and thus LBO valuation is dependent upon the quality of the prevailing financing market conditions).

Cons of Public Comps Analysis

- Con: No two companies are perfectly alike, and as such, their valuations generally should not be identical either. Thus comparable valuation ratios are often an inexact match. Also, for some companies, finding a decent sample of comparables (or any at all!) can be very challenging. As a result in Comparable Companies analysis are always running the risk of "comparing apples to oranges," never being able to find a true comparable, or simply having an insufficient set of comparable valuations from which to draw. - Con: Illiquid comparable stocks that are thinly traded or have a relatively small percentage of floated stock might have a price that does not reflect the fundamental value of that company.

Cons of Precedent Transaction Analysis

- Con: The valuation multiples found in prior transactions typically include control premium and synergy assumptions, which are not public knowledge and are often transaction-specific. These assumptions are not always achievable by other market participants conducting a new transaction. - Con: Precedent Transaction valuations are easily influenced by temporary market conditions, which fluctuate over time. For example, a prior transaction might have been conducted in a more favorable environment for debt or equity issuance.

Three Most Commonly Used Trading Multiples

- EV/Sales: Enterprise Value ÷ Sales (or Revenue) - EV/EBITDA: Enterprise Value ÷ EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization) - Price/Earnings (or P/E): Market Value of Equity ÷ Net Income (alternatively, Stock Price ÷ Earnings Per Share, or EPS)

Using the Perpetuity Method to Compute Terminal Value (for DCF Analysis)

- Identify reasonable long-term FCF growth rates to use in perpetuity, such a GDP or something slightly higher, depending on industry and company dynamics. - Calculate the Terminal Value by taking FCF from the last projection year times (1 + the perpetual growth rate). Divide this figure by the difference between the discount rate (r) and the assumed perpetual growth rate (g). - Terminal Value = FCF[Sub-n] × (1 + g) ÷ (r - g) - FCF[Sub-n] = last projection period Free Cash Flow (Terminal Free Cash Flow) - g = the perpetual growth rate - r = the discount rate, a.k.a. the Weighted Average Cost of Capital (WACC, covered in the next section of this training course)

Equity Multiple Examples

- P/E: Price/Earnings ratio for a company. This is either calculated as Share Price ÷ EPS, or Market Capitalization ÷ Earnings (they are mathematically equivalent). - P/B: Price/Book ratio for a company. This is either calculated as Share Price ÷ Book Value per Share, or Market Capitalization ÷ Shareholders' Equity (they are mathematically equivalent). - P/(Levered) Cash Flow: Price/Cash Flow ratio for a company. This is either calculated as Share Price ÷ Levered Cash Flow per Share, or Market Capitalization ÷ Levered Cash Flow (they are mathematically equivalent).

Key Assumptions and Projections (Comps Analysis)

- Peer Universe: A selection of competitor/similar companies used to determine a benchmark valuation. - EBITDA: Historical & projected Earnings before Interest, Taxes, Depreciation & Amortization. - EPS: Historical & projected Earnings Per Share.

Pros of LBO Analysis

- Pro: An excellent means to establish a "floor" valuation—i.e., an LBO analysis will determine the amount that a financial buyer (sponsor) would be willing to pay for the company, thereby determining the value that a strategic bidder will have to exceed. - Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers usually do not have synergy opportunities).

Pros of Precedent Transaction Analysis

- Pro: Generally regarded as the best valuation tool for control-transferring transactions because the previous transaction has validated the valuation (in other words, a precedent has been established, whereby a previous buyer has actually paid the amount specified in the precedent transaction). - Pro: Assuming that the required transaction data is available/public information, precedent transactions are typically an easy analysis to perform.

Pros of Public Comps Analysis

- Pro: Market efficiency ensures that trading values for comparable companies serve as a reasonably good indicator of value for the company being evaluated, provided that the comparables are chosen wisely. These comparables should reflect industry trends, business risk, market growth, etc. - Pro: Values obtained tend to be most reliable as an indicator of value of the company whenever a non-controlling (minority) investment scenario is being considered.

Steps for Levered DCF

- Project FCF after Interest Expense (to Debt) and Interest Income (from Cash); - Discount FCF using the Cost of Equity (the required rate of return on Equity); - Value obtained is the Equity Value (aka Market Value) of the business.

Steps for Unlevered DCF

- Project FCF for each year, before the impact from Debt and Cash; - Discount FCF using the Weighted Average Cost of Capital (WACC), which is a blend of the required returns on the Debt and Equity components of the capital structure; - Value obtained is the Enterprise Value of the business.

Pros of DCF Analysis

- Theoretically the most sound method if the analyst is confident in his assumptions; - Not significantly influenced by temporary market conditions or non-economic factors; - Especially useful when there is limited or no comparable information

Cons of DCF Analysis

- Valuation obtained is very sensitive to a large number of assumptions/forecasts, and can thus vary over a wide range; - Often very time-intensive relative to some other valuation techniques; - Involves forecasting future performance, which is very difficult

Three Possible Approaches in Running an LBO Analysis on a Target Company

1. Assume a minimum required return for the financial sponsor plus an appropriate debt/equity ratio, and from this impute a company value. 2. Assume a minimum required return for the financial sponsor plus an appropriate company value, and from this impute the required debt/equity ratio. 3. Assume an appropriate debt/equity ratio and company value, and from this compute the investment's expected return. (Investment Bankers usually use the first option)

Four Main Steps of a DCF Valuation (Simplified)

1. Forecast out a company's Free Cash Flows for the next 5-10 years. 2. Calculate the Weighted Average Cost of Capital (WACC). 3. Calculate the firm's Terminal Value, or the future value of the firm assuming a stable long-term growth rate. 4. Discount 5-year Free Cash Flows plus Terminal Value back to Year 0 (today) to derive the Enterprise Value of the company.

Three Main Steps of Precedent Transactions Valuation

1. Identify publicly traded companies with similar characteristics. 2. "Spread" the comps or map-out trading multiples such as EV/Sales, EV/EBITDA, and P/E. 3. Assign industry multiples to company figures to determine valuation ranges.

Three Main Steps of a Comps Valuation (Simplified)

1. Identify publicly-traded companies with characteristics similar to those of the company being valued. 2. "Spread" the Comps—i.e., map-out the trading multiples (EV/Sales, EV/EBITDA, and P/E) for this set of comparable companies. 3. Assign these multiples to company financial results to determine valuation ranges.

Using the Terminal Multiple Method to Compute Terminal Value (for DCF Analysis)

1. Identify reasonable EV/EBITDA multiple range based on historical trading ranges for the company along with comparable companies in the industry. 2. Multiply the EV/EBITDA multiple range by the end of period EBITDA estimate. The result equals the Enterprise Value of the company as of the end of the projection period.

Five Main Steps of an LBO Analysis (Simplified)

1. Make transaction assumptions based on the purchase price, Debt interest rate, etc. 2. Build the Sources & Uses table, where "Sources" lists how the transaction will be financed and "Uses" lists the capital uses—i.e., where the "Sources" money will be spent. 3. Adjust the Balance Sheet for the new Debt and Equity, and other transaction-related adjustments. 4. Project out the three financial statements (usually 5 years) and determine how much Debt is paid down each year. 5. Calculate exit value scenarios based on EBITDA multiples.

DCF Steps (in Greater Detail)

1. Project the company's Free Cash Flows: Typically, a target's FCF is projected out 5 to 10 years in the future. The further these numbers are projected out, the less visibility the forecaster will have (in other words, later projection periods will typically be subject to the most estimation error). 2. Determine the company's Terminal Value: Terminal Value is calculated using one of two methods: the Terminal Multiple Method or the Perpetuity Method. (Note that if the Perpetuity Method is used, the Discount Rate from the following step will be needed.) 3. Determine the company's Discount Rate: Calculate the company's Weighted Average Cost of Capital (WACC) to determine the Discount Rate for all future Cash flows. 4. Use Net Present Value: Discount the projected FCF and Terminal Value back to Year 0 (i.e., back to today) and sum these figures to determine the Enterprise Value of the company. 5. Make Adjustments: If using an Unlevered Free Cash Flow (UFCF) approach, subtracting out net debt and other adjustments from Enterprise Value to derive the Market Value of the company.

Steps to Remember for Executing a Comps Valuation

1. Select a Peer Universe: Pick a group of competitor/similar companies with comparable industries and fundamental characteristics. 2. Calculate Market Capitalization: It is equal to Share price × Number of Shares Outstanding. 3. Calculate Enterprise Value: Market Capitalization + Debt + Preferred Stock + Minority Interest (less common) - Cash. 4. Historical & Projected Financials: Use historical financials from filings and projections from management, sell-side equity analysts, etc. 5. Spread Multiples: Using Market Capitalization, Enterprise Value and historical/projected financials, spread (i.e., calculate) EV/EBITDA and P/E multiples. 6. ƒValue Target Company: Pick the appropriate benchmark valuation multiple for the peer group, and value the target company based on that multiple. Typically, an average or median is used.

Methods for Computing Terminal Value for DCF Analysis

1. Terminal Multiple Method: Also referred to as the Exit Multiple Method, this technique uses a multiple of a financial metric (such as EBITDA) to drive a business's valuation. These multiples can be derived using multiples prevalent among comparable companies. 2. Perpetuity Method: Assumes that the Free Cash Flows of the business grow in perpetuity at a given rate. The Perpetuity Method uses the Gordon Formula: Terminal Value = FCF[sub-n] × (1 + g) ÷ (r - g), where r is the discount rate (discussed in the next section on WACC) and g is the assumed annual growth rate for the company's FCF.

What is a Control Premium (according to Wikipedia)?

A control premium is an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company in order to acquire a controlling share in that company.

Economy of Scale

A proportionate saving in costs gained by an increased level of production. Remember that when projecting COGS for the period of analysis for a DCF analysis, while you may project revenue to increase at a growth rate of, say, 10% year-over-year, this does not exactly mean that COGS will increase 10% year-over-year as well. As Revenue grows, the gross profit margin will increase due to shrinking COGS as a percentage of revenue at the company.

Basic Shares Outstanding

Basic shares outstanding can be obtained from the first page of a company's 10-K or 10-Q.

What is included in Cash Flow from Investing?

Cash Flow from Investing Activities (CFI), which accounts for the cash generated/used by a company's investment in assets, includes the purchases of Fixed (long-term) Assets and maintenance of those Assets (Capital Expenditures), payments made for M&A activities (usually acquisitions of other companies), or Cash generated by Marketable Securities or other non-operating uses of Cash.

Calculating Cash Flow from Operating Activities (Simplified)

Cash Flow from Operations [CFO] = Net Income + Depreciation & Amortization - changes in Operating Working Capital

Why is Cash Subtracted from EV?

Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset. For example, that Cash often could be used to pay down part of the company's debt immediately, which reduces the Enterprise Value of the Company. (Note that the definition of "excess cash" is somewhat loose, as it refers to cash that is not needed to conduct the operations of the business; a simplifying assumption in most cases is to count all Cash as excess Cash.)

Ideal Scenario for Using DCF Analysis?

DCF valuations are typically most useful and reliable in a company with highly stable and predictable cash flows, such as an established Utility company. This is because with a firm such as this, you have to make less assumptions that run the risk of wildly skewing the resulting Enterprise Value. (However, do keep in mind that it is common for DCF to be used in conjunction with public comps and precedent transaction analysis in order to "triangulate" the actual price at which a company should be sold)

How Depreciation (and Amortization) Affects the Income Statement

Depreciation is an expense on the Income Statement (often buried inside displayed line items such as COGS). Increasing Depreciation will increase expenses, thereby decreasing Net Income.

Calculation of Free Cash Flow (FCF)

EBIT(1-T) + Depreciation & Amortization - Change in Net Working Capital (NWC) - Capital Expenditures = Free Cash Flow

Why is EBITDA Important?

EBITDA, one of the most important single items someone will look at in evaluating a company, is a good metric for evaluating a company's profitability. It is sometimes used as a proxy for free cash flow because it will allow you to determine how much cash is available from operations to pay interest, capital expenditures, etc.

Calculating Earnings Per Share (EPS)

EPS equals Net Income (after dividends on preferred stock) divided by the company's Weighted Average Shares Outstanding. Shares Outstanding will typically be found either on the Income Statement, below Net Income, or on the first page of the most recent 10-Q or 10-K. Weighted Average Shares Outstanding can also be calculated as the average of the number of common shares outstanding at the beginning of the period and end of the period (from the company's Balance Sheet).

Earnings Per Share (EPS; General)

EPS is an extremely important metric of a company's value: it represents the profit generated by the company for each shareholder. It will be used extensively when working through valuation techniques such as Comparable Company Analysis and Precedent Transaction Analysis.

Enterprise Value (EV)

Enterprise Value = Operating Value of a Company = Net Value of all the Claims on the Company's Assets (Excluding Excess Cash)

Why is the Cash Flow Statement important?

Generally speaking the CFS will provide a clear view of the short-term viability of a business and its ability to pay its debts. If the business is not generating enough Cash from its operations to service its obligations, it should be evident from its CFS. The bottom line, therefore, is that the CFS reflects a company's liquidity, solvency, and ongoing viability.

The Three Main Financial Statements (Simplified - WSO)

Income Statement: Revenue - COGS - Expenses = Net Income Balance Sheet: Assets = Liabilities + Shareholders' Equity Statement of Cash Flows: Beginning Cash + Cash Flow from Operations [taken as Net Income from Income Statement] + Cash Flow from Investing + Cash Flow from Financing = Ending Cash

Current Liabilities (Balance Sheet Line Item)

Liabilities that a company must meet (via payment) in the near future (generally within one year). Most Current Liabilities (other than Debt) are classified as "Operating Liabilities," or Liabilities generated by the company as part of the functioning of its business operations.

Other or Long-term Liabilities (Balance Sheet Line Item)

Liabilities that do not need to be met (via payment) in the near future (outside of one year). Most Long-term Liabilities are classified as Debt, although some qualify as "Operating Liabilities," or Liabilities generated by the company as part of the functioning of its business operations.

General Purpose of Precedent Transaction Analysis?

Precedent Transaction analyses are designed to attempt to ascertain the difference between the value of the comparable companies acquired in the past before the transaction vs. after the transaction. (In other words, the analyst determines the difference between the market value of the company before the transaction is announced vs. the amount paid for the company in a control-transferring purchase.) This difference represents the premium paid to acquire the controlling interest in the business.

Premium Paid formula (Precedent Transaction Analysis)

Premium Paid [%] = (Acquisition Price ÷ Last Trading Price - 1) × 100 - Where "Last Trading Price" is generally the closing price of the stock the day before the acquisition announcement is made.

When are Price/Book Multiples used?

Price/Book multiples are often used to value financial services companies since their balance sheets are primarily composed of liquid assets that often approximate market values. These multiples can also be used for companies with no earnings, highly variable earnings or companies not expected to continue as a going concern. Unfortunately, for most companies in most industries the Price/Book ratio is highly idiosyncratic, because the Book Value is a function of all past business activities (literally since the company's founding or most recent recapitalization). Therefore Price/Book ratios can swing wildly depending on each company's circumstances.

When are Price/Sales Multiples used?

Price/Sales multiples are typically used for companies with negative, highly volatile, or abnormally high/low EPS. For example, fast-growing companies that have no earnings yet or negative earnings (because they are spending a lot of money to grow or have not yet reached critical mass for sales) may be valued based upon multiples of Sales. A common advantage of using Price/Sales is the general stability and lower accounting distortion afforded by sales numbers. However, sales numbers can be manipulated through revenue recognition practices and growth companies can be given high valuations regardless of having no earnings or cash flow. Additionally, using Sales as a basis for valuation does not take into account the profitability of those Sales figures. Some companies, for example, may be able to turn a large profit margin on incremental sales, while others might have very narrow profit margins.

Components of Net Debt

Short-Term Debt [Debt with less than one year maturity] + Long-Term Debt [Debt with more than one year maturity] + Debt Equivalents (Operating Leases and Pension Shortfalls) - Cash and Cash Equivalents (Cash, Money Market Securities, and Investment Securities)

Stock Price (Definition)

Stock price is the price per common share of stock. It is obtained using any financial software (Thomson, Bloomberg, CapIQ) or reliable Internet pricing service (Yahoo Finance, Google Finance). (Be sure to verify that price is the closing price as of the analysis date.)

Market Risk Premium (for DCF Analysis)

The Market Risk Premium is a measure of the degree to which investors expect to be compensated for owning risky equity securities, rather than risk-free, fixed-rate investments (such as in government bonds). It is calculated using the Capital Asset Pricing Model, which assumes that the ONLY source of risk that demands compensation is overall market risk (as measured by Beta) rather than idiosyncratic (or stock-specific) risk. This model is generally used to determine the Cost of Equity for a company.

Ideal Scenario for Using Public Comps Analysis?

The analysis is best used when a minority (small, or non-controlling) stake in a company is being acquired or a new issuance of equity is being considered (this also does not cause a change in control). In these cases there is no control premium, i.e., there is no value accrued by a change in control, wherein a new entity ends up owning all (or at least the majority) of the voting interests in the business, which allows the owner to control the company cleanly. With no change of control occurring, Comparable Company analysis is usually the most relied-upon technique.

Shareholders' Equity (Balance Sheet Line Item)

The difference between Assets and Liabilities. This represents the value of the company's assets after all outstanding obligations have been paid off. This value accrues directly to the company's owners, or Shareholders.

What is an Analyst's Aim in Running an LBO Analysis?

The goal of the LBO exercise is to determine the value of the target company by assuming an expected return for a private equity investor (typically 20-30%) and a feasible capital structure, and from that, determining how much the company could be sold for (and thereby still allow the financial sponsor to achieve that required return)

What are Leverage and Interest Coverage Ratios and what are they used for?

The leverage ratio is Total Debt/EBITDA and the interest coverage ratios is Total Interest/EBITDA. These ratios are used for comparing companies based on their amount of debt compared with the amount of cash they are generating that can service the interest on their debt.

The Risk Free Rate (used in DCF Analysis)

The risk-free rate is needed in determining the Cost of Equity, and is estimated as a function of the current long-term Treasury Bond rate (assuming that the company's cash flows are being projected in terms of US$). The benchmark rate used is generally that of the 10-year bond.

Why is Cost of Debt multiplied by (1-T) in the WACC equation?

This is to acknowledge the fact that Interest Expense on Debt is (generally) tax-deductible, thereby creating a tax shield which adds value to the company. This is represented in the DCF framework by reducing the Cost of Debt component of WACC, resulting in a lower discount rate for the company's FCF, and therefore a higher valuation for the company.

Ideal Scenario for Using Precedent Transactions Analysis?

Use of precedent transactions analysis is ideal when a majority stake in a company is purchased or divested. This is because when a majority stake is purchased, the buyer assumes control of the acquired entity. By having control over the business, the buyer has more flexibility and more options about how to create value for the business, with less interference from other stakeholders. Therefore, when control is transferred, a control premium is typically paid. (General Note: when a change of control is occurring, Precedent Transaction analysis should typically be one of the valuation methods used.)

Why are valuations reached through Precedent Transactions Analysis typically higher than those reached through other methods?

Valuations reached through Precedent Transactions Analysis are typically higher because they focus on the price paid by the acquiring firm for another company, and this price includes a control premium—the value ascribed to being able to control a business rather than simply own a percentage of the equity in it.

WACC (Mathematical Definition)

WACC = K[Sub-E] + (E/(D+E)) + K(Sub-D) * (1-T) * (D/(D+E)) Where: - K[Sub-E] = Cost of Equity. K[Sub-E] = K[Sub-rf] + Beta[b] × RP, where K[Sub-rf] equals the Risk Free Rate, Beta[b] equals the levered (Equity) Beta for the company, and RP equals the Equity Market Risk Premium. The Beta and Risk Premium are calculated using the Capital Asset Pricing Model (CAPM). In particular, the Risk Premium is the quantity expected market return rate minus the risk free rate - K(Sub-D) = Cost of Debt. This is the weighted average of interest rates paid on the company's debt obligations. Notice that in WACC, Cost of Debt is taken after taxes—i.e., it is multiplied by (1 - T). - E = Market Value of Equity, i.e., Market Capitalization - D = Book Value of the company's Debt. - T = Marginal Tax Rate for the company. This rate can be different from the Effective Tax Rate used to determine Tax Expense based on EBIT.

Components of a 10-Q

o (quarterly) Financial Data (Income Statement; Balance Sheet; Cash Flow Statement) o Management Discussion & Analysis o Other disclosures

What information for a given company can be found in a 10-K?

o Business Overview o Risk Factors o Financial Data (Income Statement; Balance Sheet; Cash Flow Statement) o Management Discussion & Analysis

Most Important Balance Sheet Line Items (from Analyst Perspective)

o Cash (Asset) o Current Assets o Other or Long-term Assets o Current Liabilities o Other or Long-term Liabilities o Shareholders' Equity

C.V.S. (for Public Comps Analysis)

o Confirm relevant peer universe; o Validate key fundamental metrics; o Select appropriate multiple for valuation

Primary Information Found in Financial Statements (Forms 10-K and 10-Q)

o Management Discussion & Analysis o Income Statement o Balance Sheet Statement o Statement of Cash Flows o Notes and Exhibits to Financial Statements

Operating Working Capital

o The difference between Operating Assets and Operating Liabilities on the Balance Sheet o Generally, for the purposes of financial modeling, not as important as Net Working Capital.

Income Statement (Misc.)

o The main purpose of the Income Statement is to show the company in question's level of profitability. o The Income Statement is also referred to as the Profit and Loss Statement (P&L).