Accounting

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

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.

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

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises If you're calculating it, take the balance from last year, add this year's stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.

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.

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

First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: No changes to the Income Statement. On the 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. On the 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.

How would you calculate an equity beta?

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

If you read that a certain mutual fund achieved 50% returns last year, would you invest in it?

Past performance is not an indication of future results. This is the disclaimer you hear at the end of nearly every commercial that presents a fund's past performance as a selling point. The reason for this is because a specific investment type could perform remarkably well one year and then significantly underperform in the following year. To make an investment decision you need to research more in depth into the fund's holdings, management, fee structure, etc., because past performance—especially a single year—is not an indicator of future results. A mutual fund full of mortgage backed securities could have been up 50% a few years ago and then been down 90% the year after the market for MBSs collapsed.

If you bought a Stock X a year ago for $10, sold it today for $15, and received $5 in dividends over the year, what would your overall return be?

Return on a stock is its sale price plus dividends paid minus its purchase price, as a percentage of the purchase price. For stock X, that would be 15 plus 5 minus 10, which is 10, or 100% return on my investment.

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.

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.

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.

What is an Initial Public Offering (IPO)?

An IPO is the first public sale of stock in a previously private company. This is known as "going public." The IPO process is incredibly complex, and investment banks charge high fees to lead companies through it. Companies go public for a number of reasons—raising capital, cashing out for the original owners, and investor and employee compensation. Some negatives against "going public" include sharing future profits with public investors, loss of confidentiality, loss of control, IPO fees to investment banks, and legal liabilities. Some recent IPOs include Groupon and Zynga, and the most anticipated IPO of 2012 was Facebook, which issued its IPO at around a $100 billion valuation and was led by Morgan Stanley. 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.

What kind of an investment would have a negative beta?

An investment with a negative beta is one that moves opposite to the stock market as a whole. In other words, if the stock market moves up, the value of the negative beta investment would decline and vice versa. Gold is an investment that has a negative beta. When the stock market goes up, the price of gold typically declines as people flee from the "safe haven" of gold. The opposite happens when the market goes down, indicating a negative correlation.

How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?

A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT (1-T) by $10(1-T). Assuming a 40% tax rate, it drops EBIT (1-T) by $6, but you must add back the $10 depreciation in the calculation of Free Cash Flow. Therefore your FCF increases by $4 and your valuation will increase by the present value of that $4, (the equation for PV is below).

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

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

Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction- value companies.

How would you calculate the discount rate for an all-equity firm?

If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the discount rate.

How would you value a company with no revenue?

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

What is insider trading and why is it illegal?

Insider trading is buying or selling public securities based on information that is not available to the general public. Examples include an investment banker buying or selling the stock of a company before an M&A deal is announced or a CEO buying or selling his or her company's stock prior to making a major company announcement. The biggest insider trading scandal in the recent past involved Raj Rajaratnam, who was convicted and sentenced to 11 years in prison. He was the founder and former manager of the hedge fund, the Galleon Group. Even Martha Stewart was convicted of insider trading! Insider trading is buying or selling stock based on information that is not publicly available. For example, if a CEO of a pharmaceutical company knows that one of his or her company's drugs is going to be pulled from the shelves by the FDA, that CEO cannot sell his or her stock until the information has been released to the public.

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

Intuitively, you can think of working capital as the net dollars tied up to run the business. As more cash is tied up (either in accounts receivable, inventory, etc.), free cash flow will be reduced. Remember, if an asset goes up, this is a use of cash; if a liability goes up; it is a source of cash. 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.

What does it mean to short a stock?

Short selling is selling a stock that you don't actually own. Investors that short-sell a stock believe they will be able to purchase that stock at a lower price in the future. Typically, a short-seller will borrow the stock from another investor, and then sell it, promising to return the stock to the lender at a later date. Brokerage firms are able to facilitate this borrowing; however, not all stocks can be shorted. "Naked" short selling occurs when an investor sells the stock without actually having borrowed any. Short selling a stock is the opposite of going long in a stock. Usually an investor buys a stock believing it will sell for a higher price in the future. When short-selling, investors stock they don't actually own, in the belief that they will be able to purchase it for a lower price in the future.

How would you calculate the WACC of a private company?

Since a private company has no market capitalization and no beta, you would most likely use the WACC for a comparable public company.

What are some differences between tax accounting and GAAP accounting?

Since tax accounting is used to calculate just what income tax a company owes in a year, it is focused on just the revenues and expenses for a given year and is cash based. GAAP accounting is more concerned with tracking a company long term, so it tracks assets and liabilities as well and is accrual based. Another difference includes different the depreciation schedules: accelerated for tax accounting and straight line for GAAP accounting.

What is the difference between technical analysis and fundamental analysis?

Technical analysis is the process of picking stocks based on historical trends and stock movements. Fundamental analysis is examining a company's fundamentals, financial statements, industry, etc., and then picking stocks that are "undervalued."

If a company's stock has gone up 20% in the last 12 months, is the company's stock in fact doing well?

The answer to that question depends on a number of factors including the company's beta and the market's performance. If the stock's beta is 1 (meaning it should be as volatile as the market and therefore produce market returns) and the market was up 30% over the past 12 months, then the stock is doing relatively poorly.

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.

From the three main financial statements, if you had to choose two to analyze a company, which would you choose and why?

The key to this question is understanding that if you have the beginning and ending Balance Sheets for the period, along with the ending Income Statement, you can generate a Cash Flow Statement for yourself. So the answer to this question is easy: you want the beginning and ending Balance Sheets and the Income Statement for the same period. If I had to choose two financial statements, I would choose the Balance Sheet and the Income Statement. As long as I had the Balance Sheets from the beginning and end of the period, as well as the end of period Income Statement, I would be able to generate a Cash Flow Statement.

What is FCF?

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.

Company XYZ released increased quarterly earnings yesterday, but their stock price still dropped. Why?

There are two main reasons that this could occur. First, the entire market or the industry to which XYZ belongs could have been down on the day, which had more of an impact than the company's positive earnings. More likely, however, is that the increased earnings figures they reported were not as high as the Wall Street analysts' estimates.

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 tax 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. The most common way they occur is 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 (see the Merger Model section for more on this).

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

This statement shows everything we went through above - the major items that comprise 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.

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

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 (see: eBay/Skype). It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

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

ncome 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 iPods), 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. On the 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.

Who is a more senior creditor, a bondholder or stockholder?

A bondholder is always senior to a stockholder. In the event of bankruptcy/liquidation, the bondholder will be repaid first. Additionally, interest payments are paid to bondholders before equity holders receive any profits in the form of dividends.

How can a company raise its stock price?

A company can repurchase stock, which lowers the number of shares outstanding and therefore increases the value per share. It can improve operations to produce higher earnings, causing its EPS to be higher than anticipated by industry analysts, which will send a positive signal to the market. It can announce a change to its organizational structure such as cost-cutting or consolidation, which would lead to increased earnings. It could announce the institution of a dividend policy or an increase in an existing dividend. It can announce an accretive merger or an acquisition that will increase earnings per share. Any positive news about the company can potentially raise the stock price. If the company repurchases stock, it lowers the shares outstanding and raises the EPS, which would raise the stock price. A repurchase is also seen as a positive signal in the market. A company could announce operational efficiencies or other cost-cuts, or a change to its organizational structure such as consolidations. It could announce an accretive merger or acquisition that would increase earnings per share. Any of these occurrences would most likely raise the company's stock price.

Walk me through the IPO process for a Company that is being taken public.

When valuing a company for an IPO, the investment bank leading the deal will price the company primarily on publicly traded comparable companies. Once the banking team has identified a strong comps set, they will perform a comparable companies analysis.

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

The distribution of a dividend signals that a company is healthy and profitable, thus attracting more investors, potentially driving up the company's stock price.

When should a company buy back stock?

A company should buy back its own stock if it believes the stock is undervalued, when it has extra cash, if it believes it can make money by investing in itself, or if it wants to increase its stock price by increasing its EPS by reducing shares outstanding or sending a positive signal to the market.

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

A company's sales and expenses are recorded on its Income Statement. The Statement of Cash Flows records what cash is actually being 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 dividend discount model?

A dividend discount model is much like a DCF, but it will use dividends rather than free cash flow. Rather than projecting out free cash flow, you project out the earnings per share for the business. Assume that a certain percentage of EPS is being paid out as a dividend based on the historical dividend policy and how much cash the company wants to retain on its Balance Sheet. Project out the dividends for the next 5-10 years just as you would with free cash flow, and then discount them back and sum them like in a DCF, but rather than using WACC, you are going to use the cost of equity for the firm. For the terminal value, you will want to use an equity valuation multiple like P/E, and then discount that back to year 0, just as you would do in a DCF. The sum of the PV's of all the dividends is the per share value of the company.

When building a model, what is the most common way to project items like accounts receivable, accounts payable, inventory, depreciation, and capital expenditures?

Accounts receivable is normally projected as a percentage of revenues or using a ratio like Days Sales Outstanding. Accounts payable is normally projected as a percentage of cost of goods sold or using a ratio like Days Payable Outstanding. Inventory is normally projected as a percentage of cost of goods sold or using a ratio like Inventory Days. Depreciation can be calculated very simply using a percentage of the prior years' PP&E or can be calculated at the individual asset level using different schedules, useful lives, etc. Capex is normally projected as a percentage of revenues, or from company guidance you will have a relatively good idea of what capex requirements are going forward. How/why do you lever/unlever Beta? The levered beta will be the beta you get from a website like Yahoo finance. By unlevering the beta, you remove the financial effects of debt in the capital structure. This unlevered beta shows you the risk of a firm's equity compared to the market. Comparing unlevered betas allows investors to see how much risk they will be taking by investing in a company's equity (i.e. buying stock in the public market). When you have a company that doesn't have a beta, Company A, you can find comparable Company B, take its levered beta, unlever it, and then relever it using Company A's capital structure to come up with their beta.

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

Cash based accounting: This form of accounting recognizes revenues and expenses as of the time cash is actually collected or disbursed. For example, if a company receives a payment on a credit card, it wouldn't be recorded as revenue until the credit card company actually deposits the money into the company's bank account. Accrual accounting: With accrual accounting, as soon as the company makes a payment or sale and believes it will pay for or be paid for a good or service, it will recognize the expense or revenue. Using the prior example, if the company is using accrual accounting, they will book the revenue as soon as they are paid, and it will show up as an accounts receivable on the Balance Sheet until the money is actually deposited into their account, at which time the accounts receivable balance will go down and the cash balance will go up. With cash-based accounting, a company won't recognize expenses or revenues until the cash is actually disbursed or collected. With accrual accounting, a company will recognize expenses and revenues when it has entered into a transaction or agreement that will require it to pay or be paid, even if cash won't change hands until sometime in the future. Most companies use accrual accounting since credit cards are so prevalent.

What is correlation?

Correlation is how two stocks move in relation to each other. If two stocks have a strong positive correlation, they move up or down together. If two stocks have a strong negative correlation, when one moves up, the other should move down, and vice versa. Correlation ranges between -1 and 1. Correlation is the way that two investments move in relation to one another. If two investments have a strong positive correlation, they will have a correlation near 1 and when one goes up or down, the other will do the same. When you have two with a strong negative correlation, they will have a correlation near -1 and when one investment moves up in value, the other should move down.

What is diversification?

Diversification is mixing a wide variety of investments in your portfolio in search of a better risk/return ratio than putting all your capital into only one or a few investments. To diversify your portfolio you may want to pick investments that have a low correlation. When economic conditions push one investment to have a good period, the other may be having its down period and vice versa. Systematic risk is the risk that affects the entire market while unsystematic risk affects only specific industries. If properly diversified, investors can essentially eliminate all unsystematic risk from their portfolios. Diversification is creating a portfolio of different types of investments. It means investing in stocks, bonds, alternative investments, etc. It also means investing across different industries. If investors are properly diversified, they can essentially eliminate all unsystematic risk from their portfolios, meaning that they can limit the risk associated with individual stocks so that their portfolios will be affected only by factors affecting the entire market.

What is goodwill and how does it affect net income?

Goodwill is a line item in the assets section of a company's Balance Sheet. Goodwill can arise from an acquisition where the price paid for the firm being acquired is higher than the tangible assets being purchased. The difference between the price paid and the firm's book value would be accounted for in the "goodwill" section of the Balance Sheet. Goodwill represents intangible assets such as brand name, customer relationships, intellectual property, etc. If something happens that impairs the goodwill of the firm (such as a patent running out, an event hurting the brand, etc.), goodwill must be "written down" as an expense on the Income Statement. Impairment of goodwill affects net income in much the same way depreciation does. It is accounted for as an expense, just like depreciation is an expense, even though the company is not physically paying out cash to cover this expense. Goodwill is an intangible asset included on a company's Balance Sheet. Goodwill may include things like intellectual property rights, brand name, or customer relations. Goodwill is acquired when purchasing a firm if the acquirer pays more than the book value of its assets. When something occurs to diminish the value of the intangible assets, goodwill must be "written down" in a process much like that for depreciation. Goodwill is subtracted as a non-cash expense and therefore reduces net income.

Why do some stocks rise so much on the first day of trading after their IPO and others don't? How is that "money left on the table"?

Groupon is great example of a stock that gained over 50% during its first day of trading in 2011. The stock had an IPO price of $20 per share and rose to over $31 per share. As of October 2012, the stock has traded down below $5 per share. Money left on the table means the company could have completed the offering at a higher price, and that difference in valuation goes to the initial investors in the stock, rather than to the company raising the money. This means the company could have sold the same stock in its IPO at a higher price than it actually did. This happened a lot during the dot-com boom. Companies' stock would skyrocket on the first day of trading due to the huge hype over the stock.

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 Income Statement). 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.

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

If this was the only information you were given, you could use multiples or a precedent transactions analysis. For more information about these types of valuation techniques, refer to the "how would you value a company" question above. Since you have no information about historical or projected performance, and no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm's industry, you could identify a group of comparable companies and do a multiples analysis using the ratios from those most relevant to the company being valued.

What would be the effect of using levered free cash flow rather than unlevered free cash flow in your DCF model?

If you were to use the levered free cash flow in your DCF, you would end up with the Equity Value of the company rather than the Enterprise Value since the cash flows you are finding the present value for are after the debt investors had been repaid, therefore indicating how much cash would be available to equity investors, not to all investors.

Where does Depreciation usually show up on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

If you add a risky stock to a portfolio, what happens to the overall risk of your portfolio?

It depends on the correlation between the new investment and the rest of the portfolio. It could lower the overall risk of the portfolio if the new stock has a negative correlation compared to the rest of the portfolio.

A stock is trading at $5 and another stock is trading at $50. Which has greater growth potential?

It depends. The stock with the higher growth potential is most likely the stock with the lower market cap, so if the $5 stock has 1 billion shares outstanding and the $50 stock has 10,000 shares outstanding, the $50 stock would most likely have higher growth potential.

What is the difference between LIFO and FIFO?

LIFO and FIFO are different ways of keeping track of inventory value and cost of goods sold. LIFO (Last In First Out): With the LIFO accounting policy, a company assigns the value of the most recently purchased/produced goods to the first sale. For example, if a company built 5 widgets for $5 and then built 5 widgets for $10, the value of their inventory would be $75. The first 5 widgets they sell will have a $10 COGS and will reduce inventory by $10 each, and the last 5 widgets will have a $5 COGS and will reduce inventory by $5 each. FIFO (First in First Out): With the FIFO accounting policy, a company assigns to the first sale the value of goods built or purchased first. For example, if a company built 5 widgets for $5 and then built 5 widgets for $10, the value of their inventory would be $75. The first 5 widgets they sell will have a $5 COGS and will reduce inventory by $5 each, and the last 5 widgets will have a $10 COGS and will reduce inventory by $10 each. LIFO and FIFO are different methods of dealing with inventory and COGS in a company's accounting policy. With LIFO, the last inventory produced or purchased will be the first to be recognized when goods are sold. With FIFO, the first inventory produced or purchased will be the first recognized when goods are sold. In an inflationary environment, the cost of goods includes the less expensive items while ending inventory includes the more expensive items. This means that the net income and ending inventory amounts are higher under the FIFO method. However, in a deflationary environment, the FIFO method is likely to generate lower net income.

What is liquidity?

Liquidity is how freely an asset or security can be bought and sold on the open markets. o Money market accounts, publicly traded large cap stocks and bonds, ETF's, and open-ended mutual funds are very liquid. o Micro-cap stocks, bonds, loans, or investments in privately-owned companies could be considered relatively illiquid due to the limited market for them. Liquidity also describes how quickly an asset can be converted into cash. o Cash itself is the most liquid asset. o A large pharmaceutical production plant is not a very liquid asset because it would take the owner of the plant a long time to sell the plant and convert it into usable cash. A more liquid investment is relatively safer, all else equal, since the investor can sell it at any time. Liquidity is how easily an asset can be bought and sold by an investor. Some examples of liquid assets include money market accounts and large-cap stocks. Some non-liquid assets include many micro-cap stocks, or a large, specialized factory or production plant that could take years to convert into cash.

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

Many people would think that having excess cash on hand is not a bad thing. While it is good to have a cash buffer (especially in a time of economic turmoil), holding too much cash means you are giving up potential earnings from investing that cash elsewhere. A firm must be aware of its cash needs, and keep enough cash to cover itself in the event of a downturn, but excess cash should be used or invested. A growing company will normally reinvest its cash in the operations of the business itself. This allows the company to expand and grow. This could be an investment in equipment, more employees, new offices, increased/upgraded marketing, etc. A company could also pay out the excess earnings as additional salary or bonuses to its employees or a dividend to its shareholders. An option to preserve some sense of liquidity would be investing in short-term CDs, allowing the firm to earn interest while locking up the investment for only a short time. Other options include investing in other companies, buying out a competitor, supplier or distributor, paying off debt, repurchasing stock, expanding to new markets, etc. Although it seems like having a lot of cash on hand might be a good thing, especially in a recession, it really isn't, because there is an opportunity cost to holding cash. A company should have enough cash to protect itself from bankruptcy in a downturn, but any excess cash should be put to work. The company could pay a dividend to its equity holders or bonuses to employees, although a growing company will tend to reinvest rather than pay out cash. It can reinvest its cash in plants, equipment, personnel, or marketing; it can pay off debt, repurchase equity, or buy out a competitor, supplier, or distributor. If nothing else, that cash can earn a little something invested in CDs until it can be put to better use.

Where do you think the stock market will be in 3/6/12 months?

North Korea, Russia Probe,

How do you go from the Enterprise Value you would calculate using a DCF to a per share price for a public company?

Once you come up with your Enterprise Value, you add cash and then subtract debt, preferred stock, and minority interest to come up with an Equity Value. Once you have the Equity Value, you must use Excel to calculate a per share price based on the number of fully diluted shares outstanding. However, the number of fully diluted shares will depend on the share price, so you will have to use the iterations function in Excel in order calculate this.

What is operating leverage?

Operating leverage is the percentage of costs that are fixed versus variable. A company whose costs are mostly fixed has a high level of operating leverage. If a company has a high level of operating leverage, it means that much of any increase in revenue will fall straight to the bottom line in the form of profit, because the incremental cost of producing another unit is so low. For example, a swim club is a business that operates with a high level of operating leverage. Once the club is built and opened, its costs are relatively fixed. With the same number of staff, same size pool, same locker rooms, same maintenance expense, the club could go from 500 members to 510 members with little additional cost. Nearly 100% of the membership fees collected from the 10 new members would turn into profit. Operating leverage is the relationship between a company's fixed and variable costs. A company with more fixed costs has a higher level of operating leverage.

What are some examples of items that may need to get added back to EBITDA to get a better sense for the financial health of a company?

Some examples are one-time, non-recurring items like legal expenses, one-time disaster payments or events, restructuring charges, debt/equity financing expenses, etc. Any items that are not likely to continue from one year to the next may be added back to EBITDA

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 that is rare. What usually happens is 1 of 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.

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.

What is the market risk premium?

The market risk premium is the excess return that investors require for choosing to purchase stocks over "risk-free" securities. It is calculated as the average return on the market (normally the S&P 500, typically around 10-12%) minus the risk free rate (current yield on a 10-year Treasury).

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

The profits generated on the Income Statement after any payment of dividends are added to shareholder's equity on the Balance Sheet under retained earnings. Debt on the Balance Sheet is used to calculate interest expense on the Income Statement. Property, plant and equipment on the Balance Sheet is used to calculate depreciation expense on the Income Statement. There are many other links, but the above are some of the main connections. 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.

If you have two companies that are exactly the same in revenue, growth, risk, etc. but one is private and one is public, which company's shares would be higher priced?

The public company most likely will be priced higher due to the liquidity premium one would pay to be able to buy and sell the shares quickly and easily in the public capital markets. Another reason the public shares should be priced higher would be the transparency required for the firm to be listed on a public exchange. Publicly traded companies are required to file audited financial statements, allowing investors to view them. The public company is likely to be priced higher for a couple of reasons. The main reason is the liquidity premium investors will pay for the ability to trade their stock quickly and easily on the public exchanges. A second reason is the sort of "transparency premium" that derives from the public company's requirement to make their audited financial documents public.

Where do you find the risk-free rate?

The risk-free rate is usually the current yield on the 10-year government treasury, which can be found on the front page of The Wall Street Journal, on Yahoo! Finance, etc. This is considered "risk-free" because the U.S. government is considered to be a risk-free borrower, meaning the government is expected never to default on its debt. Recently, S&P downgraded the United States from its AAA "risk-free" rating to AA+. The other two major ratings agencies have maintained their ratings on U.S. government debt, however. See the section in the current events section of this guide for more information.

Is 15 a high P/E (price to earnings) ratio?

This is not a yes or no question. A firm's P/E ratio is important in comparison with other companies in its industry. P/E can be thought of as how many dollars an investor is willing to pay for one dollar of earnings. A high P/E represents high anticipated growth in earnings. In high growth industries, such as technology, a P/E ratio of 15 may be considered relatively low, since the company is expected to grow its earnings at a high rate, and therefore deserves a higher valuation relative to current earnings. For a large pharmaceutical company, however, a P/E of 15 may be considered high, since earnings growth may be expected to be slow but steady in future years. It depends on the industry. A P/E ratio of 15 in an industry like basic materials may be considered a bit high, but if the company is a high-growth tech company, 15 may be considered rather low.

What is the mid-year convention in a DCF?

To account for the fact that cash is collected equally over the course of the year, you discount back using "half-years" as if the cash were all collected in the middle of the year. The mid-year convention is used because the cash flows in a business are not all received at the end of a year. To account for the fact that cash is collected throughout the year, you discount back using "half-years" in order to assume the cash is all collected in the middle of the year. Since cash is not collected all at once at the end of the year, you account for that in the way you discount the cash flows. In order to do this, you will discount using "half-years," which assumes that all the cash is collected in the middle of the year, which is a more reasonable assumption. For example. The 4th year's cash flow number would be discounted using 3.5 years to assume the cash is collected midway between the end of year 3 and the end of year 4.

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. 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. 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). Note: Shareholders' equity never turns negative immediately after an LBO - it would only happen following a dividend recap or continued net losses.

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

At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet). On the 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. On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

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

Cash-based accounting recognizes revenue and expenses 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 what flows into Retained Earnings.

Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued If you're calculating Retained Earnings for the current year, take last year's Retained Earnings number, add this year's Net Income, and subtract however much the company paid out in dividends.

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 (negative or positive) tells you whether or not 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).

What does spreading comps mean?

"Spreading comps" is the task of collecting and calculating relevant multiples for comparable companies. Sometimes an analyst can pull the relevant multiples from a resource like CapitalIQ. However, sometimes you have to research a company's data and financial information in their 10-K/10-Q to make sure they have adjusted for non-recurring charges or irregular accounting across an industry that can skew multiples across comparable companies. These charges can include one-time legal expenses, restructuring fees, asset write-downs, etc. These adjustments will be detailed in the footnotes section of the financial statements. A simple comps table is shown below. A sample comps table is also included in the Excel model provided with this guide. 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.

Walk me through the 3 financial statements.

"The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must equal Liabilities plus 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."

How do the 3 statements link together?

"To tie the statements together, Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders' Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash flowing in from the final line on the Cash Flow Statement."

Describe a company's typical capital structure.

A company may finance itself using multiple layers of debt and equity, each of which will have a different cost and repayment preference in the event of bankruptcy. The paragraph below would be a relatively good answer, and the chart that follows illustrates the different layers of the capital structure. A company's capital structure is made up of debt and equity, and there may be multiple levels of each. Debt can be senior, mezzanine, or subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior debt is most secure and will be paid off first in bankruptcy, it offers the lowest interest rate. The most senior debt is bank loans; the rest is bonds, which can be issued to the general public. Equity is either preferred or common stock. Preferred stock combines some features of both debt and equity: it can appreciate in value, and also pays out a consistent dividend but it has very little or no rights in a bankruptcy. Common stock is traded on the exchanges, if the company is public. In the event of bankruptcy, common stockholders have the least claim to assets in the event of liquidation, and therefore they bear the highest level of risk and earn the highest return on investment. Common shareholders are the company's owners and are entitled to profits, which may be reinvested in the business or paid as dividends.

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 represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must 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. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. On the 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 Investing falls by $100. Overall, the Net Change in Cash falls by $68. On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. 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, Liabilities & Shareholders' Equity are down by $148 and both sides balance.

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 ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12. On the 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 end 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. On the 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.

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 CF comes from the prior reporting period's Balance Sheet. Cash from operations is calculated using changes in Balance Sheet accounts—net working capital (current assets minus current liabilities) and other changes in assets and liabilities that cannot be classified as investing or financing activities. Cash Flow's depreciation adjustment is calculated on the Balance Sheet's net property, plant, and equipment (PP&E). Investments in PP&E come from the Balance Sheet and are accounted for under investment activities on the Cash Flow Statement. Ending cash on the CF Statement goes back onto the Balance Sheet. 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.

Comparable Walk Through

Comparable Companies/Multiples Analysis (to calculate either Enterprise Value or Equity Value) o Most often an analyst will take the average multiple from comparable companies (based on size, industry, etc) and use that multiple with the operating metric of the company being valued o The most commonly used multiple is Enterprise Value/EBITDA o Other multiples analysts will use include Price/Earnings, PEG, EV/EBIT, Price/Book, EV/Sales o Some industry-specific multiples include: EV/EBITDAR (companies with significant rent/lease expense) EV/Proven Reserves, EV/Production (energy) EV/Visitors (Internet) o Different multiples may be more or less appropriate for specific industries, and some multiples calculate Equity Value, while others calculate Enterprise Value. For example, if you use an EV/EBITDA multiple, you would be calculating the total value of the firm, including debt, since you are using a metric that excludes interest expense. If you were to use a multiple such as P/E (price/earnings) ratio, you would be valuing only the equity because the metric is earnings, which hypothetically could be distributed through dividends to those who own the firm's equity. o Example: Comparable Company A is trading at an EV/EBITDA multiple of 6.0x, and the company you are valuing has EBITDA of $100 million; your company's EV would be valued at $600 million based on this valuation technique.8

What is Net Working Capital?

Current assets include items on the Balance Sheet like inventory, accounts receivable and other short term assets. Current liabilities include items such as accounts payable and other short term liabilities. An increase in net working capital is a use of cash. This could be from increasing current assets like inventory or accounts receivable. If you increase inventory for example, 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. This could include changes such as increasing accounts payable or reducing inventory. If you reduce inventory, it means you are selling more goods than you are producing, which means you are realizing a cost on your Income Statement. This is why in calculating free cash flow you subtract an increase in net working capital. If net working capital went up, a company must have "used" cash to produce the increase (for example, by purchasing more inventory than they sold). 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.

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 stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It 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. EBITDA is one of the most important single items someone will look at in evaluating a Company. EBITDA = Revenues - Expenses (excluding interest, taxes, depreciation, and amortization) A very common valuation methodology is the EV/EBITDA multiple, which estimates the Enterprise Value of a company using a multiple of its EBITDA.7 An EV/EBITDA multiple is probably the most commonly used "quick and dirty" valuation multiple used by investment banks, private equity firms, hedge funds, etc. Another use of EBITDA is the calculation of a company's leverage ratio (Total Debt/EBITDA) and interest coverage ratios (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. 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 is the value of a firm as a whole, to both debt and equity holders. To calculate Enterprise Value in its simplest form, you take the market value of equity (aka the company's market cap), add the debt and the value of outstanding preferred stock, add the value of any minority interests the company owns, and then subtract the cash the company currently holds. 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. EV= MVE + Debt + Preffered Stock + Minority Interest - Cash

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.

First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. On the 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. On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it's not clear which asset since the question never stated the specific asset to write-down). 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 happens when Accrued Compensation goes up by $10?

For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). On the Cash Flow Statement, Net Income is down by $6, and 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. On the 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.

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

If the company feels its stock price is inflated, it would raise a large amount of capital relative to the percentage of ownership sold. If new projects the company plans on investing in may not produce immediate or consistent cash flows to make interest payments... If the company wants to adjust its capital structure, or pay down debt... If the company's owners want the ability to sell off a portion of their ownership and monetize their investment... There are several reasons for issuing stock rather than debt. First, if a company believes its stock price is inflated, issuing stock can raise a lot of capital relative to the ownership sold. Second, if the projects to be funded may not generate predictable cash flows in the immediate future, the company would want to avoid the obligation of consistent coupon payments required by the issuance of debt. Issuing stock is also an effective way to adjust the debt/equity ratio of a company's capital structure or to monetize the owners' 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.

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.

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 are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment 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. Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.

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

Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income. Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity. Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

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.

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

No changes to the Income Statement. 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. On the 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.

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

No changes to the Income Statement. On the 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. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 billion of market cap?

Normally the larger company will be considered "safer" and therefore will have a lower WACC. However, depending upon their respective capital structures, the larger company could have a higher WACC. 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.

When would a company collect cash from a customer and not show it as revenue? If it isn't revenue, what is it?

Normally this will occur when a customer pays for a good or service to be delivered in the future. Some examples would be annual magazine subscriptions, annual contracts on cell phone service, online dating site memberships, etc. The revenue is not recognized until the good or service is delivered to the customer. Until it is delivered, it is recorded as deferred revenue (liability) on the Balance Sheet. It will be recognized as revenue as it is delivered, and the deferred revenue line item on the Balance Sheet will be reduced accordingly. 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.

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

Normally you make very simple assumptions here and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples: • Accounts Receivable: % of revenue. • Deferred Revenue: % 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 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).

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.

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

Of the four main valuation techniques (Market Value, Market Comps, Precedent Transactions and DCF) the highest valuation will normally come from the Precedent Transactions technique, because a company will pay a premium for the projected synergies coming from the merger. A DCF analysis will typically give you the next highest valuation simply because those building the DCF model tend to be somewhat optimistic in their assumptions and projections. Market Comps and Market Value will usually produce the lowest valuations.

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.

When should an investor buy preferred stock?

Preferred stock could be looked at as a cross between debt and equity. Preferred stock will normally provide investors with a fixed dividend rate (like a bond), but also allow for some capital appreciation (like a stock). Preferred stock may also have a conversion feature which allows shareholders to convert their preferred stock into common stock. Preferred typically does not have voting rights like those of common stock. Preferred is senior to common stock within the company's capital structure. An investor should buy preferred for the upside potential of equity while limiting risk and assuring stability of current income in the form of a dividend. Preferred stock's dividends are more secure than those from common stock, and owners of preferred stock enjoy a superior right to the company's assets, though inferior to those of debt holders, should the company go bankrupt.

What is Beta?

Represents relative volatility or risk of a given investment with respect to the market. β< 1 means less volatile than market (lower risk, lower reward). β > 1 means more volatile than market (higher risk, higher reward). A beta of 1.2 means that an investment theoretically will be 20% more volatile than the market. If the market goes up 10%, that investment should go up 12%. Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta less than 1.

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.

How does depreciation affect the cash balance if it is a non-cash expense?

Since depreciation is an expense, it will reduce the amount of taxes a company will pay. Since taxes are a cash expense, anything that affects them—including depreciation—will affect the cash balance.

When calculating Enterprise Value, do you use the book value or the market value of equity?

Technically, you should use the market value of both debt and equity, so as to estimate the true value based on supply and demand. In practice however, you normally use the market value of only the equity because, if a company is publicly traded, this is a very easy value to come up with simply by looking up a company's market cap. 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 are the three components of the Statement of Cash Flows5?

The Statement of Cash Flows is one of the three financial reports that all public companies are required by the SEC to produce on a quarterly basis. (Most non-public companies also produce Cash Flow (CF) Statements.) The CF Statement comprises the three main components described below, showing all the company's sources and uses of cash. Since companies tend to use accrual accounting, a company's net income may not (and most of the time does not) portray how much cash is actually flowing in or out due to non-cash expenses, investing activities, financing activities, changes in working capital, etc. Because of this, even profitable companies may have trouble managing their cash flows, and non-profitable companies may be able to survive without raising outside capital. Cash from Operations - Cash generated or lost through normal operations, sales, and changes in working capital (more detail on working capital below). Cash from Investing - Cash generated or spent on investing activities; may include, for example, capital expenditures (use of cash) or asset sales (source of cash). This section will also show any investments in the financial markets and operating subsidiaries. Note: This section can explain a large negative cash flow during the reporting period, which isn't necessarily a bad thing if it is due a large capital expenditure in preparation for future growth. Cash from Financing - Cash generated or spent on financing the business; may include proceeds from debt or equity issuance (source of cash) or cost of debt or equity repurchase (use of cash). The three components of the Cash Flows Statement are Cash from Operations, Cash from Investing, and Cash from Financing.

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).

How should you project Depreciation & 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 multiply to get to their revenue. Of these two methods, bottoms-up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

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

This is a common interview mistake - incorrectly stating that Working Capital changes show up on the Income Statement. 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.

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. On the 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. On the 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. If this seems strange to you, you're not alone - see this Forbes article for more on why writing down debt actually benefits companies accounting-wise: http://www.forbes.com/2009/07/31/fair-value-accounting-markets-equities-fasb.html

Walk me through a Discounted Cash Flow model.

This is one of the most common questions in investment banking interviews. Don't mess it up! To begin, project free cash flows for a specified period, usually five to ten years. Free cash flow is equal to EBIT (earnings before interest and taxes) multiplied by (1-the tax rate) plus (depreciation and amortization) minus capital expenditures minus the change in net working capital. Next, predict free cash flows for the years beyond the five or ten years projected. This requires establishment of a terminal value, as is detailed in the next question below. Once future cash flows have been projected, calculate the present value of those cash flows. First, establish an appropriate discount rate—the Weighted Average Cost of Capital, or WACC. This calculation is discussed in the following two questions. To find the present values of the cash flows (which is equal to the company's Enterprise Value), we discount them by the WACC, as follows. The final cash flow (CFn) in the analysis will be the sum of the terminal value calculation and the final year's free cash flow. For a much more in depth description of a Discounted Cash Flow analysis, view a DCF tutorial online (Investopedia is a great resource) and study the Excel model you received when you purchased this guide. 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, 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.

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

Three examples come to mind: 1. Web-based subscription software 2. Cell phone carriers that cell 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 GAAP (Generally Accepted Accounting Principles), you only record revenue when you actually perform the services - so the company would not record everything as revenue right away.

How do you calculate a firm's terminal value?

To establish a terminal value, either you can use the formula above, which is the perpetuity growth methodology, or you can use the terminal multiple method. In the terminal multiple method, you assign a valuation multiple (such as EV/EBITDA) to the final year's projection, and use that as the "terminal value" of the firm. In either case, you must remember to discount this "cash flow" back to year zero as you have with all other cash flows in the DCF model. 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.

All else equal, should the cost of equity be higher for a company with $100 million of market cap or a company with $100 billion 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 the Capital Assets Pricing Model?

Used to calculate the required/expected return on equity (ROE), or the cost of equity of a company 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) plus the company's beta (a measure of the stock's volatility in relation to the stock market) times the market risk premium.

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 "turns into" real revenue on the Income Statement.

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. Investment bankers use valuation in pitch books and other presentations to guide clients toward what they should expect. 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. Valuation is the procedure of calculating the worth of an asset, security, company, etc.

What is the difference between Adjusted Present Value and WACC?

WACC incorporates the effect of interest tax shields into the discount rate. o Typically calculated from actual data from Balance Sheets and used for a company with a consistent capital structure over the period of the valuation APV adds present value of financing effects to Net Present Value assuming all Equity Value o Useful where costs of financing are complex and if capital structure is changing o Used for Leveraged Buyouts o See investopedia.com for more information on APV

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 raising new capital, which is also a representation of the riskiness of investment in the company. WACC represents the blended cost to both debt holders and equity holders, based on the cost of debt and the cost of equity for that specific firm. 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.

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 using the same techniques you use for a public company, with a couple of exceptions: o You cannot use a straight market valuation since the company is not publicly traded. o A DCF can be complicated by the absence of an equity beta, which would make calculating WACC difficult. In this case, you have to use the equity beta of a close comp in your WACC calculation. Financial information for private companies is more difficult to find because they are not required to make public online filings. An analyst may apply a discount in a comparable companies valuation if the comps are publicly held, because a public company will demand a 10-15% premium for the liquidity an investor enjoys when investing in a public company because it is easier to buy and sell in the public markets. 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.

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

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

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?

You would use 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. And that's the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

Walk me through the major items in Shareholders' Equity.

• 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 keeps 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 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 that to be an "add-back" or "non-recurring" charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges "below the line" then you do not add it back for the EBITDA / EBIT calculation. Also note that 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.