Basic Accounting, Finance, and Valuation - WSO

What is Net Working Capital?

- Net Working Capital = Current Assets - Current Liabilities - An increase in Net Working Capital is a "use of cash" which could take the form of investing in current assets like inventory or increasing accounts receivable due to slower collections, for example. A decrease in NWC is a "source of cash," which would include changes such as increasing accounts payable or a drop in inventory. This is why in calculating free cash flow you subtract an increase in NWC. If NWC went up a company must have "used" cash to cause this increase (for example, they purchased more inventory than they sold) Net Working Capital is equal to current assets minus current liabilities. It is a measure of whether a company is able to pay off its short term liabilities with its short term assets. A positive number means they can cover their short term liabilities with their short term assets. If the number is negative, the company may run into trouble paying off their creditors which could result in bankruptcy if their cash reserves are low enough

Why might there be multiple valuations of a single company?

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

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

Of the four main valuation techniques 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 will normally give you the next highest valuation simply because those building the DCF tend to be somewhat optimistic in the assumptions and projections going into their model. Market Comps and Market Value will normally give the lowest valuation.

LBO Valuation

- An LBO (leveraged buyout) is when a firm (usually a Private Equity firm) uses a higher than normal amount of debt (known as leverage) to finance the purchase of a company. The PE investors will purchase the company with a percentage of its own equity capital (anywhere from 10% to 40%), and the remainder will be financed with debt either through bank loans, bonds or a combination of the two. The PE firm then uses the cash flows from the acquired company to pay off the debt over time. Many times the PE firm uses the assets of the company being acquired as collateral for the loan. When the PE firm is ready to sell the company, ideally the debt has been partially or fully paid off and they can collect most of the profits of the sale as the majority equity owners of the company. Since a smaller equity check was needed up front due to the higher level of debt used to purchase the company, this can result in higher returns to the original investors than if they had paid for the company with entirely their own equity (without any debt).

What is the link between the balance sheet and the statement of cash flows?

- Beginning cash on the statement of cash flows comes from the prior time period's balance sheet - Cash from operations is calculated from changes in balance sheet accounts -- Net Working Capital - Deprecation comes from property, plant, and equipment on the balance sheet - Investments in PP&E come from the balance sheet and are accounted for under cash flow from investing - Ending cash goes back onto the balance sheet Well, the beginning cash on the statement of cash flows comes from the previous periods balance sheet. The cash from operations is impacted by the change in net working capital which is current assets minus current liabilities which are both balance sheet accounts. Depreciation comes from property, plant, and equipment which effects cash from operations. Any change in property, plant, and equipment due to the purchase or sale of that equipment will affect cash from investing. Finally, ending cash balance from the cash flow statement is the cash balance on the new period's balance sheet.

What are some ways you can value a company?

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

What is EBITDA?

- EBITDA stands for earnings before interest, taxes, depreciation, and amortization and is a good metric to evaluate a company's profitability and is sometimes used as a proxy for free cash flow. - EBITDA = Revenues - Expenses (Excluding tax, interest, depreciation, and amortization) - A very common valuation methodology is to use the EV/EBITDA multiple which will estimate the enterprise value of a company using a multiple of its EBITDA EBITDA stands for Earnings Before Interest Taxed Depreciation and Amortization and is a good indicator of a company's financial performance. It is a good way of comparing the performance of different companies because it removes the effects of financing and accounting decisions like interest and depreciation. It is also considered a rough estimate of free cash flow.

What is Enterprise Value?

- Enterprise value is the value of an entire firm, both debt and equity - Enterprise value = Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash

What are the three main financial statements?

- Income Statement (Revenue - COGS - Expenses = Net Income) - Balance Sheet (Assets = Liabilities + Shareholders Equity) - Statement of Cash Flows (Beginning Cash + CF from Operations + CF from Investing + CF from Financing = Ending Cash)

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

- Intuitively, you can think of working capital as the dollars tied up to run the business. As more cash is tied up (either in accounts receivable, inventory, etc) there will be less free cash flow generated. Since you subtract the change in net working capital in the calculation of free cash flow, if NWC increases FCF decreases

Comparable Companies/Multiple Analysis

- 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 he or she is valuing - The most commonly used multiple is EV/EBITDA - Other multiples analysts will use include Price/Earnings, PEG, EV/EBIT, Price/Book, EV/Sales - Different multiples may be more or less appropriate for specific industries and some multiple calculate Equity Value, while others calculate Enterprise Value. For example, if you use an EV/EBITDA you would be calculating the total value of the firm, including the debt since since you are using a metric which excludes interest expense. If you were to use a firm's P/E ratio you would only be valuing the equity because the metric is earnings, which hypothetically could be distributed to those that own the equity of the firm - For example if comparable Company A is trading at an EV/EBITDA multiple of 6x, and the company you are valuing has an EBITDA of $100 million, their EV would be valued at $600 million based on this valuation technique.

What does spreading comps mean?

- Spreading comps is the task of collecting and calculating relevant multiples for comparable companies - Many times, an analyst can simply pull the relevant multiples from a source like CapitalIQ. However, sometimes the analyst will research the company's data and financial information in their 10K/10Q to make sure they have adjusted for non-recurring charges or irregular accounting across an industry which can skew multiples across comparable companies - These adjustments will be detailed in the footnotes section of the financial statements Spreading comps is the process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis/comparison.

What is a primary market and what is a secondary market?

- The primary market is the market an investment bank will go to in order to sell 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 (NYSE, NASDAQ, etc)

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 others but these are the main ones 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.

Walk me through a Discounted Cash Flow model

- To begin, we need to project the free cash flows for a period of time, usually 5 to 10 years. Free cash flow is equal to EBIT * (1 - tax rate) + D&A - Capex - Change in Net Working Capital - Next we must predict the free cash flows for the years beyond the 5 to 10 we have projected. To do this we must establish a terminal value - Now that we have established our future cash flows, we must calculate the present value of each of those flows. To do this we must establish an appropriate discount rate. This discount rate is the Weighted Average Cost of Capital or WACC - 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: Enterprise value = CF1/(1+WACC)^1 + CF2/(1+WACC)^2 + ... + CFN/(1+WACC)^N - 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 To begin, we would project the free cash flows of the company for about 5 years. Free cash flow is EBIT + D&A - Capex - change in Net Working Capital. Then you must predict the free cash flow beyond 5 years which is done either using a terminal value multiple or using the perpetuity method. To calculate the perpetuity you must establish a terminal growth rate which is usually around the rate of inflation or GDP growth. Then multiply the year 5 cash flow by 1 plus the growth rate and divide it by your discount rate minus the growth rate. Now, in order to do this you must have established a discount rate. For a discounted cash flow you use WACC, which is the weighted average cost of capital, as your discount rate. You discount all your cash flows back to year zero using that rate. The sum of the present values of all those cash flows is the estimated present value of the firm.

What is Valuation?

- 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. Value their company, or value a company that they are thinking about purchasing or divesting.

What is WACC and how do you calculate it?

- WACC stands 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 the company's cash flows and terminal value and reflects the overall cost of a company raising new capital, which is also a representation of the riskiness of an investment in the company - WACC represents the blended cost to both debt holders and equity holders of a firm based on the cost of debt and the cost of equity for that specific firm. WACC = [(E/D+E+P)(Ke)] + [(D/D+E+P)(1-T)(Kd)] + [(P/D+E+P)(Kp)] E = Market value of equity D = Book value of debt P = Value of preferred stocks Ke = Cost of Equity (calculate using CAPM) Kd = Cost of Debt (current yield of debt) Kp = Cost of Preferred Stock (Interest rate on Preferred stock) T = Corporate Tax Rate WACC is the percentage of equity in the capital structure times the cost of equity (which is calculated using the Capital Assets Pricing Model) plus the percentage of debt in the capital structure times 1 minus the corporate tax rate times the cost of debt (which is the current yield on their outstanding debt) plus the percentage of preferred stock in their capital structure times the cost of preferred stock (if there is any preferred stock outstanding)

What is the difference between an income statement and a statement of cash flows?

A company's sales and expenses are recorded on their income statement. The statement of cash flows records what cash is actually being used and where it is being spent by the company during that time period. Some additional items included on the cash flow statement could be issuance or repurchase of debt or equity, capital expenditures, or other investments. Amortization and Depreciation will be reflected on the income statement, but will be added back to net income on the cash flow statement, since they are non cash expenses.

What is an Initial Public Offering (IPO)?

An IPO occurs the first time a company sells shares of stock to the public market. Most times the company will either go public to raise capital in order to grow the business, or to allow the original owners and investors to cash out some of their investment. Some negatives for going public include sharing future profits with the public investors, loss of confidentiality, loss of control, IPO expenses to investment banks, legal liabilities etc.

What are the components of each of the items on the statement of cash flows?

Cash from Operations - Cash generated from the normal operations of a company Cash from Investing - Change in cash from activities outside the normal scope of the business - This may reflect the purchase of property, plant, and equipment, and other investments not reflected on the income statement Cash from Financing - Cash from changes in liabilities and shareholder's equity including any dividends that were paid out to investors. For example, the issuance of any debt or equity, or the repurchase of debt or equity would be reflected here Cash flow from operations is the cash generated from the normal operations of a company. The cash flow from investing is the change in cash due to outside occurrences such as the purchase or sale of property, plant, and equipment, or any other investments. Cash flow from financing involves the increase or decrease in cash due to the issuance or repurchase of equity and debt.

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

Cash from Operations, Cash from Investing, Cash from Financing

How do you calculate free cash flow?

FCF = EBIT * (1 - T) + D&A - Capex - change in NWC - Free cash flow is EBIT (earnings before interest and taxes) times 1 minus the tax rate plus depreciation and amortization minus capital expenditures minus change in net working capital.

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

Revenues - COGS ----------------------- Gross Profit - Operating Expenses ------------------------ Operating Income - Other Expenses - Income Taxes ------------------------ Net Income The first line of the income statement would be revenues or sales. From that you subtract COGS which leaves you with Gross Profit. Then you subtract operating expenses which gives you operating income. From operating income you subtract other expenses and income taxes, leaving you with net income.

How do you calculate a firm's terminal value?

Terminal Value = FCF10(1+g)/(WACC-g) - To establish a terminal value, you can either 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 your "terminal value" of the firm - In either case you must remember to still 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, you choose an operation metric (most common is EBITDA) and apply a comparable company's multiple to that number from the final year of projections. The second method is the perpetuity growth method. To use this method you choose a modest growth rate, usually just a bit higher than the inflation rate or the GDP growth rate, in order to assume that the company can grow at this rate indefinitely. We then multiply the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate.

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

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

Market Valuation/Market Capitalization

The market value of equity is only used for publicly traded companies and is calculated by multiplying the number of shares outstanding by the current stock price

Why do you project out free cash flows for the DCF model?

The reason you project out FCF for the DCF is because the 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.

Why do you subtract cash from Enterprise Value?

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

How are the three main financial statements connected?

There are many links between the three financial statements: - Starting with the income statement, the last line item is net income. Net Income is added to cash flow from operations on the cash flow statement - Beginning cash balance is the cash from the balance sheet in the prior period - After making adjustments to Net Income for non-cash items, the cash flow from operations, investing and financing, the ending cash balance becomes the cash on the current periods balance sheet under assets - Net Income (minus any dividends paid) flows from the income statement onto the retained earnings column (shareholder's equity) of the balance sheet, causing the balance sheet to balance Some other connections: - Interest expense on the income statement is calculated from the long-term debt on the balance sheet - Depreciation on both the income statement and cash flow statement is calculated based on property, plant, and equipment from the balance sheet - Change in working capital on the cash flow statement is calculated from changes in current assets and current liabilities on the balance sheet

Precedent Transactions

With this valuation technique an analyst would need to research historical transactions that are similar to the transaction in question. This would include looking at the size of the companies involved, their industry, their economic situation at the time of the transaction, etc. Once an analyst has found transactions that are comparable, they look at how these companies were valued. What were the EV/EBITDA and EV/SALES multiples paid ? They would calculate a valuation based on the sale prices in those transactions, and apply the multiple to the appropriate metric of the company being valued. Most of the time this valuation technique will result in the highest valuation due to the inclusion of the "control premium" a company is willing to pay for the assumed "synergies" they hope will occur after the purchase.