Technicals

Multiples in transaction deal comps?

- EBIT multiple where the target's EBITDA and EBIT have been adjusted to reflect reported synergies, which leads to a lower purchase multiple. - Enterprise value in context of M&A is referred to Total Enterprise Value (TEV) - Equity value in context of M&A is called "offer price", "offer value".

Why would a company buy back (aka repurchase) shares? What would be the impact on share price and the financial statements?

- Share buyback removes shareholders and helps the company consolidate ownership. - Excess liquidity and no better alternative but to use it "We don't see any better investment than ourselves" Undervalued shares. If you buy back 1,000 shares at 10 dollars and issue 1000 shares when price reaches 20 dollars then you make money without ownership dilution - Make certain metrics look more attractive. Less shares means higher earnings per share and return on assets. - Lower assets and earnings stay the same.

Describe a recent M&A deal

1. Name of acquirer and target 2. Size of the deal and premium offered 3. Form of consideration (stock vs cash) 4. Acquirer and target share price impact after announcement 5. Strategic rationale: Read the press release and a few deal analysis articles to get opinions on the goals and the market's perspective on the transaction

Trading Comps Analysis Process

1. Select comparable companies (peer group) 2. Pick which multiples you will use (EV/EBITA, P/E) 3. Pick which timeframe you will use - Last twelve months (LTM) - Forecast basis (1 year forward or 2 year forward) 4. For each multiple, apply the calculated mean/median to the target company's corresponding operating metrics to arrive at a value - Ex. Multiply the derived average LTM PE ratio by company's LTM EPS to arrive at equity value per share

How would you value a company that has no revenue?

A company that has no revenue can still be valued by valuing drivers like subscribers, monthly active users

How would you value a painting?

A painting has no intrinsic value, generates no cash flows and thus cannot be valued in the traditional sense. The pricing of a painting is a function of what someone is willing to pay for it and not anchored by fundamentals.

Trading comps pros and cons

Advantages - A reality based valuation: provides framework to value a company based on current market conditions, industry trends and growth of companies with "similar" operating and financial statistics. Those who believe that markets efficiently price stocks will argue that comps are more reliable method of valuation. - Sanity check to DCF: the DCF relies on highly sensitive assumptions about company's future performance. It's easy to make DCF say what you want to say. A comps analysis relies on observable market prices as a key input makes comps a critical sanity check to the DCF valuation. Disadvantages - Apples to oranges: truly comparable companies are rare and differences are hard to account for. Explaining value gaps between the company and its comparable involves judgement. - Doesn't reflect intrinsic value: many people feel that the stock market is emotional and fluctuates irrationally (sometimes market can be wrong) - Liquidity: Thinly traded, small capitalisation or poorly followed stock may not reflect fundamental value.

Transaction comps strengths and weaknesses

Advantages - Recent comparable transactions can reflect supply and demand for saleable assets. It can give you real market insight into what you can expect to receive or what you might expect to pay. Disadvantages - Past transactions are rarely directly comparable - apples and oranges - Public data on past transactions can be misleading - Public data rarely discusses deal protection put in place by acquirer and target (there are things other than purchase price that affect deal prices) - Values obtained often vary over a wide range and can be of limited usefulness - Prevailing market conditions can lead to signficant distortions - Premiums and appropriate multiples change over time

Walk me through a simple M&A model.

An M&A model takes two companies and combines them into one entity. First assumptions need to be made about the purchase price and any other uses of funds such as refinancing target debt and paying transaction and financing fees). Then assumptions about the sources of funds need to be made - will the acquirer pay for the acquisition using cash, take on additional debt or issue equity. Once those basic assumptions are in place, the acquirer's balance sheet is adjusted to reflect the consolidation of the target. Certain line items - like working capital can simply be lumped together. A major adjustment involves the calculation of incremental goodwill created in the transaction, which involves making assumptions about asset write ups, and deferred taxes created or eliminated. Lastly, deal-related borrowing and pay-down, cash used in the transaction, and the elimination of target equity all need to be reflected. In addition, the income statements are combined to determine the combined ("pro forma") accretion/dilution in EPS. This can be done as a bottom's up analysis - starting from the buyer's and seller's standalone EPS and adjusting to reflect incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write ups. Alternatively, the accretion dilution can be a top down, whereby the two income statements are combined starting with revenue and working its way down to expenses, while making the deal related adjustments.

Would acquirers generally prefer $100 in revenue synergies or $100 in cost synergies?

An acquirer would generally prefer $100 in cost synergies because all those cost savings after accounting for tax flow through to the bottom line, while revenue synergies have associated costs that reduce the bottom line benefit. For example - $100 in revenue synergies for a company with 40% pretax profit margins and a 25% tax rate would see $100 x 40 % x (1-25%) = $30 flow to the bottom line, while the same company would see $100 in cost synergies flow $100 x (1-25%) = $75 flow to the bottom line.

If I want to gather the details needed to spread a deal comp, where might I go?

Buyer and/or seller deal announcement press releases, proxy filing and merger agreement to learn about the general deal terms, target company filings (annual and quarterly reports) for historical financial data, analyst research reports and financial data vendors like Bloomberg, Capital IQ, or Factset for historical target share prices and earnings forecasts.

How does buying a building impact the 3 statements?

Cash goes down by the purchase price and is reflected in the cash from investing section. On the balance sheet, the offsetting entry to the cash reduction is an increase in PP&E. There is no immediate impact on the income statement. Over the life of the asset, depreciation expense from the building is recognized on the income statement and reduces net income by the amount of depreciation expense net of tax expense saved due to the depreciation expense. That's because depreciation is generally tax deductible. On the cash flow statement, depreciation is added back since it is non-cash. On the balance sheet, PPE is reduced by the depreciation and is offset by a reduction to retained earnings for the depreciation expense.

How would you handle stock options when calculating a company's share count?

Companies often issue stock options. The common convention is to include in the dilutive share count any vested (exercisable) options whose strike price is below the current share price ("in the money"). In addition, any option proceeds that the company would receive from the exercise of these options are assumed to be used by the company to repurchase shares at the current share price (called the treasury stock method). Some finance professionals use all outstanding in the money options (not just the vested in the money ones) to perform the analysis, the logic being that any options that are still unvested will be vesting soon and since they are in the money it is more conservative to include them in the share count (we agree with this view, by the way).

What does a goodwill impairment tell you about a deal?

Companies that have made acquisitions in the past are required to regularly estimate the value of their past acquisitions. A goodwill impairment happens when the acquiring company determines that the current value is lower than the original price paid for the target company. For example, if an acquirer paid $100 million for a business with $40 million in goodwill now estimates the value of the acquired business to be $70 million, the acquirer must recognize a $30 million goodwill impairment via retained earnings, bringing the goodwill balance down to $10 million.

How would you handle convertible bonds in the share count?

Convertible bonds are assumed to be converted into common stock if the conversion price of the bond (book value of bond / shares bond is convertible into) is lower than the current share price. For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing a bond convertible into 10 million shares of common stock. Because the current share price is > the conversion price, we would assume that the bond is converted for the purposes of calculating the diluted share count.

How would you handle convertible preferred stock in the share count?

Convertible preferred stock is assumed to be converted into common stock for the purpose of calculating diluted shares if the liquidation value (also called the conversion price) of the preferred stock is lower than the current share price. For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing 10 million preferred shares, each granting the holder the right to collect either $50 per preferred share (it's liquidation value) or to convert it to 1 share of common stock. Because the current share price is > the liquidation value, we would assume that the preferred stock is converted for the purposes of calculating the diluted share count.

What are deferred tax assets (DTAs)?

DTAs are created when a company recognizes a tax expense on its GAAP income statement that, due to a temporary timing difference between GAAP and IRS accounting rules, is lower than what must be paid to the IRS in that time period. Net operating losses (NOLs) that a company can carryforward against future income often create DTAs. For example, a company that reported pre-tax loss of $10 million will not get an immediate tax refund. Instead, it will be able to carry forward these losses and apply them against future profits. However, for GAAP reporting purposes it will recognize the tax benefit from a presumed future tax refund immediately on the income statement (that's accrual accounting). This difference gets captured in DTAs. As the company generates future profits and uses those NOLs to reduce the future tax liability, the DTAs are reversed.

What are deferred tax liabilities (DTLs)?

DTLs are created when a company recognizes a tax expense on its GAAP income statement that, due to a temporary timing difference between GAAP and IRS accounting rules, is not actually paid to the IRS in that period, but rather is expected to be paid in the future. A common example of DTL's is related to depreciation. Specifically, for tax purposes, companies can depreciate using accelerated depreciation methods, while most companies will elect to use straight-line depreciation for GAAP reporting purposes. This means that for a given depreciable asset, the amount of depreciation expense recognized in the early years for tax purposes will be greater than under GAAP. Those temporary differences are recognized as DTLs. However, since these differences are just temporary - under both book and tax reporting the same cumulative depreciation will be recognized of the life of the asset - at a certain point into the asset's useful life, an inflection point will be reached where the depreciation expense for tax reporting will become lower than for GAAP. At this point, the DTL will stop growing and instead begin to reverse, until it goes back to 0 at the end of the asset's useful life.

What is deferred (unearned) revenue?

Deferred revenue is a liability that represents cash already collected from customers for services that have yet to be performed, or for products yet to be delivered. In other words - revenue that hasn't been earned. A common example of this is gift cards or service agreements or implied rights to future software upgrades associated with a product sold - customers usually pay upfront for these.

What are some common enterprise value multiples?

EV/Revenue, EV/EBIT, EV/EBITDA

How do you calculate earnings per share?

Earnings per share (EPS) is calculated as net income divided by the company's weighted average shares outstanding during the period. There are two ways to measure EPS - Basic and Diluted. Basic EPS is net income divided by the actual shares, while Diluted EPS is net income divided by actual shares and shares from potentially dilutive securities such as options, restricted stock, and convertible bonds or stock.

Which multiples are the most popular in valuation?

Enterprise value / EBITDA multiples are probably the most common, followed by EV/EBIT and P/E. There are several others that are more industry- and company-specific. For example, P/B ratios are used to value financial institutions and EV/Revenue multiples are used to value companies with negative earnings.

What is the difference between enterprise value and equity value?

Enterprise value = equity value + net debt. Conceptually, enterprise value represents the value of the operations of a business, which is independent of the capital structure. Equity value represents the value of the business to equity owners after subtracting net debt, where net debt equals the company's gross debt and debt-like claims such as preferred stock, net of any cash and other non-operating assets.

What are some examples of "non-recurring" items?

Examples of non-recurring include legal settlements (gain or loss), restructuring expenses and inventory write-down or asset impairments.

Do companies prefer straight-line or accelerated depreciation?

For GAAP reporting purposes, companies generally prefer straight-line depreciation. That's because a company will record lower depreciation in the early years of the asset's life than if they had used accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income than under accelerated depreciation.

Define free cash flow yield and compare it to dividend yield and P/E ratios

Free cash flow (FCF) yield = FCF (cash from operations−capital expenditures)/Share Price For the purposes of this calculation, FCF is usually defined as cash from operations less investing activities. FCF yield is similar to dividend yield (dividend per share/share price ) as both are a way to gauge equity returns relative to a company's share price. Unlike dividend yield, however, FCF yield is based on cash generated, as opposed to cash actually distributed. As a measure of fundamental value, FCF yield is more useful because many companies don't issue dividends (or an arbitrary fraction of their free cash flows). If you flip the FCF yield you get Share price//FCF, which produces a cash flow version of a P/E ratio. This has the advantage of benchmarking price against actual cash flows as opposed to accrual profits. It also, however, has the disadvantage that cash flows can be volatile and period specific swings in working capital and deferred revenue can have a material impact on the multiple.

What does accretion/dilution analysis tell you about the attractiveness of a transaction?

From a valuation perspective, an accretive deal is not necessarily indicative of value creation for the acquirer and vice versa for dilutive deals. However, significant accretion or dilution is often perceived by buyers (and public company buyers in particular) as an indication of potential investor reaction to the transaction. Specifically, dilutive deals are feared by buyers to lead to decline in their share price after announcement. This fear is rooted in the notion that investors will apply the pre-deal PE ratio to the now-lower pro forma EPS. These concerns, while quite valid when viewed through the prism of buyers' short-term concerns about meeting EPS targets, or not actually relevant to whether a deal actually creates long term value for the acquiring company's shareholders, which is a function of intrinsic value of the newly combined company.

What is goodwill?

Goodwill is an asset that captures excess of the purchase price over fair market value of the net assets of an acquired business. For example, suppose an acquirer buys a company for a purchase price of $500 million with a fair market value of $450 million. In this case, goodwill of $50 million would be recognized on the acquirer's balance sheet. Often in the preliminary phase of analyzing acquisitions, the fair market value is unknown and the target's book value is used instead.

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Growth and cost of capital are not the only drivers of value. Another critical component is return on invested capital. All else equal, if one of the companies has a higher return on equity, you would expect its PE ratio to be higher. Other reasons may include relative mispricing or inconsistent calculations of EPS due to things like nonrecurring items and different accounting assumptions.

How does selling a building impact the 3 statements?

If I sell a building for $10 million that has a book value of $6 million on my balance sheet, I will recognize a $4 million gain on sale on the income statement which will - ignoring taxes for a moment - increase my net income by $4 million. On the cash flow statement, since the $4 million gain is non-cash, it will be subtracted out from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. On the balance sheet, the $6 million book value of the building is removed, while retained earnings increases by $4 million. The net credit of $10 million is offset by a $10 million debit to cash that came from the cash flow statement.

If the market is what matters, when valuing a public company, do we even need a comps analysis? Why not just use the market cap of the company directly to value it?

If the market was perfectly efficient, it stands to reason that it would price individual equities correctly rendering a comps analysis pointless. However, the thinking behind a comps analysis for a public company is that the market may be efficient on average, but it can be off when pricing individual companies.

What is a transaction comps (deal comps)?

If you're trying to value a company for the purposes of an acquisition (you're an investment banker trying to help your client find a suitable acquirer), looking at the price paid to acquire comparable companies in recent acquisitions. Acquirers must pay a premium to compel sellers to sell; this premium can range from 10-50% above market price. As a result, deal comps will yield a higher valuation than trading comps.

Is it better to finance a deal via debt or via stock?

In a 100% stock transaction, a deal is accretive when a high PE company acquires a low PE company. When considering debt, the buyer's access to debt financing and cost of debt (interest rate) will influence the buyer's willingness to finance a transaction with debt. The incremental interest expense impacts the income statement, reducing pro forma net income and EPS. From the seller's perspective, a seller will generally prefer cash (i.e. debt financing) over a stock sale unless seller resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration.

What are the most common balance sheet adjustments in an M&A model?

In an M&A analysis, some acquirer and target balance sheet line items can simply be lumped together. However, there are some line items that need to be adjusted to reflect both deal-related accounting and funding adjustments. On the accounting side: • Goodwill: Eliminate pre-deal target goodwill and create new goodwill from the deal • PP&E and Intangible Assets: Write up assets to fair market value as appropriate • Deferred tax liabilities: Create new deferred tax liabilities in a stock sale (Advanced concept- if not comfortable with this adjustment do not mention it) • Target equity: Eliminate target equity from the consolidation On the funding side: • Debt: Create new acquirer debt (if the deal was partially funded with debt) and eliminate Target debt (Target debt is often refinanced and reflected in the new acquirer debt financing, although in rare cases it can carry over) • Equity: Increase the existing value of acquirer equity by the value of any new acquirer equity issued in the deal • Cash: Reduce cash by the amount of excess cash used to fund the deal and pay transaction and financing fees with a corresponding reduction to equity (for the transaction fees) and to new debt (for the financing fees)

What are the most common income statement adjustments in an M&A model?

In an acquisition, the acquirer and target income statements are consolidated, meaning they are lumped together. Some of the line items, however, need to be adjusted to reflect accounting and deal funding issues. The most common adjustments include the following: • Revenue: Increase consolidated revenue by any revenue synergies (if applicable) Synergies reduce expenses and increase pro forma net income and pro forma eps. • Operating expenses: Reduce consolidated expenses by any expected cost synergies • Incremental D&A from write ups: Since target assets like PPE and Intangible assets are written up to fair market value in a deal, the acquirer will record higher depreciation and amortization on those written up assets, therefore reducing PFNI and PFEPS. • Other expenses: Transaction or deal fees (sellers pay to lawyers and IB) are expensed as incurred on the income statement and reduces pro forma net income. • Interest expense: Acquirer interest expense is adjusted up when debt financing is used to fund the deal. Target interest expense is eliminated when target debt is refinanced. In addition, financing fees are amortized over the term of debt and the noncash expense is recognized within interest expense. • Interest income: Reduce interest income by the impact of any excess used to fund the deal • Tax: All the adjustments above need to be tax-affected at the acquirer's tax rate. • Share count for calculating pro forma EPS: Use the acquirer's pre-deal share count and add the number of acquirer shares issued in the transactions

How would you evaluate the buy vs. rent decision in NYC?

In order to do a proper comparison, let's assume that I have enough upfront capital to make a down payment, otherwise obviously I have to rent. Let's also assume the investment period is 10 years. Assuming I buy, during this investment period I have to pay monthly mortgage, real estate tax and maintenance fees (which will be offset by some tax deductions on interest and depreciation). I assume I'll be able to sell the property at a price that probably reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to a sale, I can calculate my IRR. I would then compare this IRR against the IRR from renting as follows: First, I would estimate the rental cost of a comparable property, factoring in rent escalations over a 10-year period. In addition, since I don't have an initial down-payment to make, I would put that money to work elsewhere - say as a passive investment in the stock market. I would assume an annual return over the 10-year period consistent with the historical long-term return on the stock market (5-7%). I would then be able to calculate an IRR based on these inflows and outflows and compare the IRRs and make a decision. Of course, I would keep in mind that this comparison isn't perfectly apples to apples. For example, investing in a NYC property is riskier than investing in the stock market due to the leverage and the lower liquidity. NYC real estate is liquid but not as liquid as public stocks. For example, if I get two identical IRRs, I would probably go with renting, since it wouldn't appear that I'm being compensated for the added risk.

Walk me through the income statement (IS).

Income statement shows how much revenue a company earned over a specific time period. The income statement starts with revenues generated during the period and subtracts cost of goods sold to arrive at gross profit. Gross profit minus SG&A gives EBITDA. Depreciation and Amortisation are subtracted to give operating income (aka EBIT). Then, non-operating expenses like interest expense are subtracted to arrive at pre-tax income. Then tax expense is removed to arrive at net income, which is the bottom line. Below the income statement, you will also find earnings per share for the period usually presented.

How should increases in inventory get handled on the cash flow statement?

Increases in inventory, as well as any other working capital assets, reflect a usage of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement. Conversely, increases in working capital liabilities represent a source of cash and should be presented as an inflow in the section.

Do you amortize intangible assets?

Intangible like customer lists, copyrights and patents - assets that have a finite life - are amortized, while others like trademarks (and goodwill) are considered to have indefinite lives and are not amortized.

Which section of the cash flow statement captures interest expense?

Interest expense is recognized on the income statement and thus gets indirectly captured in the cash from operations section.

How do capital leases affect the three financial statements?

Leases treated as capital leases (as opposed to operating leases) create an asset and associated liability for the thing that is being leased. For example, if a company leases a building for 30 years, the building is recognized as an asset on the lessee's balance sheet with a corresponding debt-like liability. The income www.wallstreetprep.com 15 statement impact is the depreciation expense associated with the building, as well as interest expense associated with the financing.

How would you value bitcoin?

Like all currencies, Bitcoin has no intrinsic value and thus cannot be valued like a traditional cash flow generating asset. Instead, the pricing of bitcoin depends on perceptions on the probability that it will ultimately become a full-fledged currency and stable medium of exchange. There is no DCF or fundamental valuation that can be performed on bitcoin.

When applying a peer group-derived EV/EBITDA multiple onto your target company, what is an argument for using the group's median multiple as opposed to the group's mean multiple?

Medians remove the distortive impact of outliers on the peer group multiple.

What's the difference between a merger and an acquisition?

Mergers and acquisitions (M&A) refer to the combination of two businesses. The terms are often used interchangeably. A transaction can always be thought of as an acquisition, although a merger more often refers to an acquisition by two similarly sized companies, where the form of consideration is at least partially with stock so shareholders from both entities remain.

Is negative working capital a bad thing?

Negative working capital doesn't tell you much without some context. For example, a company could have negative working capital (i.e. current assets < current liabilities) because it is very efficient at collecting revenue (low accounts receivable), keeping low inventory, and taking time with paying vendors (high A/P), while efficiently investing excess cash into higher-yielding investments. In this case, negative working capital is a good thing. However, the opposite could be true as well - negative working capital could be a sign of impending liquidity problems. For instance, imagine a company that's mismanaged its cash and now faces a high accounts payable balance that's coming due very soon, with a low inventory balance that desperately needs replenishing, and low levels of accounts receivable. A company in this state will need to find external borrowing quickly to stay afloat.

What's included in net debt?

Net debt includes all types of debt - short-term and long-term, loans and bonds. It includes other non- equity financial claims such as preferred stock and non-controlling interests. From this gross debt amount, cash and any other non-operating asset such as short-term investments and equity investments should be subtracted to arrive at net debt. Net Debt = Short-Term Debt + Long-Term Debt - Cash and Cash Equivalents.

Do companies depreciate land?

No, land is considered to have an indefinite life and is not depreciated.

Is it bad if a company has negative retained earnings?

Not necessarily. Retained earnings will be negative if the company has generated more accounting losses than profits. This is often the case for early-stage companies that are investing heavily to support future growth. The other component of retained earnings is common or preferred dividends, which could contribute to a lower or even negative retained earnings.

Is EBITDA a good proxy for cash flow?

Not really. That's because even though EBITDA does add back D&A - typically the largest non-cash expense - it does not capture any working capital changes during the period. It also doesn't capture cash outflows from taxes or interest payments. Those adjustments would need to be made to get to operating cash flows. EBITDA also doesn't capture stock-based compensation (SBC) expenses required to get to operating cash flows (although an increasingly used "adjusted EBITDA" calculation does add back SBC).

Should two identical companies but with different rates of leverage trade at different P/E multiples?

P/E multiples can vary significantly due to leverage difference for otherwise identical companies. All else equal, as a company borrows money (debt), the EPS (denominator) will decline due to higher interest expense. The impact on the share price, on the other hand, is harder to predict and depends on how the debt will be used. At the two most extreme cases, imagine the debt proceeds will go unused, generating no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment. In this scenario, the share price can be expected to decline to such a level that the PE ratio declines. On the other hand, if the debt is used to efficiently invest and grow the business, the P/E ratio will increase.

What are some common equity multiples?

P/E, Price/Book, Equity/Levered Cash Flows, Market cap/net income, PEG ratio

Why would a company issue equity vs. debt (and vice versa)?

Perhaps the greatest advantage of equity is that it has no required payments, thus giving management more flexibility around the repayment of capital (equity eventually gets it back in the form of dividends, but timing and magnitude are entirely at the board and management's discretion). Another advantage in the case of public equity is that it gives companies access to a very large investor base. On the other hand, equity dilutes ownership, and is generally more expensive (i.e. higher cost of capital). In addition, public equity comes with more regulation and scrutiny. An advantage of debt is that unlike equity, debt is tax-deductible (although recent tax reform rules limit the deduction for highly-levered companies). In addition, debt results in no ownership dilution and generally has a lower cost of capital. Of course, the disadvantages are that debt means the company faces required interest and principal payments, and it introduces the risk of default. In addition, debt covenants can restrict management from undertaking a variety of activities.

When would a DCF be an inappropriate valuation method?

Practically speaking, when you don't have access to financial statements, a credible DCF analysis valuation is difficult and limited and a comps analysis might be more realistic. For example, if you have a data point such as revenue or EBIT, a comps analysis is easier to implement. Another scenario in which a DCF may be unfeasible company is not expected generate positive cash flows for the foreseeable future. In this case, much of the company's value is pushed out to a distant time horizon making the DCF less reliable. Another example is a company that isn't valued as a going concern, but rather on a liquidation basis. In this case a DCF is inappropriate and a liquidation analysis is preferred.

How would you value a private equity firm?

Private equity firms generate two types of cash flows: management fees and performance fees. Each have different risk profiles and thus merit a sum of the parts approach. The first type of cash flow, and the easiest to model, is related to management fees. Private equity firms charge management fees of 1- 2% on total capital raised. The most common valuation approach for this is to apply a market multiple to the current or next year forecast for management fees. The second cash flow comes from the far more difficult to predict performance fees. Private equity firms charge 15-20% of the returns on the investments (portfolio companies) they manage. Since these fees are realized when sponsors exit their investments, they are lumpy and difficult to forecast. The investments themselves are illiquid, highly leveraged and thus highly sensitive to future market conditions. Thus, the typical approach here is to also apply a multiple on these cash flows, but a much lower multiple than that applied to management fees.

What are some reasons that a company might acquire another company?

Reasons to acquire another company include: • Accelerate time to market with new products and channels (organic growth) • Remove competition (buying a competitor is called horizontal integration) • Achieve supply chain efficiencies (buying a supplier or customer is called vertical integration)

Assume a company has ROA of 10% and a 50/50 debt-to-equity capital structure. What is the ROE?

Return on assets = net income/average assets, while return on equity = net income / average equity. Imagine a company with $100 in assets. An ROA of 10% implies $10 in net income. Since the debt/equity mix is 50/50, the return on equity is $10/$50 = 20%.

Why are increases in accounts receivable a cash reduction on the cash flow statement?

Since cash flow statements start with net income, and net income captures all of a company's revenue - not just cash revenue - an increase in accounts receivable suggests that more customers paid with credit during the period and so an adjustment down needs to be made to net income when arriving at cash since the company never actually received those funds - they're still sitting on the balance sheet as receivables.

How would you handle restricted stock in the share count?

Some finance professionals completely ignore restricted stock from the diluted share count because they are unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the logic that eventually they will vest, and it is thus more conservative to count them (we agree with this view, by the way).

Why should companies acquired by a strategic acquirer expect to fetch higher premiums thanthose selling to private equity buyers?

Strategic buyers may be able to benefit from synergies, which enable them to offer a higher price.

Why might one company trade at a higher multiple than another?

Superior fundamental performance such as better growth prospects, higher return on invested capital, lower cost of capital (WACC), stronger cash flows.

What are synergies? Why are they important in a deal? What are some examples of synergies?

Synergies are cost savings or incremental revenues arising from an acquisition. They are important because if any acquirer believes synergies can be realized, it would be willing to pay higher premiums (above the fair market value for a company's net assets). Examples of synergies are cost savings from eliminating overlapping workforces, closing redundant facilities, lower costs due to scale, cross selling opportunities, etc.

Contrast the DCF approach to comps

The DCF values a company based on the company's forecasted cash flows. This is viewed as the most direct and academically rigorous way to measure value, but it suffers from several drawbacks, most notably that it is very sensitive to assumptions which makes it easily to manipulate. Comps, on the other hand, values a company by looking at how the market values similar businesses. Comps relies much more heavily on market pricing to determine value than the DCF. While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced in an acquisition, it is vulnerable to two criticisms - 1) The market isn't always right and therefore a comps analysis is simply pricing, as opposed to valuing a business and 2) There are very few truly comparable companies so you're in effect always comparing apples and oranges. Because both approaches have drawbacks, both approaches are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa). For example, an analyst valuing an acquisition target will look the premiums and values paid on comparable transactions to determine what the acquirer must realistically expect to pay. But in addition, the analyst may value the company using the DCF to help show how far off the "intrinsic" value the market prices are. Another example of how these two valuation approaches are used together is when an investor considers investing in a business - the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuation derived using a DCF (although it bears repeating that the DCF's sensitivity to assumptions is a frequent criticism of its usefulness).

What's the difference between WACC and IRR?

The IRR is the discount rate on a stream of cash flows that leads to a net present value of 0. The WACC (or cost of capital) is the minimum required internal rate of return for both debt and equity providers of capital. Thus an IRR that exceeds the WACC is often used as criteria for deciding whether a project should be pursued.

You are evaluating a company that has net income of $100 million and a PE multiple of 15x. The company is considering raising $200 million in debt in order to pay a one-time special cash dividend to shareholders. Do you think this is a good idea?

The answer depends on several factors. If we make an assumption that the PE multiple stays the same after the dividend and a cost of debt of 5% • Net income will drop from $100 to $90 [($200 new borrowing x 5%) = $10 million] • Equity value will drop from $1,500 million (15.0 x $100 million) to $1,350 million (15.0 x $90 million). That's a $150 million drop in equity value. However, shareholders are immediately getting $200 million. So ignoring any tax impact, there's a net benefit of $200 - $150 million to shareholders from this move. Obviously, the assumptions we made about taxes, cost of debt and the multiple staying the same inform the result. If any of those variables are different - for example, if the cost of debt is higher, equity value might be destroyed in light of this move. A key assumption in getting the answer here was that PE ratios will stay the same at 15x. A company's PE multiple is a function of its growth prospects, returns on equity and cost of equity. Borrowing more without any compensatory increase in investment or growth will raise the cost of equity (via a higher beta) which will pressure the PE multiple down. So while it appears based on our assumptions that this is an ok idea, it could easily be a bad idea given a different set of assumptions. Moreover, it is possible to broadly say that borrowing for the sake of issuing dividends is unsustainable indefinitely, because eventually debt levels will rise to a point where cost of capital and PE ratios are adversely impacted. Debt should generally be used to support investments and activities that will increase firm and shareholder value rather than to extract cash from the business. The most notable exceptions to this are companies like Apple with low cost of debt and large excess cash that can't be distributed due to repatriation reasons and thus borrow to issue dividends.

Walk me through a balance sheet (BS).

The balance sheet shows a company's assets, liabilities and equity sections at a point in time. Assets are organized in order of liquidity, with a section for "current assets" representing assets that can generally be converted into cash within a year. These include cash itself, along with accounts receivable and inventories. Common long-term assets include property, plant and equipment, intangible assets and goodwill. Liabilities are also organized in order of when they are due - current liabilities include accounts payable and short-term debt, while long-term liabilities include long-term debt. Lastly, the equity section shows a company's common stock, treasury stock and retained earnings. Assets represent what a company owns and must always equal liabilities and equity - which represent the way assets were funded.

How are the 3 financial statements connected?

The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period. In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period.

What is working capital?

The definition of working capital is current assets less current liabilities. Since current liabilities represent payments that a company needs to make within the year while current assets are things that can be turned into cash within the year (things like accounts receivable, inventory and cash itself), working capital is used as a measure of a company's liquidity. Generally, the more current assets a company has relative to its current liabilities, the lower the company's liquidity risk.

When do you capitalize vs. expense items?

The distinction between what gets capitalized as an asset and what gets expensed is determined based on the timing of the estimated benefits. Purchases of things like fixed assets and intangible assets that are expected to benefit the firm for many years (specifically more than 1 year) need to be capitalized, while the benefits related to the salaries paid apply to the specific period generated.

If 80% of a DCF valuation comes from the terminal value, what should be done?

The explicit forecast period may not be long enough - the explicit stage should range from 5-10 years. Alternatively, the terminal value assumptions are too aggressive and do not reflect stable growth. A related possibility is that the final year in the explicit stage doesn't reach normalized stable growth. For example, a company that is explicit to make significant investments over the next 5 years will show a very low present value of stage 1 cash flows.

How is the income statement connected to the balance sheet?

The income statement is directly connected to the balance sheet through retained earnings. Specifically, retained earnings increase (are credited) each period by net income less dividends. The offsetting balance sheet adjustments impact a variety of line items on the balance sheet, including working capital and fixed assets.

How would you value a private company?

The main difference between valuing a private and public company is availability of data - private companies are usually not required to make their financial statements and details public. Historical data is critical for performing a DCF. The most common way to estimate the value of a private company is to use comparable company analysis (CCA). This approach involves searching for publicly-traded companies that most closely resemble the private or target firm. To apply this method, we first identify the target firm's characteristics in size, industry, operation, etc., and establish a "peer group" of companies that share similar characteristics. We then collect the multiples of these companies and calculate the industry average.

What is the impact of share issuance on EPS?

The major impact to EPS is that the actual share count increases, thereby decreasing EPS. However, there is sometimes an impact on net income. That's because assuming share issuances generate cash for the company, there will be higher interest income, which increases net income and EPS slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the negative impact to EPS from a higher share count.

What is the impact of share repurchases on EPS?

The major impact to EPS is that the actual share count is reduced, thereby increasing EPS. However, there is sometimes an impact on net income. That's because assuming share repurchases are funded with the company's excess cash, any interest income that would have otherwise been generated on that cash is no longer available, thereby reducing net income - and EPS - slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the positive impact to EPS from a lower share count.

What typically makes comparable acquisition analysis more challenging than trading comps?

The most challenging part of performing a transaction comps analysis is locating all the documents required to spread the comps. This data is often hard to find or completely missing when either the acquirer, the target, or both are not public.

Walk me through a DCF.

The most common approach to building a DCF is called the unlevered DCF approach and involves the following steps: 1. First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage should be forecast explicitly for a period of 5-10 years. 2. Next, the value of all unlevered FCFs beyond the initial forecast period need to be calculated - this is called the terminal value. This value should represent the present value at the end of the initial forecast period. The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach. 3. Next, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital. 4. At this point, you have enterprise value. To get to equity value, you then need to subtract net debt as of the valuation date. 5. Lastly, to arrive at the DCF value per share, divide the equity value by diluted shares outstanding as of the valuation date.

How do you calculate offer value?

The offer value in the context of M&A refers to the equity purchase price being offered by the buyer to acquire the seller. Like equity value, offer value is calculating by multiplying fully diluted shares outstanding (including options and convertible securities) times the offer price per share.

Since cost of equity is higher than cost of debt, why not finance with all debt?

The required return on debt will increase with the level of debt as a percentage of the capital structure because a more highly levered business has a higher default risk. As a result, an optimal capital structure for most companies includes some mix of debt and equity.

How many years would it take to double a $100,000 investment at a 9% annual return (no calculator)?

The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72 by the investment's annual return. In this case, the rule of 72 suggests that it would take approximately 72/9 = 8 years.

A company acquired a machine for $5 million in 2003 and has since generated $3 million in accumulated depreciation. In addition, the PP&E now has a fair value of $20 million. Assuming GAAP, what is the value of that PP&E on the company's balance sheet?

The short answer is $2 million. Except for certain liquid financial assets which can be written up to reflect fair market value, companies must carry the value of assets at their historical cost.

What's the difference between the unlevered DCF and the levered DCF?

The unlevered DCF discount the unlevered FCFs to arrive directly at enterprise value. Then, when you have a present value, just add any non-operating assets such as cash and subtract any financing related liabilities such as debt. That will get you equity value. The appropriate discount rate for the unlevered DCF is the weighted average cost of capital because the rate should reflect the riskiness to both debt and equity capital providers (because UFCFs are cash flows that belong to both debt and equity providers). The levered DCF approach on the other hand, arrives at equity value directly - first you forecast and discount the levered FCFs which gets you directly to equity value. Then you can add back net debt to get to enterprise value. The appropriate discount rate on LFCFs is the cost of equity, since these cash flows belong solely to equity owners and should thus reflect the cost of equity capital.

How do you calculate the terminal value?

There are two common approaches for calculating the terminal value: 1) Growth in perpetuity and the 2) Exit multiple approach. The growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the stage 1 forecast period, and inserting this assumption into the perpetuity formula: Terminal value = Unlevered Free cash flow / (WACC - long term growth rate) Terminal value = Levered Free cash flow / (Cost of equity - long term growth rate) The exit EBITDA multiple approach calculates the terminal value by estimating the EBITDA multiple the company will be valued at the last year of stage 1 forecast. A common way to do this is to look at the current enterprise value (EV)/EBITA multiple the company is trading at and assume the company will be valued at that same multiple in the future.

Walk me through a cash flow statement (CFS).

There are two methods by which cash flow statements are organized: Direct and Indirect. The most common approach is the indirect method, whereby the cash flow statement is broken out into 3 sections - cash from operations, cash from investing activities, and cash from financing activities. Together they add up to the net change in cash during the period. Cash from operations starts with net income and adds back non-cash expenses like depreciation and amortization as well as reconciles changes in working capital to arrive at cash flow from operations. Cash from investing activities captures capital expenditures and other investing activities like purchases of intangible assets or financial investments. Lastly, cash from financing activities captures cash inflows from borrowing and stock issuances and outflows from dividends, debt repayment and share repurchases.

Do accounts receivable get captured on the income statement?

There is no accounts receivable line on the income statement, but it does get captured, if only partially, and indirectly in revenue. Specifically, revenue is recognized on the income statement during a period, regardless of whether cash was received. That means that a portion of the revenue line on the income statement will reflect accounts receivable. That's why the other two financial statements are better for understanding what is happening to accounts receivable. Specifically, the cash flow statement reconciles revenue to cash revenue while the absolute balance of accounts receivable can be observed on the balance sheet.

Do inventories get captured on the income statement?

There is no inventory line on the income statement, but it does get captured, if only partially, and indirectly in cost of goods sold (and potentially other operating expenses). For example, COGS is recognized on the income statement during a period, regardless of whether the associated inventory was purchased during the same period. That means that a portion of the COGS line on the income statement will likely reflect a portion of inventory used up. That's why the other two financial statements are better for understanding what is happening to inventory. Specifically, the cash flow statement shows the year-over-year changes in inventory, while the absolute balance of beginning and end-of-period inventory can be observed on the balance sheet.

What's more important - the income statement or the cash flow statement?

They are both important and any serious analysis requires using both. However, I would think that the cash flow is slightly more important because it reconciles net income, the accrual-based bottom line on the income statement to what's happening to cash, while also showing you the critical movement of cash during the period. Without the cash flow statement, I can only see what's happening from an accrual profitability standpoint. The cash flow statement on the other hand can alert me to any liquidity issues, as well as any other major investments or financial activities that do not hit the income statement. The one situation in which I would prefer the income statement is if I also have the beginning and end- of-year balance sheet. That's because I could reconcile the cash flow statement simply by looking at the balance sheet year over changes along with the income statement.

How should operating leases be treated in a DCF valuation?

They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar in nature to debt obligations than to a simple expense. In fact, the option to account for leases as operating lease is set to be eliminated starting in 2019 for that reason. In the meantime, when operating leases are significant for a business (retailers and capital-intensive businesses), the rent expense should be ignored from the free cash flow buildup, and instead, the present value of the lease obligation should be reflected as part of net debt.

How can a profitable firm go bankrupt?

To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it is unable to get favorable terms from suppliers and must pay cash for all inventories and supplies, what can occur is that despite a profitable income statement, the company suffers from liquidity problems due to the timing mismatch of cash inflows and outflows. While reliably profitable companies who simply have these working capital issues can usually secure financing to deal with it, theoretically, if financing becomes unavailable for some reason (the 2008 credit crisis is an example where even profitable companies couldn't secure financing), even a profitable company could be forced to declare bankruptcy.

Contrast trading comps, deal comps and DCF - which approach should yield the highest value?

Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factors in purchase premiums. Because purchase premiums can often be quite significant - as high as 25%-50% above market prices, the multiples derived from this analysis - and thus the resulting valuation - tends to be higher than a straight trading comps valuation or a standalone discounted cash flow valuation.

What can a transaction comps analysis tell you that a trading comps analysis cannot?

Transaction comps can provide insight into purchase premiums that buyers and sellers should expect when negotiating a transaction.

How do you calculate transaction value?

Transaction value in the M&A context refers to the target's implied enterprise value given the offer value. As such, the transaction value equals the target offer value plus the target's net debt.

Can companies amortize goodwill?

Under GAAP, public companies are not allowed to amortize goodwill. Instead, it must be tested annually for impairment.

How do operating leases affect the three financial statements?

Under US GAAP, companies can choose to account for leases as operating or capital leases. Operating leases primarily only impact the income statement. When leases are accounted for as operating leases, lease (rent) payments are treated as operating expenses like wages and utilities: Regardless of whether you sign a 1-year lease or a 30-year lease, every time you pay the rent, cash is credited and an operating expense is debited. The only significant balance sheet impacts have to do with timing differences between payments (prepaid and accrued rent) and the matching of rent payments to when the tenant benefits from that rent (leading to balance sheet accruals for smoothing of rent escalations and upfront rent incentives like a free month). Starting in 2019, operating leases will no longer be allowed under US GAAP.

What's the difference between levered FCF (FCFE) and unlevered FCF (FCFF)?

Unlevered free cash flow is the amount of available cash a firm has before accounting for its financial obligations such as interest payments. To calculate those, you start with EBIT which is an unlevered measure of profit because it excludes interest and any other payments to lenders. Then you subtract taxes, add depreciation and ammortization, subtract capital expenditures and subtract increase in working capital. By contrast, levered FCF represent cash flows that remain after payments to lenders including interest expense and debt paydowns. These are cash flows that belong to equity owners. Instead of starting with tax effected EBIT, you start with net income, add back non-cash items and make working capital adjustments and subtract capital expenditures.

When valuing a company using multiples, what are the tradeoffs of using LTM vs. forward multiples?

Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT and EPS forecasts are subjective. This is particularly problematic for smaller public firms, whose guidance tends to be less reliable and generally harder to come. That said, LTM suffers from the problem that historical results are often distorted by nonrecurring expenses and income that were recognized during the period and distort the picture of recurring operating performance. That's why when using LTM results it is important to exclude nonrecurring items to get a clean multiple. That's why both LTM and forward multiples are often presented side by side, rather than picking just one.

When would you value a business using a P/B ratio?

When book value does capture a substantial part of the true value of a business. Financial institutions are most common example. Bank stocks are notorious for trading at prices below book value per share as the prices take into consideration the increased risks from a bank's trading activities.

What is the appropriate cost of capital when valuing a company using the DCF?

When doing an unlevered DCF, the WACC is the right cost of capital because it reflects cost of capital to all providers of capital. When doing a levered DCF, the right cost of capital is the cost of equity.

When would you not want to use a comps analysis to value a company?

When there are no good comparable companies.

Are acquirers more likely to achieve revenue synergy or cost synergy expectations?

While both revenue and cost synergy expectations are often not fully achieved post transaction, revenue synergy assumptions tend to be less accurate than cost synergy assumptions. That's because cost synergies can map to specific cost cutting initiatives such as laying off workers and shutting down facilities while revenue synergies tend to be driven by higher-level, more uncertain assumptions around cross selling opportunities and new products.

How do you value a company?

While there are a variety of methods for valuing companies, they largely fall under two categories: The first is intrinsic valuation, where the value of a business is arrived at by looking at the ability of that business to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and says that the value of business equals the present value of its future free cash flows. The second is relative valuation, where the value of a business is arrived at by looking at comparable companies and applying the average or median valuation multiples derived from the peer group - often EV/EBITDA, P/E, or some other relevant multiple to value the target company. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called trading comps, or by looking at the multiples of comparable companies that have been recently acquired, which is called deal comps.

What are the main weaknesses of comps as a valuation approach?

With comps, you're always comparing apples to oranges. Truly comparable companies are rare, and differences are hard to account for. Explaining value gaps between the company and its comparable involves judgment. In addition, thinly traded, small capitalization or poorly followed stocks may not reflect fundamental value. Lastly, many people feel that the stock market is emotional and that it sometimes fluctuates irrationally (i.e. the market can be wrong).

Can a company have negative net debt?

Yes. Negative debt simply means that a company has more cash than debt. For example, Apple and Microsoft have massive negative net debt because they hoard so much cash. In these cases, companies will have enterprise values lower than their equity value.

If a company trades at a forward PE of 20.0x, and acquires a company trading at a forward PE of 13.0x. Assuming the deal is 100% stock-for-stock, and a 20% premium is being offered, will the deal be accretive in year 1?

Yes: stock for stock deals where the acquirer's PE is higher than target's are always accretive. Don't get tricked - a 20% premium just brings the target's PE to 13 + (13 x 20%) = 15.6 PE, still below the acquirer's.

Should two identical companies but with different rates of leverage trade at different EV/EBITDA multiples?

You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company's value and profits independent of its capital structure. Technically, they will not be exactly equal because EV does depend on cost of capital so there will be some variation

What are the financial statements you'll typically find in a 10K?

Youi will find an income statement, cash flow statement, and balance sheet. Those are the three core financial statements. In addition, companies also include a statement of shareholders' equity and statement of comprehensive income.