FT Partners

How are the three financial statements connected?

- NI flows from Income Statement into cash flow from operations on Cash flow statement -NI minus Dividends is added to retained earnings from the prior period's balance sheet to come up with retained earnings on the current period's balance sheet -Beginning cash on the CF statement is cash from the prior period's Balance Sheet, and Ending Cash on the CF statement is Cash on the current period's Balance Sheet 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 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 period' s 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. 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

What is a Collateralized Debt Obligation (CDO)?

A CDO is the broad asset class in which a number of interest paying assets are packaged together (securitized) and sold in the form of bonds. An investor pays the market value for the CDO, and then has the rights to the interest payments in the form of coupon payments over time. A Collateralized Debt Obligation is a type of security that pools together a number of interest paying assets, and pays "coupon payments" based on those assets future cash flows.

What is a derivative?

A derivative is a type of investment that derives its value from the value of other assets like stocks, bonds, commodity prices or market index values. Some derivates are futures contracts, forwards contracts, calls, puts, etc.

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

A bondholder is always a more senior creditor than a stockholder. In the event of bankruptcy/liquidation the bondholder will be paid 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 could repurchase stock which lowers the number of shares outstanding. It could also produce higher earnings, causing its EPS to be higher than anticipated by industry analysts which would send a positive signal to the market. They could announce a change to their organizational structure such as cost-cutting or consolidation. They could also announce an accretive merger or an acquisition that will increase their earnings per share. Any type of positive news about the company could potentially raise the stock price. If the company repurchases stock, it lowers the shares outstanding, raises the EPS which will raise the stock price. A repurchase is also seen as a positive signal in the market. A company could also announce a change to its organizational structure like cost-cuts or consolidations or they could announce an accretive merger or acquisition that will increase their earnings per share. Any of these occurrences would most likely raise the company' s stock price.

When should a company buy back stock?

A company will buy back its own stock for a number of reasons. When it believes the stock is undervalued, when it has extra cash, when it believes it can make money by investing in itself, or when it wants to increase its stock price by increasing its EPS due to a reduction in shares outstanding or send a positive signal to the market.

Describe a company's typical capital structure.

A company' s capital structure is made up of debt and equity, but there are different levels of each. Debt can be broken down into senior, mezzanine and subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior is paid off first, it will have a lower interest rate. Equity can also be broken down into preferred stock and common stock. Preferred stock is like a combination of debt and equity in that it has the opportunity for some appreciation in value, but more importantly pays out a consistent dividend, that is not tied to the market price of the stock. Common stock is the final piece of the capital structure, and is the stock that is traded on the exchanges. In the event of bankruptcy, the common stockholders will have the last right to assets in the event of liquidation, and therefore are bearing the highest level of risk. Due to this they will demand the highest return on their investment.

What is the difference between the income statement and 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

What is a Credit Default Swap?

A credit default swap is essentially insurance on a company's debt and is a way to insure that an investor will not be hurt in the event of a default. They are sold over the counter in a completely unregulated market. The credit default swap market is estimated at $62 trillion. Essentially, if you own the bond of company X and you purchase a CDS of that bond, and company X defaults, the party that sold you the CDS is responsible for paying you a certain amount of what you lost because of the default. Can be used for hedging (as an insurance policy against the bond defaulting) or speculating (purchase the swap with the thought that the bond will become distressed, and more investors will desire the insurance, raising the value of the swap which can be sold).

What is a mortgage backed security?

A mortgage-backed security is a class of asset-backed security whose cash flows are secured by a package of mortgages. They will pay periodic payments that are very similar to coupon payments (interest) from bonds.The MBS market essentially allowed the investment community to lend money to homeowners, with banks acting as the middlemen. An investor pays to purchase an MBS, and is paid back over time with the mortgage payments from the homeowners. Many MBS were rated AAA because they were considered highly diversified, and it was thought that the housing market would not collapse across the board. Unfortunately, we now know that housing values were highly correlated and the AAA rating has proven to be optimistic at best. A mortgage-backed security is a security that pays its holder a periodic payment based on the cash flows from the underlying mortgages that fund the security

What are some defensive tactics that a target firm may employ to block a hostile takeover?

A poison pill shareholder rights plan gives existing shareholders the right to purchase more shares at a discount in the event of a takeover, making the takeover less attractive by diluting the acquirer. A Pac-Man defense is when the company which is the target of the hostile takeover turns around and tries to acquire the firm that originally attempted the hostile takeover. A white knight is a company which comes in with a friendly takeover offer to the target company which is being targeted in a hostile takeover.

Can you tell me about a recent IPO you have followed?

ADYEY

What is an Initial Public Offering (IPO)?

An IPO is the first sale of stock in a previously private company to the public markets. This is known as "going public." The IPO process is incredibly complex and investment banks charge large fees to lead companies through it. Companies IPO for a number of reasons including raising capital, cashing out for the original owners and investors, and employee compensation. 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. 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.

What is a leveraged buyout? How is it different from a merger?

An LBO is when a group, usually a private equity firm, purchases a company using a relatively high amount of financial leverage, meaning the purchase is financed using mostly debt, with a relatively low equity investment. Ideally, the company then pays off the debt over the investment horizon using the cash flow from the business. Over the course of the investment, the capital structure changes from a high percentage of debt to a high percentage of equity. For example, a PE firm purchases a company for $100mm, using $20mm in equity and borrowing $80mm in debt. Over the course of 5 years, they pay off the debt using the company's cash flow. Even if the company's enterprise value does not increase over the 5 years, if the firm now sells the company for $100mm, the fund would have returned $120mm on a $20mm investment, a healthy return. Essentially, an LBO takes place when a fund wants to buy a company now with the intention of exiting the investment usually within three to seven years and potentially changing management to increase the company' s profitability. What makes it a leveraged buyout is the fact that the acquiring firm will fund the purchase of the company with a relatively high level of debt and then pay off the debt with the cash flows produced by the firm. This means that by the time the fund is ready to sell the company, the business will ideally have little to no debt and the PE firm will collect a higher percentage of the selling price and/or use the excess cash flow to pay themselves a dividend since the debt has been reduced or paid off.

What is the difference between and investment grade bond and a "junk bond"?

An investment grade bond is one that has a good credit rating, a low risk of bankruptcy and therefore pays a low interest rate. A "junk bond" is a bond that has a poor credit rating and a relatively high risk of bankruptcy and is therefore required to pay investors a higher interest rate. An investment grade bond is a bond issued by a company that has a relatively low risk of bankruptcy and therefore has a low interest payment. A "junk bond" is one issued by a company that has a high risk of bankruptcy but is paying high interest payments.

When should an investor buy preferred stock?

An investor should buy preferred who wants the upside of potential of equity, but wants to limit risk in the form of a dividend. The investor would receive steady interest-like payments (dividends) that are more secure than the dividends from common stock. Preferred Stock owners also get a superior right to the company' s assets should the company go bankrupt (although less rights than debtholders).

Balance Sheet

Assets = Liabilities + Shareholder Equity

Comparable Companies (To calculate either Enterprise Value or Equity Value)

Average multiple from comparable companies (based on size, industry, etc), multiplied by the operating metric of the company you are valuing Most common multiple is Enterprise Value/EBITDA Others include Price/Earnings, PEG, EV/EBIT, Price/Book, EV/Sales Different multiples may be more or less appropriate for specific industries For example, if comparable company A is trading at an EV/EBITDA multiple of 6.0x, and the company you are valuing has EBITDA of $100 million, their EV would be valued at $600 million based on this valuation technique.

Statement of Cash Flows

Beginning Cash + CF from Operations (cost to run business, rent, employee pay, sales, interest) + CF from Investing (reinvesting in company or selling assets, ex. buying equipment) + CF from Financing (paying principle on loans, getting from from sending out bonds ) = Ending Cash

What is the link between the Balance Sheet and the Statement of Cash flows?

Beginning cash on cash flow comes from the prior time period's balance sheet Cash from operations is calculated from changes in balance sheet accounts -- Net Working Capital (Current Assets-Current Liabilities) Depreciation comes from Property, Plant & Equipment on the balance sheetInvestments 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 period' s balance sheet. The cash from operations is impacted by the change in net working capital which is Current Assets minus Current Liabilities. Depreciation comes from property, plant and equipment which affects 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 balance sheet.

What are some recent trends in investment banking?

Consolidation: Banks being acquired by other banks. JPMorgan buying Bear Stearns, Barclays buying part of Lehman Brothers. Capital Infusions: Buffett investing in Goldman Sachs, Mitsubishi investing in Morgan Stanley, TARP Global Expansion: Firms looking to expand into other, fast growing nations Technology: High technology is being used to execute trades, and distribute information more quickly

What are options?

Call Option: Gives the holder the right to purchase an asset for a specified exercise price on or before a specified expiration date. Put Option: Gives the holder the right to sell an asset for a specified exercise price on or before a specified expiration date. Options are a type of derivative that gives the bearer the "option" to buy or sell a security at a given date, without the obligation to do so. The buyer of the option pays an amount less of the actual value of the stock and has the OPTION to buy or sell the stock for a set price on or before a set date.

What is EBITDA?

EBITDA stands for Earnings before interest, taxes, depreciation, and amortization and is a good metric to evaluate a company's profitability EBITDA=Revenues - Expenses (Excluding tax, interest, depreciation and amortization) EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization and is an 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.

Why might there be multiple valuations of a single company?

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

What is Enterprise Value?

Enterprise value is the value of an entire firm, both debt and equity. The equation is below. Enterprise value = Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash Enterprise value is the value of a firm as a whole, to both debt and equity holders. In order to calculate enterprise value you take the market value of equity (AKA the company' s market cap), add the debt, add the value of the outstanding preferred stock, add the value of any minority interests the company owns and then subtract the cash the company currently holds.

LBO Valuation

Essentially an LBO (leveraged buyout) is when a firm uses a higher than normal amount of debt to finance the purchase of a company, then uses the cash flows from the company to pay off the debt over time. Many times they use the assets of the company being acquired as collateral for the loan. When they are ready to sell the company, ideally the debt has been partially or fully paid off, and they can collect most of the profits from the sale as the sole 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 all their own equity (ie without any debt). For more detailed information on LBO's, see the LBO analysis in the advanced section.

What is "face value"?

Face value or par value of a bond is the amount the bond issuer must pay back at the time of maturity. Bonds are usually issued with a $1,000 face value.

Highest Valution:

From lowest to highest: Of the four main valuation techniques (Market Value, Market Comps, DCF and Precedent Transactions) the highest valuation will normally come from the Precedent Transactions technique because a company will pay a premium for the 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 (similar companies) and market value (Just how the market values) will normally give the lowest valuation.

What kind of an investment would have a negative beta?

Gold is a type of investment that would have a negative beta. When the stock market goes up, the price of gold drops as people flee from the "safe haven" of gold. The opposite happens when the market goes down, implying a negative correlation.

What is hedging?

Hedging is a financial strategy designed to reduce risk by balancing a position in the market. For example, an investor that owns a stock could hedge the risk of the stock going down by buying put options on that security or other related businesses in the industry.

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 could a firm increase the returns on an LBO acquisition?

In order to increase a Private Equity fund's return on an LBO investment, there are a number of drivers that can be changed. o The most obvious way to increase a potential return is to increase the sale price when the firm monetizes its investment. o In modeling the returns, you could also increase your projections for the acquired companies earnings and cash flows. o The firm could also negotiate a lower purchase price, which would have the similar effect as raising the selling price. o Finally, the private equity firm could increase the amount of leverage or debt on the deal. The higher the leverage, the higher the return all else equal. However, increasing the leverage puts more financial stress on the company being acquired and increases the bankruptcy risk. There are a many ways a Private Equity fund can increase the return on an investment. First, they could increase the sale price at the time of monetization through either an increase in operating profits or multiple expansion. Up front, they could negotiate a lower purchase price, or increase the amount of leverage they use in purchasing the company which would imply a smaller equity check with a higher internal rate of return on the capital deployed.

In a leveraged buyout, what would be the ideal amount of leverage to put on a company?

In order to maximize returns in a leveraged buyout, the acquiring firm wants to finance the deal with the least amount of equity possible. However, they need to be careful as to not put the company into financial distress by overburdening the acquired company with debt.

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 do 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.

Are most mergers stock swaps or cash transactions and why?

In strong markets, most mergers are stock swaps mainly because the prices of companies are so high, as well as the fact that the current owners will most likely desire stock in the new company, anticipating growth in the strong market.

What is insider trading and why is it illegal?

Insider trading is the action of buying or selling stock in a company based on information that is not publicly available. For example, if a CEO of a pharmaceutical company knows that a drug is going to be pulled from the shelves by the FDA, he cannot sell his stock until that information has been released to the public.

What happens to Free Cash Flow if New 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 Account 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 Net Working Capital increases, your Free Cash Flow will decrease.

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

It depends on the correlation of the new investment to the portfolio. It could potentially lower the overall risk of the portfolio.

What is liquidity?

Liquidity is how freely an asset or security can be bought and sold on the open markets by an investor o Money market accounts are very liquid, publicly traded large cap stocks are also very liquido Micro-cap stocks could be relatively low liquid due to the limited market demand for them It also is how quickly an asset can be converted into cash Cash itself is obviously the most liquid asset A larger pharmaceutical production plant is not a very liquid asset 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, large-cap stocks, etc. Some non-liquid assets include many micro-cap stocks, or in the example of a large corporation a large, specialized factory or production plant which could take years to convert into cash.

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"?

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 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 offered it at. This happened a lot during the .com boom. Company' s stock would skyrocket on the first day of trading due to the huge hype over the stock.

What makes a company an attractive target for a Leveraged Buy-Out?

Most importantly, an LBO needs to have a steady stream of cash flows so they are able to pay down the debt used to purchase the business. This means the company should be at the lower end of the risk spectrum, have limited need for additional capital expenditures, and preferably be in a relatively stable industry. A good candidate should also have a strong management team (unless the Private Equity firm intends to replace them), the ability to reduce its cost structure and a solid asset base that can be used as collateral. The most important characteristic of a good LBO candidate is steady cash flows. The firm ideally could pay off a significant portion or all of the debt raised in the acquisition over the life of the investment horizon, with minimal bankruptcy risk. Some other good characteristics include strong management, cost-cutting opportunities, and a non-cyclical industry.

Can you ever end up with negative Shareholders' equity? What does it mean?

Negative Shareholders' Equity is common 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 Shareholder's 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 2nd scenario) NOTE - Shareholder's Equity never turns negative immediately after an LBO - It would only happen following a dividend recap or continued net losses.

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

Negative Working Capital is not necessarily a bad sign. It depends on the type of company and the specific situation. Below are a few examples. 1) Some companies with subscriptions or longer-term contracts often have negative Working Capital because of 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 use 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 is Net Working Capital?

Net Working Capital is equal to Current Assets minus Current Liabilities. It is a measure of how able 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.

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. Operating leverage is the relationship between a company' s fixed and variable costs. A company whose costs are mostly fixed has a high level of operating leverage.

What are some examples of non-recurring (one time unlike depcreiation/amortization ) charges that 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 Proce

Income Statement

Revenues - COGS - Expenses = Net Income

What does it mean to short a stock?

Short selling is selling a stock that you don't actually own. An investor that short-sells a stock is taking the position that they will be able to purchase that stock at a lower price in the future. Normally a short-seller will borrow the stock from another investor, and then sell it. Naked short selling occurs when an investor sells the stock without having any of the stock actually borrowed. Short selling a stock is essentially the opposite of going long in a stock. When an investor buys a stock, they believe they will be able to sell the stock for a higher price in the future. When short-selling, the investor sells a stock they don' t actually own, under the belief they will be able to purchase it for a lower price in the future.

What does spreading comps mean?

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 the difference between technical analysis and fundamental analysis?

Technical analysis is the process of picking stocks based on historical trends and stock movements mainly based on charts. Fundamental analysis is examining a company' s fundamentals, financial statements, industry, etc and 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?

This depends on a number of different factors including the beta of the company and the performance of the market. 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.

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 you feel is extremely accurate, you can give that more weight, if you are extremely confident in your DCF you can give that more weight. Valuing a company is as much an art as it is a science.

What is the coupon payment?

The coupon payment is the amount that a company will pay to a bondholder normally on an annual or semi-annual basis. It is the coupon rate x the face value of the bond. For example, the coupon payment on an annual 10% bond with a $1,000 face value is $100.

What is the default premium?

The default premium is the difference between the yield on a corporate bond and the yield on a government bond with the same time to maturity to compensate the investor for the default risk of the corporation, compared with the "risk-free" comparable government security.

.What is the default risk?

The default risk is the risk of a given company going bankrupt

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

The distribution of a dividend signals to the public that a company is healthy and profitable and it can also attract more investors, potentially driving up the company' s stock price.

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

The first line of the income statement would be revenues or sales. From that you subtract cost of goods sold which leaves you with your gross margin. Then you subtract your operating expenses, leaving you with your operating income. From operating income you subtract any other expenses, and your income taxes, which leaves you with your net income.

Why would a company like Facebook/Twitter receive billion dollar valuations when they have very low revenues and profit margins?

The key here is that investors are anticipating extremely high future earnings of these businesses due to their reach and growth trajectory, and are less focused on the present revenues and margin Their belief is that Facebook or Twitter will, in the future, be able to tap into the earning power of their millions of users in some way they aren't currently doing With the social media giant Facebook, investors are banking on the fact that in the future, the company will find a better way to monetize their massive user base. With over 200 million members, if Facebook can find a better way to charge higher rates for advertising, their earnings could be astronomical! Another reason a company like Facebook may receive a valuation in the billions is because companies like Microsoft are willing to pay astronomical premiums for a small equity stake in the business in order to try and catch the wave of the future and establish a closer partnership. For example, in 2007 Microsoft invested in Facebook at a valuation of $15 billion

What is the difference between a bond and a loan?

The main difference between a bond and a loan is the market that it is traded on. A bond issuance is usually for a larger amount of capital, is sold in the public market and can be traded. A loan is issued by a bank, and is not traded on a public market.

What is the market risk premium?

The market risk premium is the required return that investors require for investing in stocks over investing in "risk free" securities. It is calculated as the average return on the market (around 12-13%)- the risk free rate (current yield on a 10 year treasury)

Market Valuation / Market Capitalization

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

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 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.

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

The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to lenders and investors from the earnings of a company.

What are the three types of mergers and what are the benefits of each?

The three types of mergers are horizontal, vertical and conglomerate. A horizontal merger is a merger with a competitor and will ideally result in synergies. A vertical merger is a merger with a supplier or distributor and will ideally result in cost cutting. A conglomerate merger is a merger with a company in a completely unrelated business and is most likely done for market or product expansions, or to diversify its product platform and reduce risk exposure.

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

There are 2 ways you could do this: 1) Bottoms-Up Build - Start with individual products/customers - estimate the average sale value or customer value - and then the growth rate in sales and sales values to tie everything together 2) Tops-Down Build - Start with the "big-picture" metrics like overall market size - then estimate the company's market share and how that will change in the coming years - and then multiply to get their revenue Of these two methods, Bottoms-Up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

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 within the market value of equity. You also subtract cash because you can either use that cash to pay off some of the debt, or pay yourself a dividend, effectively reducing the purchase price of the company.

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

There are a number of reasons a company may issue stock rather than debt to fund its operations. First, if it believes its stock price is inflated, it can issue stock and receive a high price for the shares. If the projects for which the money is being raised may not generate predictable cash flows in the immediate future, the company may have a difficult time paying the consistent coupon payments required by the issuance of debt. The company could also choose to issue stock if they want to adjust the debt/equity ratio of their capital structure.

What are some ways you can value a company?

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 leverage buyout valuation.

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 could have been down on the day (or the industry to which XYZ belongs), which had more of an impact than the company' s positive earnings. More likely however, is that even though they released increased earnings, the figures were not as high as the Wall Street analyst estimates.

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

This is another question that you can use to show your interest in the markets. It is not a right or wrong question; everyone has different opinions on where the market is going. You need to have an opinion and a well thought out reasoning for that opinion. If you think the market is going to drop in the next three months, hit a bottom and then begin to bounce back, have a reason why you think it is going to drop, why it is going to bottom out, and why it will begin to rise. It is more important you display logical reasoning than whether or not your prediction turns out to be true. Also, remember to stick to your reasoning. Your interviewer may try to challenge you and challenge your reasoning. If you have come up with a solid response, you should be confident in your answer and confident in your reasoning. Do not change your opinion just to agree with your interviewer.

Is 15 a high P/E ratio?

This is not a yes or no question. A firm's P/E ratio is important in comparison with other companies in their industry. P/E can be thought of 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 their earnings at a high rate, and therefore deserve a higher valuation relative to their earnings. For a large pharmaceutical company, however, a P/E of 15 may be considered high, since their earnings growth may be expected to slow in future years. It depends on the industry of the company you are looking at. A P/E ratio of 15 in an industry like basic materials is a bit high, but if this company is a high growth tech company, 15 may be considered rather low.

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

Three examples: 1 ) Web-based subscription software 2) cell phone carriers that sell annual contracts 3) Magazine publishers that sell subscriptions - Companies that agree to services in the future often collect cash upfront to ensure stable revenue * This makes investors happy as well since they can better predict a company's performance - Per the rules of 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

Walk me through a DCF

To begin we would project the free cash flows of the company for about 5 years. Free cash flow is EBIT times 1 minus the tax rate, plus Depreciation and Amortization, minus CapEx, minus the Change in Net Working Capital. Then you must predict the free cash flows beyond 5 years which is done either using a terminal value multiple or the 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 (low single digit percentage). 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, and 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 value of the firm. 2 problems for DCF: You are assuming you are in January and have the res of the year to collect cash flow. what if you are in July? must use a stub period, to adjust for calenderization and only discount the rest of the year. how to use stub period? denominator is to the power of .5 also have to use mid year discounting peroid increment discounting period by .5 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 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 GDP growth rate, in order to assume that the company can grow at this rate infinitely. 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. 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 one 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).

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. -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. - COGS should be tied directly to Revenue and each "unit" produced should incur an expense. - Other items such as rent, Capex , 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

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

To value this company, you must 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.

What is the difference between APV and WACC?

WACC incorporates effect of interest tax shields into the discount rateo 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 NPV assuming all-equity value o Useful where costs of financing are complex and if capital structure is changing o Use for Leveraged Buyouts

Precedent Transactions

With this valuation technique you need to find historical transactions that are similar to the transaction in question. This includes the size of the company, the industry they are in, the economic situation, etc. Once you have found transactions that are comparable, look at how those companies were valued. What were the EV/EBITDA and EV/Sales multiples paid? Calculate a valuation multiple based on the sale prices in those transactions, and apply the multiple to the appropriate metric of the company in question. Most of the time this valuation technique will result in the highest valuation due to the inclusion of the "control premium" that a company will pay for the assumed "synergies" that they hope will occur after the purchase.

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

You should do more research because past performance 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% last year due to the market for MBS's collapsing. To make an investment decision you need to research more in depth into the fund' s holdings.

You are advising a client in the potential sale of the company. Who would you expect to pay more for the company: a competitor, or an LBO fund?

You would expect a competitor who is a strategic buyer to pay more for the given company. This is due to the fact that strategic buyers would derive additional benefits (synergies) and therefore higher cash flows from the purchase than would an LBO fund which is traditionally a financial buyer.

if company A has a higher P/E than company B

accretitive

cash from operating activities

cash received from sales, cash paid out to suppliers, interest, employees, taxes measure of companies operating profit

accretitive

company A's EPS pre-deal < company A's EPS post-deal; accretive

Dilutive merger

company A's EPS pre-deal > Company A's EPS post-deal; dilutive

company A < company B p/e

dilutive

Unlevered vs levered FCF

levered if cash flow that business has after paying expenses; obtain enterprise value (equity value) unlevered is cash flow business have before paying expenses such as interest expense; (most common)

cash from financing activities

money raised through share issuances, bond issuances, loans, deduct share buyback, dividends, positive means company is raising money

free cash flow

operating cash flow - capital expenditures capital expenditures = money from investing activities (buying assets) Free cash flow is EBIT (Earnings Before Interest and Taxes) times 1 minus the tax rate plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital

cash from investing activities

purchase or sale of longer term assets money spent to grow business buildings, acquisitions, buying securities usually negative but can be positive if company is selling assets

A stock is trading at $5 and a stock is trading at $50, which has greater growth potential?

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