Max Ellis Guide - Banking
What is the typical long term growth rate under the perpetuity growth method?
2.5-3.0% because that is what the historic GDP is (you can't assume it grows faster than the GDP otherwise the company will take over the world).
And the cost of equity?
Capital Asset Pricing Model: Risk-Free Rate+Levered Beta(Expected Market Return-Risk-Free Rate)
Company A has a share price of $25 and 1,000,000 shares outstanding buys Company B with 40% equity paying $15/share with 500,000 shares outstanding. Company A has a net income of $4,000,000 and company B has a net income of $1,000,000, cost of debt is 6% (40%tax rate), there is $250,000 (after tax) in hard synergies. Is this accretive of dilutive?
Company B= $15X500,000=$7,500,000 paid. $7,500,000X40%=$3,000,000 in equity; $7,500,000-$3,000,000=$4,500,00 in debt. #3,000,000/$25=120,000 new shares issued. $4,500,000x6%x(1-40%)=$162,000 interest expense from debt. Old EPS: $4,000,000/1,000,000=$4.00 New EPS: ($4,000,000+$1,000,000+$250,000-$162,000)/(1,000,000+120,000)=$5,088,000/1,120,000=$4.54 It is accretive ($4.54 vs. $4.00)
What are comparable companies? why should I look at it?
Comparable companies are looking at what multiples similar companies are trading at in the public markets. IF you are thinking about taking a private company public, then you should focus on this.
If the company used 50% debt and 50% equity to buy the company, what would be the cost of debt that makes the purchase P/E neutral (assuming a 40% tax rate)?
Cost %'s can be invested to find the PE of debt 0.5X(PE of debt)_0.5X10=PE of 12 PE of debt=14 Cost of debt after taxes=1/14=7.14% 0.0714/(1-0.40)=.1109 or 11.90% cost of debt
How do you value a company?
Discounted cash flows, precedent transactions, comparable companies, and in the case of a financial sponsor a leveraged buy-out.
What if I have a private company?
Find closet competitors, unlever their betas, average that, then lever it back up at your company's leverage ration and tricks rate.
What is the difference between IRS accounting and GAAP accounting?
IRS accounting is on a cash basis, GAAP accounting is on an accrual basis.
What is IRR?
Internal rate of return; what discount rate is required to make the net present value of all cash uses/ sources equal to 0.
What are precedent transactions? Why should I look at it?
Looking at previous transactions s to see what multiples are being paid. if a company wants to sell itself/spin of a subsidiary, this is one of the more important valuation metrics.
Your company issues bonds at par for $100. How do you acount for it?
On the Statement of cash flows, cash from financing increases by $100. This means an increase in cash on the balance sheet of $100, but there is also an increase of $100 in debts payable.
What are the other ways of valuing a company?
Sum of parts, book value, liquidation value.
Can I get equity value from a DCF?
Use levered fcf instead of unlevered fcf and make the cost of equity the discount rate.
How do you calculate it?
(Debt/Debt+Equity) X Cost of Debt X (1-maringal tax rate)+(Equity/Debt+Equity) X Cost of Equity
How do you calculate terminal value (both ways)?
-Exit multiple method, where you assume at the end of the period you assume the company is sold for similar multiples at what recent transactions have been occuring at. -Perpetuity method where you assume the company continues to grow at one rate forever. ((Last year of projections FCF)X(1+perpetuity growth rate))/(discount rate-perpetuity growth rate)
Weighted Average Cost of Capital (WACC)
-The average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation -Can see how much interest the company has to pay for every dollar it finances.
Terminal Value (TV)
-The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as interest rates and the current value of the asset, and assuming a stable growth rate. -terminal value can also refer to the value of an entire company at a specified future valuation date
How much equity contribtuion do you usually see in LBO's?
35-40%
What are common leverage amounts? Why?
4-7X Net Debt/EBITDA. You use fcf to pay down debt over the holding period, so you want a leverage amount similar to how many years you plan on holding the company.
What is a DCF? Why should I look at it?
A DCF is where you project out free cash flows for an appropriate amount of time, find the terminal value at the end of these projections, discount the values back to the present and then sum them. a DCF provides the 'intrinsic value', or what the company is worth if you just hold onto it and decide not to sell it.
What is a deferred tax asset? How do they normally arise?
A deferred tax asset is a tax benefit that you get in the future. This arises when you have negative net income one year, which creates the DTA.
What is a deferred tax liability? How do they normally arise?
A deferred tax liability is where you owe/will owe the government money in the future for taxes, but the government has not charged you yet. This usually arises when you use accelerated depreciation for the IRS and a slower depreciation rate on your books.
What is an LBO? Why should i look at it?
An LBO is used as benchmark for private equity firms to see whether or not they can make an appropriate return on a company by buying is with primarily debt and using free cash flow to pay down this debt and build equity over time. You project out the free cash flows for the holding periods, build in a debt schedule, find the terminal value, discount these values to the present and sum them. It is important to see whether or not a financial sponsor might pay more for a company than a strategic acquirer.
What is dividend recap?
At the end of the holding period you basically re=LBO it; take on a lot more debt at the company and pay investors a large dividend.
What do I look for in comparable companies? Why?
Basically the same as precedent transactions, for the same reasons.
A company with a P/E of 10 uses 100% equity to buy a company with a P/E of 12. Is this accretive of dilutive?
Dilutive; you receive ten dollars upfront to give up one dollar of earning power but are paying twelve dollars upfront to receive one dollar of earning power.
Why can't I use EV/EPS?
EPS is only available to equity holders whereas EV represents all stakeholders.
What does the end value of the DCF give you?
Enterprise Value.
Which one is more expensive? Why?
Equity is more expensive because when a company declares bankruptcy, they get paid last. Numerically, the cost of equity takes into account the leverage ratio, making equity more expensive. There is also a tax benefit associated with debt.
Which way of calculating terminal value is more common?
Exit multiple method.
What are the five uses of cash?
Finance operations, pay a dividend, pay down debt, buy back equity, make an acquisition.
What is EBITDA a proxy for? EBIT?
Free cash flow, operating income.
How do you get to free cash flows from (revenue/operating cash flows/net income)?
From revenues: revenues minus cost of goods sold gives you gross profit, minus supplies, general & administrative, and depreciation and amortization gives you EBIT. Tax affect EBIT to give you Earnings Before Interest After Taxes, then add back depreciation & amortization, subtract changes in working capital and capital expenditures to get (unlevered) FCF. From operating cash flows: Subtract capital expenditures, From net income: Add back interest, tax affect it, add back depreciation & amortization, subtract changes in working capital and cappex.
How do I calculate enterprise value?
Fully diluted equity (in the money options, warrants, convertible debt) + net debt + minority interests
What is the difference between hard synergies and soft synergies?
Hard synergies are cost savings that are almost sure to be had; soft synergies are increases in revenue/net income which are harder to predict accurately.
When would this ranking get switched up?
If the economic environment has recently changed then there might not be any relevant precedent transactions, changes in wacc/projected fcf/terminal value would change a DCF, the public markets could be in a bubble or depression for comparable companies, debt prices could be cheap or there could be synergies for an add on company in an LBO.
Let's say a company has had great free cash flow for the past 100 years and it declares bankruptcy. Why would this happen?
It probably has taken on a lot of debt and can no longer pay down the principle/interest.
On January 1st your company issues $100 debt at a 10% interest rate. You immediatly use that money to buy $100 of equipment that has a 10 year useful life and it is depreciated using the straight line method. How do you account for it when this transaction takes place? At the end of the year (assume you let the interest accrue)?
January 1st: Cash from financing increases by $100, cash from investing decreases by $100. On the balance sheet property, plant, & equipment increases by $100, but so does debts payable. Year end: On the income statement you have a depreciation expense of $10 and an interest expense of $10. Income before taxes is -$20 and you have a tax benefit of $8. Net income is -$12 which flows through to the statement of cash flows. Add back non-cash expenses (depreciation of $10) and changes in working capital (you let the interest accrue, so $10) and you have cash increase by $8. This flows into the cash account on the balance sheet, net PP&E decreases by $10, and interest payable increases by $10. The difference in this is -$12 (found on the income statement) and goes into the retained earnings.
Why is leverage important?
Leverage helps reduce the initial amount of equity needed, which helps to increase the internal rate of return.
How do I calculate leverage?
Leverage is some form debt in the numerator (total debt, net debt, total senior secured) divided by EBIT/EBIDA/EBITDAR/ect.
How do I lever Beta?
Levered Beta=Unlevered Beta X (1+(Debt/Equity)X(1-tax rate))
Where do i find cost of debt?
Look at Bloomberg on the debts outstanding and look at the yield to maturitiest.
What is net working capital? Can you think of a case where a company can keep net working capital negative but still be very successful?
Net working capital is current assets (excluding cash) minus current liabilities. Wal-Mart has a great supply chain where they keep inventory relatively low, get paid right away by customers, and don't have to pay their supplies until the end of the month.
If I issue debt for $100, what happened to EV?
No change, debt increases $100 is canceled out by a cash increase of $100.
Free Cash Flow (FCF)
Operating cash flow minus capital expenditures
What multiples do you look at?
P/E, EV/EBITDA, EV/Sales, Debt/EBITDA, Interest Expense/EBITDA
Which valuation usually gives you the highest amount? Second? Third? Fourth?
Precedent transactions due to control premium and synergies, DCF because of management optimism, comparable companies because the liquidity premium, LBO in last because there are rarely premiums.
What do I look for in precedent transactions? why?
Similar industry/core competency, similar size, similar geography are the three big ones. You also want a similar economic environment. After that you might want similar ratios, metrics , multiples, credit ratings, customers, suppliers, etc. There is no perfect comp, but by finding as similar as possible you can find the most accurate valuation as possible.
How does $10 depreciation flow through financial statements?
Starting with the income statement, you have a $10 depreciation expense, but a $4 tax benefit. The net income is -$6, which flows through to the statement of cash flows. Add back non-cash expenses (depreciation) of $10 and you get an increase in cash from operations of $4. This flows through to the balance sheet where cash increases by $4, net property, plant, & equipment decreases by $10, and the difference from that (found in net income) is -$6 which flows into the statement of retained earnings.
If you had one financial statement, which would it be?
Statement of cash flows. Can get Free Cash Flows and use it to run a discounted cash flows or compare to competitors.
If you had one financial statment, which would it be? What about two?
Statment of cash flows. Can get Free Cash Flows and use it to run a discounted cash flows or compare to competitors. If you had two then balance sheet and income statement; you can get the cash flows from these two.
The day after that (bonds are still at $50), you buy them back. How do you account for it?
Unusual income on the income statement increases by $50, but there is a tax expense of $20 to get to a net income of $30. This flows through to the statement of cash flows but you subtract out non cash gains of $50 so cash from operations is -$20. Cash from financing is -$50. Net change in cash is -$70 which is taken into account in the balance sheet cash account. Debts payable also decreases by $100 and the difference of that is $30 (found in the income statement) flows into the retained earnings.
How can I increase IRR?
Using more debt and less equity, increase fcf, paying a lower multiple, selling at a higher multiple, finding synergies between a platform and add-in/tuck-on, industry is more appealing at end of holding period than beginning, hiring very experienced management moving the headquarters to a more tax friendly environment.
How long do you project out cash flows?
Usually between 3-10 years, but it can be longer under unusual circumstances.
What is the discount rate you use?
Weighted average cost of capital.
What is minority interest?
When company A owns 60% of Company X, 100% of Company X's earnings is recorded on A's books so you need to add the other 40% of Company X to account for other stakeholders.
The next day the market values those bonds at $50. How do you account for it?
You do not do anything.
Working Capital
indicates whether a company has enough short term assets to cover its short term debt Working Capital=Current Assets-Current Liabilities
Beta
measure of volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole
If the cost of debt is 6%, what % of equity is needed to be P/E neutral?
y=portion of debt needed 0.06x(1-0.4)=0.036=PE of 27.7 27.7y+10(1-y)=12 17.7y=2 y=11.25%, so equity=88.75%
