Guide 2

Walk me through the major line items on the cash flow statement.

First the beginning cash balance, the cash from operations, then cash from investing activities, then cash from financing activities and finally the ending cash balance

How would you value a company with no revenue?

First you would make reasonable assumptions about the company's projected revenues (and projected cash flows) for future years. Then you would calculate the net present value of these cash flows.

How do you value a company?

-discounted cash flow -comparable companies analysis -precedent transactions (when you buy a company, you tend to pay a control premium - or the value per share that you pay is more than what they are actually worth. this makes the value higher than it should be and this is why it tends to overvalue projects)

Walk me through the major items on an income statement.

3 main components - Revenue, expenses, and net income. Depreciation and amortization are non-cash expenses Revenue- COGS = Gross margin - Operating expenses (d/a) =Operating income (EBIT) -interest expense -income taxes =Net income

Describe a typical company's capital structure.

A company's capital structure is just what it sounds like: the structure of the capital that makes up the firm, or its debts and equity. Capital structure includes permanent, long-term financing of a company, including long-term debt, preferred stock, and common stock. The statement of a company capital structure as expressed above reflects the order in which contributors to the capital structure are paid back, and the order in which they have claims on a company's assets should it liquidate. Debt has first priority, then preferred stock holders, then common stock holders. Be sure to understand the difference between secured and unsecured.

What is EBITDA?

A proxy for cash flow Earnings before interest, taxes, depreciation, and amortization It can be found on the income statement by starting with EBIT and adding depreciation and amortization back

Is A/R a source or use of cash? Is A/P a source or use of cash?

A/R is a use of cash, because for every dollar that should be coming in the door from those that owe money for goods/services, that cash has been delayed by a collection time period (company is waiting to receive money). conversely, A/P is a source of cash, because companies have the ability to purchase items without immediately paying cash.

Say you knew a company's net income. How would you figure out their FCF?

Add back D/P since these are not cash expenses. Subtract the company's capex (how much money the company invests each year in plant and equipment), then subtract the change in net working capital

Why industries are you interested in? What are the multiples that you use for those industries?

As discussed, different industries use different multiples. Answering the first part of the question, pick an industry and know any major events that are happening. Next, if you claim interest in a certain industry, you must known how companies in the industry are commonly valued.

Why do deferred taxes happen?

As noted in my previous article, deferred taxes exist because accounting methods for shareholder income (what the company tells you) and taxable income (what the company tells the taxman) are different. Let's use an example from the funny pages. Popeye's chum Wimpy was always asking for a hamburger today in exchange for payment next Tuesday. In other words, he wanted the benefit up front, but he wanted to delay his payment for as long as possible. Like Wimpy, companies want to do the same thing with their taxes. The longer they can defer (or delay) taxes, the longer they have use of that cash, which means they can use it to make more money. Companies paint as dreary a picture as possible to the taxman in order to reduce or delay tax payments, but to someone they're trying to impress -- shareholders -- they'll probably show a rosier picture. When companies delay their tax payments, they create deferred tax liability accounts (DTLs) to reflect future tax obligations. The most common reason for DTLs is depreciation. When a company buys property, plant, or equipment (PP&E), it makes assumptions that either depreciate (reduce the value of) this PP&E slowly or quickly. To you, the shareholder it's trying to impress, the company depreciates slowly, showing you higher income. For the taxman, the company accelerates depreciation, which lowers income and tax payments. Theoretically, over time, this will eventually reverse, and the company will have to pay up. Because of this, the company books DTLs to reflect future tax obligations. Some other events that can prompt DTLs include research and development- or merger-related expenses, where management estimates can make shareholder and taxable incomes different.

What is Beta?

Beta is the value that represents a stock's volatility with respect to overall market volatility

What is Chapter 7? What is Chapter 11?

Both chapter 7 and chapter 11 are forms of corporate bankruptcy. technically speaking, they are chapters of the U.S. bankruptcy code. chapter 7 is the section of the that covers liquidation of a company. chapter 11 is the section of the code that outlines how a company can be protected by the us court system under the plan of reorganization. generally speaking, companies in distress declare chapter 11 and seek advice from investment banks (namely restructuring groups within investment banks) who advise them on the best course of action. as mentioned earlier, they capital structure of a firm is exceptionally important during these proceedings, in order to determine how much the firm is worth and what percentage of the initial investment that investors in each piece of the capital structures can expect.

Can I apply CAPM to latin american markets?

CAPM was developed for the use in US markets, however, it is presently the best known tool for calculating discount rates. Hence, while CAPM is not exact, it is a good framework for thinking about and analyzing discount rates outside of the US as fundamentally, markets are based on similar principles.

What is a coverage ratio? What is a leverage ratio?

Coverage ratios are used to determine how much cash a company has to pay its existing interest payments. The formula usually comes in the form of EBITDA/interest. leverage ratios are used to determine the leverage of the firm, or the relation of its debt to its cash flow generation or equity. there are many forms of this ratio. a standard leverage ratio would be debt/ebitda or net debt/ebitda. debt/equity is another form of a leverage ratio, yet it measures the relation of debt to equity that a company is using to finance its operations

What are deferred taxes?

Deferred taxes take either the form of an asset or liability. They arise for many reasons, but for us, it's important to understand that they are kept on the balance sheet and are meant to hold the place for future tax adjustments. In essence, if you paid more in taxes than you owe, you'd have deferred tax asset that you could use to offset future taxes. If you paid less in taxes than you owed, you would have a deferred tax liability, of which you would add to future tax payments.

What is goodwill?

Goodwill is an asset on the balance sheet. It is intangible. It can be the premium that one firm pays for another over the current market valuation. It can also reflect the value of other things, such as a corporate brand. If coke were purchased by Pepsi, one could expect pepsi to pay a large premium over coke's existing assets and a massive goodwill entry on pepsi's balance sheet, to reflect the coke global brand.

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

If this is all the info you are given, you can use the comparable transaction or multiple method to value this company (rather than DCF method). To use the multiples method, you can examine common stock information of comparable companies in the same industry to get the average multiples of price to earnings. You can then apply that multiple to find the company's value.

What is net debt?

Net debt is debt - cash and cash equivalents, or the true amount of debt that the firm has, after it uses its existing cash to pay off current outstanding debt.

What are the different multiples that can be used to value a company?

P/E, Revenue, EBITDA, EBIT, and book value. The relevant multiples depend on the industry. Internet companies are often valued with revenue multiples; this explains why companies with low profits can have such high market caps. Many companies are valued using EBITDA. Furthermore, P/E ratios come under scrutiny because net income is the "E" and net income includes interest and tax payments, which might not be the same post-acquisition.

How do you calculate the terminal value of a company?

Perpetuity formula - TY FCF = FCF(last year)(1+g)/(rd-g)

Why are the P/E multiples for a company in London different than that of the same company in the States?

The P/E multiples can be different in the two countries even if all other factors are constant because of the difference in the way earnings are recorded. Overall market valuations in American markets tend to be higher than those in the UK.

Is 10 a high P/E ratio?

The answer to this or any question like it is "it depends." P/E ratios are relative measurements, and in order to know whether a P/E ratio is high or low, we need to know the general P/E ratios of comparable companies. Generally, higher growth firms will have higher P/E ratios because their earnings will be low relative to their price, with the idea that earnings will eventually grow more rapidly than the stock's price.

What is meant by the current ratio? What is meant by the quick ratio?

The current ratio measures the ability of a company to pay its short-term obligations. The higher, the better. It is current assets/current liabilities. The quick ratio also measures the ability of a company to meet its short-term obligations The higher, the also better. However, the quick ratio doesn't include inventory, as this is often considered a non-liquid current asset. So the formula is (current assets-inventory)/current liabilities.

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

The income statement is a record of revenue and expenses while the statement of cash flows records the actual cash that has either come into or left the company. The statement of cash flows has the following categories: operating cash flows, investing cash flows, and financing cash flows. Interestingly, a company can be profitable as show in the income statement, but still go bankrupt if it doesn't have the cash flow to meet interest payments. Both statements are linked by Net Income.

What is the link between the balance sheet and the income statement?

The main link between the two statements is that profits generated in the income statement get added to shareholder's equity on the balance sheet as retained earnings. Also, debt on the balance sheet is used to calculate interest expense in the income statement.

If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt vs. equity)?

The right answer is it depends. First and foremost, companies should seek to raise money from the cheapest source possible. However, there might exist certain conditions, limitations, or implications of raising money in one form or another. For example, although the cheapest form of debt is typically the most senior (corporate loans), the loan market might not have any demand for a company to issue a new loan. Or the company might not have the cash flow available to make interest payments on the new debt. Or the equity markets might very well receive a new offering from this company, more than the debt markets (thus equity is chapter than debt). Or the cost of raising an incremental portion of debt might exceed that of raising equity. All of this should be considered when answering this question. Be prepared to ask more clarifying questions.

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

The statement of cash flows starts with the beginning cash balance, which comes from the balance sheet. Also, cash from operations is derived using the using the changes in balance sheet accounts (such as A/P, A/R, etc). The net increase in cash flow for the prior year goes back onto the next year's balance sheet.

Why might there be multiple valuations for a single company?

There are several different methods by which one can value a company. And even if you use the rigorously academic DCF analysis, the two main methods (WACC and APV) make different assumptions about interest tax shields, which can lead to different valuations. This is the basic principle in corporate finance and one of the many reasons that market capitalizations fluctuate.

How do you unloved a company's beta?

Unlevering a company's beta means calculating the beta under the assumption that it is an all-equity firm. The formula is as follows: Levered = Unlevered * (1+(1-t)(D/E)

The CEO of a 500 mil company has called you, her investment banker. She wants to sell the company. She wants to know how much she can expect for the company today.

Valuation question.

What is the difference between APV and WACC?

WACC incorporates the effect of tax shields into the discount rate used to calculate the present value of cash flows. WACC is typically calculated using actual data and numbers from balance sheets for companies and industries. APV adds the present value of the financing effects (most commonly, the debt tax shield) to the net present value assuming an all-equity value, and calculates the adjusted present value. The APV approach is particularly useful in cases where subsidized costs of financing are more complex, such as in a leveraged buyout.

How do you get the discount rate for an all-equity firm?

You use the capital asset pricing model, or CAPM

What happens to each of the three primary financial statements when you change a. gross margin b. capex c. any other change?

a. if gross margin decreased, revenue decreased relative to sales. Thus for the income statement, you would probably pay lower taxes, but if nothing else changed, you would likely have lower net income. the cash flow statement would be affected in the top line with less cash likely coming in. hence, if everything else remained the same, you would likely have less cash. going to the balance sheet, you would not only have less cash, but to balance that effect, you would have to lower shareholder's equity b. if capex decreased, then first the level of capex would decrease on the statement of cash flows. this would increase the level of cash on the balance sheet but decrease the level of property plant and equipment, so total assets would remain the same. on the income statement, the depreciation expense would be lower in subsequent years, so net income would be higher, which would increase cash and shareholder's equity in the future c. changing one sheet has ramifications on all the other statements both today and in the future

What is the formula for CAPM?

re=rf +B(rm-rf) rf= risk free rate = the treasury bond rate for the same period