Valuation

How are the three main financial statements connected?

-net income flows from the is into cash flow from operations on the cf statement -net income minus dividends is added to retained earnings from the prior periods balance sheet to come up with retained earning on the current periods balance sheet -beginning cash on the cf statement is cash on the current periods balance sheet

What is the difference between accounts receivable and deferred revenue?

Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. Deferred revenue is the opposite, money that has not yet been recorded as revenue because it was collected for goods or services not yet delivered.

How could a company have positive EBITDA and still go bankrupt?

Bankruptcy occurs when a company can't make its interest or debt payments. Since EBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company's EBITDA, then if they have insufficient cash on hand, they would soon default on their debt and could eventually need bankruptcy protection.

How do you determine which valuation methodology to use?

Because each method has unique ability to provide useful information, you don't choose just one. The best way to determine the value of a company is to use a combination of valuation techniques. For example, if you have a precedent transaction valuation that you feel is extremely accurate, you may give that result more weight. Or if you are extremely confident in your DCF analysis, you will place more emphasis on its outcome. Valuing a company is as much an art as it is a science.

When looking at the acquisition of a company, do you look at Equity Value or Enterprise Value?

Because the acquiring company must purchase both liabilities and equity in order to take over the business, the buyer will need to assess the company's Enterprise Value, which includes both the debt and the equity.

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

Beginning cash on the Statement of Cash Flows comes from the previous period's Balance Sheet. Cash from operations on the Cash Flow Statement is affected by the Balance Sheet's numbers for change in net working capital, current assets minus current liabilities. Property, plant, and equipment is another Balance Sheet item that affects the Cash Flow Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of property, plant, and equipment will affect cash from investing. Finally the Cash Flow Statement's ending cash balance becomes the beginning cash balance on the new Balance Sheet.

What is Beta?

Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta less than 1.

Would you be calculating Enterprise Value or Equity Value when using a multiple based on free cash flow or EBITDA?

EBITDA and free cash flow represent cash flows that are available to repay holders of a company's debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors. A multiple such as P/E ratio, based on earnings alone, represents the amount available to common shareholders after all expenses are paid, so if you used this multiple, you would be calculating the value of the firm's equity.

Why might there be multiple valuations of a single company?

Each method of valuation will generate a different value because it is based on different assumptions, different multiples, or different comparable companies and/or transactions. Generally, the precedent transaction methodology and discounted cash flow method lead to higher valuations than comparable companies analysis or market valuation does. The precedent transaction result may be higher because the approach usually will include a "control premium" above the company's market value to entice shareholders to sell and will account for the "synergies" that are expected from the merger. The DCF approach normally produces higher valuations because analysts' projections and assumptions are usually somewhat optimistic.

What is Enterprise Value?

Enterprise Value is the value of a firm as a whole, to both debt and equity holders. To calculate Enterprise Value in its simplest form, you take the market value of equity (aka the company's market cap), add the debt and the value of outstanding preferred stock, add the value of any minority interests the company owns, and then subtract the cash the company currently holds.

Walk me through a Discounted Cash Flow model.9

First, project the company's free cash flows for about 5 years using the standard formula.( Free cash flow is EBIT times 1 minus the tax rate, plus Depreciation and Amortization, minus Capital Expenditures, minus the Change in Net Working Capital.) Next, predict free cash flows beyond 5 years using either a terminal value multiple or the perpetuity method. To calculate the perpetuity, establish a terminal growth rate, usually about the rate of inflation or GDP growth, a low single-digit percentage. Now multiply the Year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate. Your discount rate is the Weighted Average Cost of Capital, or WACC. Use that rate to discount all your cash flows back to year zero. The sum of the present values of all those cash flows is the estimated present Enterprise Value of the firm according to a discounted cash flow model.

How do you calculate Free Cash Flow?

Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital

What kind of an investment would have a negative beta?

Gold is an investment that has a negative beta. When the stock market goes up, the price of gold typically declines as people flee from the "safe haven" of gold. The opposite happens when the market goes down, indicating a negative correlation.

If you could use only one financial statement to evaluate the financial state of a company, which would you choose?

I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating. The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business. And the Balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF Statement would show.

From the three main financial statements, if you had to choose two to analyze a company, which would you choose and why?

If I had to choose two financial statements, I would choose the Balance Sheet and the Income Statement. As long as I had the Balance Sheets from the beginning and end of the period, as well as the end of period Income Statement, I would be able to generate a Cash Flow Statement.

When would you not want to use a DCF?

If you have a company that has very unpredictable cash flows, then attempting to project those cash flows and create a DCF model would not be effective or accurate. In this situation you will most likely want to use a multiples or precedent transactions analysis.

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 construct 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.

What is Net Working Capital?

Net Working Capital is current assets minus current liabilities. It is a measure of a company's ability 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. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient.

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

Of the four main valuation techniques (Market Value, Market Comps, Precedent Transactions and DCF) the highest valuation will normally come from the Precedent Transactions technique, because a company will pay a premium for the projected synergies coming from the merger. A DCF analysis will typically give you the next highest valuation simply because those building the DCF model tend to be somewhat optimistic in their assumptions and projections. Market Comps and Market Value will usually produce the lowest valuations.

What is the difference between public Equity Value and book value of equity?

Public Equity Value is the market value of a company's equity; while the book value is just an accounting number. A company can have a negative book value of equity if it has been taking large cash dividends, or running at a net loss; but it can never have a negative public Equity Value, because it cannot have negative shares or a negative stock price.

If Enterprise Value is $150mm, and Equity Value is $100mm, what is net debt?

Since Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest, if we assume there is no minority interest or preferred stock, then Net Debt will be $150mm - $100mm, or $50mm.

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

Since you have no information about historical or projected performance, and no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm's industry, you could identify a group of comparable companies and do a multiples analysis using the ratios from those most relevant to the company being valued.

What does spreading comps mean?

Spreading comps means calculating relevant multiples from comparable companies and summarizing them for easy analysis and comparison. It can be challenging when a company's data and financial information must be scoured to conduct the necessary research.

What is the Capital Assets Pricing Model?

The Capital Assets Pricing Model, referred to as CAPM, is used to calculate the required return on equity or the cost of equity. The return on equity is equal to the risk free rate (usually the yield on a 10-year U.S. government bond) plus the company's beta (a measure of the stock's volatility in relation to the stock market) times the market risk premium.

Why might two companies with similar growth and profitability have different valuations?

The difference in valuation could reflect some sort of a competitive advantage that isn't represented on the financial statements. Perhaps the more valuable company is a market leader in a key region or owns uniquely valuable intellectual property or enjoys a significantly stronger management track record.

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 debt holders and equity holders from the earnings of a company.

What are some ways you can value a company?

There are a number of ways I can think of to value a company, and I'm sure you know even more. The simplest is probably market valuation, which is just the public Equity Value of a company based on the public markets. To get the Enterprise Value, you add the net debt on its books, preferred stock, and any minority interest. A few other ways to value a company include comparable company analysis, precedent transactions, discounted cash flow, leveraged buyout valuation, and liquidation valuation.

What is the link between the Balance Sheet and 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.

How do you calculate a firm's terminal value?

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 commonly 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 where you choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You 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.

When would a company collect cash from a customer and not show it as revenue? If it isn't revenue, what is it?

This typically occurs when a company is paid in advance for future delivery of a good or service, such as a magazine subscription. If a customer pays for delivery of 12 months of magazines in advance, cash from that purchase goes onto the Balance Sheet as cash, but also increases deferred revenue, a liability. As each issue is delivered to the customer over the course of the year, the deferred revenue line item will go down, reducing the company's liability, while a portion of the subscription payment will be recorded as revenue.

All else equal, should the cost of equity be higher for a company with $100 million of market cap or a company with $100 billion of market cap?

Typically, a smaller company is expected to produce greater returns than a large company, meaning the smaller company is more risky and therefore would have a higher cost of equity.

When calculating Enterprise Value, do you use the book value or the market value of equity?

When calculating a company's Enterprise Value, you use the market value of the equity because that represents the true supply-demand value of the company's equity in the open market.

All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 billion of market cap?

Without knowing more information about the companies, it is impossible to say. If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. However, if the larger company has a lot of high-interest debt, it could have a higher WACC.

Could a company have a negative book Equity Value?

Yes, a company could have a negative book Equity Value if the owners are taking out large cash dividends or if the company has been operating for a long time at a net loss, both of which reduce shareholders' equity.

How do you value a private company?

You can value a private company with the same techniques you would use for a public company but with a few differences that make it more difficult. Financial information will likely be harder to find and potentially less complete and less reliable. Second, you can't use a straight market valuation for a company that isn't publicly traded. In addition, a DCF can be problematic because a private company won't have an equity beta to use in the WACC calculation. Finally, if you're doing a comps analysis using publicly traded companies, a 10-15% discount may be required as a 10-15% premium is paid for the public company's relative liquidity.

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

You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa.