IBD Questions Basic
A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?
$10 million / $1,000 = 10,000 convertible bonds. $1,000 / $50 = 20 shares per bond. So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million.
What is Operating Working Capital?
(Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt)
Could you ever end up with negative shareholders' equity? What does it mean?
- 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 Shareholders' Equity. - 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.
Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its Diluted Equity Value?
1,000. Options are out of the money.
How do you take into account a company's competitive advantage in a valuation?
1. Highlight the 75th percentile or higher for the multiples rather than median. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company.
How do you select Comparable Companies or Precedent Transactions?
1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you also limit the set based on date and often focus on transactions within the past 1-2 years.
What other Valuation methodologies are there?
1. Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive 2. Replacement Value - Valuing a company based on the cost of replacing its assets 3. LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range 4. Sum of the Parts - Valuing each division of a company separately and adding them together at the end 5. M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth 6. Future Share Price Analysis - Projecting a company's share price based on the P / E multiples of the public company comparables, then discounting it back to its present value
How would you value a company that has no profit and no revenue?
1. You could use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV / Unique Visitors and EV /Pageviews (for Internet start-ups, for example) rather than EV / Revenue or EV / EBITDA. 2. You could use a "far-in-the-future DCF" and project a company's financials out until it actually earns revenue and profit.
When is a DCF useful? When is it not so useful?
A DCF is best when the company is large, mature, and has stable and predictable cash flows (think: Fortune 500 companies in "boring" industries). Your far-in- the-future assumptions will generally be more accurate there. A DCF is not as useful if the company has unstable or unpredictable cash flows (tech start-up) or when Debt and Operating Assets and Liabilities serve fundamentally different roles (ex: Banks and Insurance Firms - see the industry- specific guides for more).
What's the difference between accounts receivable and deferred revenue?
Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.
At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.
After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back - and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback - so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68. On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilities & Shareholders' Equity are down by $148 and both sides balance.
Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?
After a year has passed, Apple must pay interest expense and must record the depreciation. Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12. On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That's the only change on the Cash Flow Statement, so overall Cash is down by $2. On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders' Equity is also down by $12 and both sides balance.
If Depreciation is a non-cash expense, why does it affect the cash balance?
Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay
Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?
At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet). On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.
Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?
Calculating Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only what's available to common shareholders.
What's the difference between cash-based and accrual accounting?
Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.
When do you use an LBO Analysis as part of your Valuation?
Clearly, you use this whenever you're analyzing a Leveraged Buyout - but it is also used to "set a floor" on the company's value and determine the minimum amount that a PE firm could pay to achieve its targeted returns.
What are the 3 major valuation methodologies?
Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.
How do you apply the valuation methodologies to value a company?
Create a graph of different multiples showing the minimum, 25th percentile, median, 75th percentile, and maximum for each set.
Can you walk me through how to calculate EBIT and EBITDA? How are they different?
EBIT is just a company's Operating Income on its Income Statement; it includes not only COGS and Operating Expenses, but also non-cash charges such as Depreciation & Amortization and therefore reflects, at least indirectly, the company's Capital Expenditures. EBITDA is defined as EBIT plus Depreciation plus Amortization.
What are the most common Valuation multiples? And what do they mean?
Enterprise Value / Revenue: How valuable is a company in relation to its overall sales. Enterprise Value / EBITDA: How valuable is a company in relation to its approximate cash flow. Enterprise Value / EBIT: How valuable is a company in relation to the pre-tax profit it earns from its core business operations. Price Per Share / Earnings Per Share (P / E): How valuable is a company in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities.
What's the formula for Enterprise Value?
Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests - Cash
Why do we look at both Enterprise Value and Equity Value?
Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees ("the sticker price"), while Enterprise Value represents its true value, i.e. what it would really cost to acquire.
How do you use Equity Value and Enterprise Value differently?
Equity Value gives you a general idea of how much a company is worth; Enterprise Value tells you, more specifically, how much it would cost to acquire. Also, you use them differently depending on the valuation multiple you're calculating. If the denominator of the multiple includes interest income and expense (e.g. Net Income), you use Equity Value; otherwise, if it does not (e.g. EBITDA), you use Enterprise Value.
What's the difference between Equity Value and Shareholders' Equity?
Equity Value is the market value and Shareholders' Equity is the book value. Equity Value could never be negative because shares outstanding and share prices can never be negative, whereas Shareholders' Equity could be positive, negative, or 0. For healthy companies, Equity Value usually far exceeds Shareholders' Equity because the market value of a company's stock is worth far more than its paper value.
Walk me through a $100 "bailout" of a company and how it affects the 3 statements.
First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders' Equity would go up by $100 to make it balance.
What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it?
First, it hides the amount of debt principal and interest that a company is paying each year, which can be very large and may make the company cash flow- negative; as mentioned above, it also hides CapEx spending, which can also be huge. EBITDA also ignores working capital requirements (e.g. Accounts Receivable, Inventory, Accounts Payable), which can be very large for some companies. Finally, companies like to "add back" many charges and expenses to EBITDA, so you never really know what it represents unless you dig into it in-depth. It is widely used mostly because of convenience (it's easy to calculate) and because it has become a standard over time. EBITDA is more about comparability than cash flow approximation.
Let's say that a company has 10,000 shares outstanding and a current share price of $20.00. It also has 100 options outstanding at an exercise price of $10.00. It also has 50 Restricted Stock Units (RSUs) outstanding. Finally, it also has 100 convertible bonds outstanding, at a conversion price of $10.00 and par value of $100. What is its Diluted Equity Value?
First, let's tackle the options outstanding: since they are in-the-money (exercise price is lower than the share price), we assume that they get exercised and that 100 new shares get created. The company receives 100 * $10.00, or $1,000, in proceeds. Its share price is $20.00 so it can repurchase 50 shares with these proceeds. Overall, there are 50 additional shares outstanding now (100 new shares - 50 repurchased). The 50 RSUs get added as if they were common shares, so now there's a total of 100 additional shares outstanding. For the convertible bonds, the conversion price of $10.00 is below the company's current share price of $20.00, so conversion is allowed. We divide the par value by the conversion price to see how many new shares per bond get created: $100 / $10.00 = 10 new shares per bond Since there are 100 convertible bonds outstanding, we therefore get 1,000 new shares (100 convertible bonds * 10 new shares per bond). In total, there are 1,100 additional shares outstanding. The diluted share count is therefore 11,100. The Diluted Equity Value is 11,100 * $20.00, or $222,000.
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write-down of $100.
First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. On the Cash Flow Statement, Net Income is down by $60 but the write-down is a noncash expense, so we add it back - and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40. On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it's not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders' Equity is also down by $60 - and both sides balance.
Can you walk me through how you use Public Comps and Precedent Transactions?
First, you select the companies and transactions based on criteria such as industry, financial metrics, and geography (see the next question). Then, you determine the appropriate metrics and multiples for each set - for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples - and you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply those numbers to the financial metrics for the company you're analyzing to estimate the potential range for its valuation.
What would you use with Free Cash Flow multiples - Equity Value or Enterprise Value?
For Unlevered Free Cash Flow (Free Cash Flow to Firm), you would use Enterprise Value, but for Levered Free Cash Flow (Free Cash Flow to Equity) you would use Equity Value (see the diagram above).
How long does it usually take for a company to collect its accounts receivable balance?
Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.
Under what circumstances would Goodwill increase?
Goodwill will increase if the company re-assesses its value and finds that it is worth more 1. The company gets acquired or bought and and goodwill changes as a result 2. The company acquires another company and pays more than what assets are worth.
Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?
He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they require to finance their operations.
How do you decide when to capitalize rather than expense a purchase?
If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.
How do you factor in Convertible Bonds into the Enterprise Value calculation?
If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value (no Treasury Stock Method required - just add all the shares that would be created as a result of the bonds). If the Convertible Bonds are out-of-the-money, then you count the face value of the convertibles as part of the company's Debt.
Let's say that you're comparing a company with a strong brand name, such as Coca-Cola, to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins. Which one will have the higher EV / EBITDA multiple?
In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name.
Why do you subtract Cash in the formula for Enterprise Value? Is that always accurate?
In an acquisition, the buyer would "get" the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you'd effectively have to "pay" to acquire another company.
Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?
In cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would "turn into" Cash.
Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?
In most cases, yes, because the terms of a Debt issuance usually state that Debt must be repaid in an acquisition. And a buyer usually pays off a seller's Debt, so it is accurate to say that Debt "adds" to the purchase price.
Why is the Income Statement not affected by changes in Inventory?
In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.
Walk me through how Depreciation going up by $10 would affect the statements.
Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.
Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.
Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPods), which is a net addition to cash flow - so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders' Equity is up by $6 and both sides balance.
Can you give examples of major line items on each of the financial statements?
Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income. Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity. Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.
Where does Depreciation usually show up on the Income Statement?
It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently
The S&P 500 Index (or equivalent index in other country) has a median P / E multiple of 20x. A manufacturing company you're analyzing has earnings of $1 million. How much is the company worth?
It depends on how it's performing relative to the index, and relative to companies in its own industry. If it has higher growth and/or higher margins, you may assign a higher multiple to it - maybe 25x or even 30x, and therefore assume that its Equity Value equals $25 million or $30 million. If it's on par with everyone else, then maybe its valuation is just $20 million. And if it's underperforming, perhaps it's lower than that. Qualitative factors, such as management team and market position, also come into play and may determine the appropriate multiple to use.
Let's say we create a brand-new operating metric for a company that approximates its cash flow. Should we use Enterprise Value or Equity Value in the numerator when creating a valuation multiple based on this metric?
It depends on whether or not this new metric includes the impact of interest income and interest expense. If it does, you use Equity Value. If it does not, you use Enterprise Value.
Why are Public Comps and Precedent Transactions sometimes viewed as being "more reliable" than a DCF?
It's because they're based on actual market data, as opposed to assumptions far into the future. Note, however, that you still do make future assumptions even with these (for example, the "Forward Year 1" and "Forward Year 2" multiples in the graphs above are based on projections for each company in the set).
When is a Liquidation Valuation useful?
It's most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company's Liabilities have been paid off with the proceeds from selling all its Assets. It is often used to advise struggling businesses on whether it's better to sell off Assets separately or to sell 100% of the company.
Let's say a company has 100 shares outstanding, at a share price of $10.00 each. It also has 10 options outstanding at an exercise price of $5.00 each - what is its Diluted Equity Value?
Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all "in-the-money" - their exercise price is less than the current share price. As a result, it now has $50 in additional cash, which it uses to buy back 5 of the new shares we created. 1050
What happens when Inventory goes up by $10, assuming you pay for it with cash?
No changes to the Income Statement. On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.
Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?
No changes to the Income Statement. Cash Flow Statement - Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10. On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.
Could EV / EBITDA ever be higher than EV / EBIT for the same company?
No. By definition, EBITDA must be greater than or equal to EBIT because to calculate it, you take EBIT and then add Depreciation & Amortization, neither of which can be negative.
Could a company have a negative Equity Value? What would that mean?
No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.
Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?
Nope. In fact, you almost always show a range. And you may make the median the center of that range, but you don't have to - you could focus on the 75th percentile, 25th percentile, or anything else if the company is outperforming or underperforming for some reason.
What happens when Accrued Compensation goes up by $10?
Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6. On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.
The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability. What's the difference between them, and when do you use each one?
P / E depends on the company's capital structure, whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, insurance firms, and other companies where interest is critical and where capital structures tend to be similar. EV / EBIT includes Depreciation & Amortization, whereas EV / EBITDA excludes it - you're more likely to use EV / EBIT in industries where D&A is large and where Capital Expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).
When would a company collect cash from a customer and not record it as revenue?
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.
Why do we add Preferred Stock to get to Enterprise Value?
Preferred Stock pays out a fixed dividend, and Preferred Shareholders also have a higher claim to a company's assets than equity investors do. As a result, it is more similar to Debt than common stock. Also, just like Debt, typically Preferred Stock must be repaid in an acquisition scenario.
Should you use Enterprise Value or Equity Value with Net Income when calculating valuation multiples?
Since Net Income includes the impact of interest income and interest expense, you always use Equity Value.
You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case?
Sometimes this happens when there is a substantial mismatch between the M&A market and the public markets. For example, no public companies have been acquired recently but lots of small private companies have been acquired at low valuations. For the most part this generalization is true but there are exceptions to almost every "rule" in finance. And if you want proof, just take a look at the valuation graph we've been using throughout this part of the guide.
How do you calculate diluted shares and Diluted Equity Value?
Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt, and convertible preferred stock.
Would an LBO or DCF produce a higher valuation?
Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you only get "value" out of its final year. With a DCF, by contrast, you're taking into account both the company's cash flows in the period itself and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and back-solve for how much you could pay for the company (the valuation) based on that. See the LBO section of the guide for more.
Walk me through the 3 financial statements.
The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative. The company has high interest expense and is no longer able to afford its debt. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash completely when paying back the debt. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.
How would you value an apple tree?
The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree's cash flows (intrinsic valuation).
Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?
These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.
Why do you use Enterprise Value for Unlevered Free Cash Flow multiples, but Equity Value for Levered Free Cash Flow multiples? Don't they both just measure cash flow?
They both measure cash flow, but Unlevered Free Cash Flow (Free Cash Flow to Firm) excludes interest income and interest expense (and mandatory debt repayments), whereas Levered Free Cash Flow includes interest income and interest expense (and mandatory debt repayments), meaning that only Equity Investors are entitled to that cash flow (see the funnel diagram above).
A company's current stock price is $20.00 per share, and its P / E multiple is 20x, so its EPS is $1.00. It has 10 million shares outstanding. Now it does a 2-for-1 stock split - how do its P / E multiple and valuation change?
They don't. Think about what happens: the company now has 20 million shares outstanding... but its Equity Value has stayed the same, so its share price falls to $10.00. Its EPS falls to $0.50, but its share price has also fallen to $10.00, so the P / E multiple remains 20x. Splitting stock into fewer units or additional units doesn't, by itself, make a company worth more or less. However, in practice, often a stock split is viewed as a positive sign by the market... so in many cases a company's value will go up and its share price won't necessarily be cut in half, so P / E could increase.
For Public Comps, you calculate Equity Value and Enterprise Value for use in multiples based on companies' share prices and share counts... but what about for Precedent Transactions? How do you calculate multiples there?
They should be based on the purchase price of the company at the time of the deal announcement. For example, a seller's current share price is $40.00 and it has 10 million shares outstanding. The buyer announces that it will pay $50.00 per share for the seller. The seller's Equity Value in this case, in the context of the transaction, would be $50.00 * 10 million shares, or $500 million. And then you would calculate its Enterprise Value the normal way: subtract cash, add debt, and so on.
Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.
This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down - so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60 - so Liabilities & Shareholders' Equity is down by $40 and it balances.
When would a Liquidation Valuation produce the highest value?
This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the Comparable Companies and Precedent Transactions would likely produce lower values as well - and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.
When would you use a Sum of the Parts valuation?
This is used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division, and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to calculate the Total Value.
How do the 3 statements link together?
To tie the statements together, Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders' Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash flowing in from the final line on the Cash Flow Statement.
What about how you calculate Unlevered FCF (Free Cash Flow to Firm) and Levered FCF (Free Cash Flow to Equity)?
Unlevered FCF = EBIT * (1 - Tax Rate) + Non-Cash Charges - Change in Operating Assets and Liabilities - Capital Expenditure Levered FCF = Net Income + Non-Cash Charges - Change in Operating Assets and Liabilities - Capital Expenditure - Mandatory Repayments
If cash collected is not recorded as revenue, what happens to it?
Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance "turns into" real revenue on the Income Statement.
Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?
Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement
How would you present these Valuation methodologies to a company or its investors? And what do you use it for?
Usually you use a "Football Field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. • Pitch Books and Client Presentations - When you provide updates and tell them what you think they're worth. • Parts of Other Models - Defense analyses, merger models, LBO models, DCFs, and almost everything else in finance will incorporate a Valuation in some way. • Fairness Opinions - Right before a deal with a public seller closes, its financial advisor creates a "Fairness Opinion" that justifies the acquisition price and directly estimates the company's valuation.
How are the key operating metrics and valuation multiples correlated? In other words, what might explain a higher or lower EV / EBITDA multiple?
Usually, there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well. Plenty of other non-financial factors explain higher or lower multiples
Why do we bother calculating share dilution? Does it even make much of a difference?
We do it for the same reason we calculate Enterprise Value: to more accurately determine the cost of acquiring a company. Normally in an acquisition scenario, in-the-money securities (ones that will cause additional shares to be created) are 1) Cashed out and paid by the buyer (raising the purchase price), or 2) Are converted into equivalent securities for the buyer (also raising the effective price for the buyer).
Why do you need to add Noncontrolling Interests to Enterprise Value?
Whenever a company owns over 50% of another company, it is required to report 100% of the financial performance of the other company as part of its own performance. You must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary. If you did not do that, the numerator would reflect less than 100% of the company, but the denominator would reflect 100%.
What is working capital? How is it used?
Working Capital = Current Assets - Current Liabilities. If it's positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound."
Could a company have a negative Enterprise Value? What does that mean?
Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You often see it with companies on the brink of bankruptcy, and sometimes also with companies that have enormous cash balances.
This same company also has Cash of $10,000, Debt of $30,000, and Noncontrolling Interests of $15,000. What is its Enterprise Value?
You subtract the Cash, add the Debt, and then add Noncontrolling Interests: Enterprise Value = $222,000 - $10,000 + $30,000 + $15,000 = $257,000.
When you're looking at an industry-specific multiple like EV / Proved Reserves or EV / Subscribers (for telecom companies, for example), why do you use Enterprise Value rather than Equity Value?
You use Enterprise Value because those Proved Reserves or Subscribers are "available" to all the investors (both debt and equity) in a company. This is almost always the case unless the metric already includes interest income and expense
If you were buying a vending machine business, would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated normally, or one in which the machines were leased? The Depreciation expense and the lease expense are the same dollar amounts and everything else is held constant.
You would pay a higher multiple for the one with leased machines if all else is equal. The Purchase Enterprise Value would be the same for both acquisitions, but Depreciation is excluded from EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower for the one that owns its own machines. For the company with leased machines, the lease expense would show up in Operating Expenses, making EBITDA lower and the EV / EBITDA multiple higher. This goes back to one of the points we've made throughout this guide: in isolation, specific valuation multiples don't mean much. You need to see what goes into the numbers and what standards are used. In this case, it would be more meaningful to use an EBIT or EBITDAR multiple to compare the two potential acquisitions.
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?
You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).
If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?
You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that's the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.
Rank the 3 main valuation methodologies from highest to lowest expected value.
there is no ranking that always holds up.
What are the flaws with Public Company Comparables?
• No company is 100% comparable to another company. • The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates depending on the market's movements. • Share prices for small companies with thinly-traded stocks may not reflect their full value.
Two companies have the exact same financial profiles (revenue, growth, and profits) and are purchased by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?
• One process was more competitive and had a lot more companies bidding on the target. • One company had recent bad news or a depressed stock price so it was acquired at a discount. • They were in industries with different median multiples. • The two companies have different accounting standards and have added back different items when calculating EBITDA, so the multiples are not truly comparable.
What are some flaws with Precedent Transactions?
• Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all have huge effects. • Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.
What are some examples of industry-specific multiples?
• Technology (Internet): EV / Unique Visitors, EV / Pageviews • Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) • Oil & Gas: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Production, EV / Proved Reserves
Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?
• The company has just reported earnings well-above expectations and its stock price has risen in response. • It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. • It has just won a favorable ruling in a major lawsuit. • It is the market leader in an industry and has greater market share than its competitors.
