Technical Finance Questions
ModD
= MacD / 1 + (YTM/2) measured in dollars
Cost of Equity
= rfr + B*(rm - rfr)
Would acquirers generally prefer $100 in revenue synergies or $100 in cost synergies?
An acquirer would generally prefer $100 in cost synergies because all those cost savings after accounting for tax flow through to the bottom line, while revenue synergies have associated costs that reduce the bottom line benefit. For example - $100 in revenue synergies for a company with 40% pretax profit margins and a 25% tax rate would see $100 x 40 % x (1-25%) = $30 flow to the bottom line, while the same company would see $100 in cost synergies flow $100 x (1-25%) = $75 flow to the bottom line.
What does an inverted yield curve tell you?
An inverted yield curve means that yields on longer maturities are lower than shorter maturities of otherwise comparable bonds, like treasuries. Normally, yield curves are upward sloping as issuers must pay a premium to entice investors to keep their capital locked up for a longer term. When the yield curve inverts, it is usually a harbinger of an economic slowdown and recession. In fact the last 7 recessions were preceded by an inversion of the yield curve and it is considered a strong leading indicator by economists and investors alike. The inversion happens as investors anticipate market interest rates to decline down the road (presumably because they expect a slowdown and thus expect monetary policy makers to eventually lower rates to stimulate the soon-to-be slowing economy) and thus prefer the safety of long term maturities at the current higher rates over investing in shorter maturities and having to re-invest at the lower expected future rates.
Unlevered Free Cash Flow (UFCFs)
By line item: EBIT * (1-Tr) Plus: D&A Less: chgs. NWC Less: CapEx
What kind of company usually makes for a good LBO candidate?
Companies that make good LBO candidates have steady, predictable cash flows with little cyclicality, minimal ongoing capital expenditures and working capital investment requirements, perhaps with subsidiary businesses that can be immediately sold to help pay down debt.
How do you calculate working capital?
Current Assets - Current Liabilities Cash, AR, Inventories AP, ST-Debt, Accrued Liabilities
What is the maximum leverage in an LBO typically based on?
Debt to equity mix in private equity deals has hovered around 60% debt / 40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies across industries. The more predictable the cash flows, the larger the tolerance for higher debt to equity mix. Debt/EBITDA - a measure of leverage relative to profitability has hovered in the 5.0-7.0x range and is pressured upward as overall valuations increase. When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. It has come down because of the risks inherent to high debt burdens.
What are the two most important assumptions in a DCF?
Discount rate (WACC) Terminal Growth Assumptions
Which multiples are the most popular in valuation?
EV / EBITDA multiples are probably the most common, followed by EV/EBIT and P/E. There are several others that are more industry- and company-specific. For example, P/B ratios are used to value financial institutions and EV/Revenue multiples are used to value companies with negative earnings.
What is the appropriate numerator for an equity multiple?
Enterprise Value Equity value = EV - net debt EBIT, EBITDA, UFCFs, and revenue multiples all have EV as the numerator because the denominator is unlevered (pre-debt) measures of profitability EPS, AT-cfs, and BVequity all have equity value in the numerator because the denominator is levered (post-debt)
What is the difference between equity value and enterprise value?
Enterprise value = equity value + net debt. Conceptually, enterprise value represents the value of the operations of a business, which is independent of the capital structure. Equity value represents the value of the business to equity owners after subtracting net debt, where net debt equals the company's gross debt and debt-like claims such as preferred stock, net of any cash and other non-operating assets.
Do companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, companies generally prefer straight-line depreciation. That's because a company will record lower depreciation in the early years of the asset's life than if they had used accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income than under accelerated depreciation.
Define free cash flow yield and compare it to dividend yield and P/E ratios.
Free cash flow (FCF) yield = FCF/share price (FCF is defined as cash from operations - capital expenditures). For the purposes of this calculation, FCF is usually defined as cash from operations less investing activities. FCF yield is similar to dividend yield (dividend per share/share price) as both are a way to gauge equity returns relative to a company's share price. Unlike dividend yield, however, FCF yield is based on cash generated, as opposed to cash actually distributed. As a measure of fundamental value, FCF yield is more useful because many companies don't issue dividends (or an arbitrary fraction of their free cash flows). If you flip the FCF yield you get share price/FCF, which produces a cash flow version of a P/E ratio. This has the advantage of benchmarking price against actual cash flows as opposed to accrual profits. It also, however, has the disadvantage that cash flows can be volatile and period specific swings in working capital and deferred revenue can have a material impact on the multiple.
What is Goodwill?
Goodwill is an asset that captures excess of the purchase price over fair market value of the net assets of an acquired business. For example, suppose an acquirer buys a company for a purchase price of $500 million with a fair market value of $450 million. In this case, goodwill of $50 million would be recognized on the acquirer's balance sheet. Often in the preliminary phase of analyzing acquisitions, the fair market value is unknown and the target's book value is used instead.
Discuss bond duration
Is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond's term is linear, whereas its duration is non-linear and accelerates as time to maturity lessens. Measures how long it takes, in years, for an investor to be repaid the bond's price by the bond's total cash flows. In general the higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk)
Macaulay Duration
Is the weighted average time until all the bond's cash flows are paid. By accounting for PV of future bond payments, this kind of duration helps an investor evaluate and compare bonds independent of their term or time to maturity. Longer the duration, more sensitive the bond is to changes in interest rates
Discuss mezzanine financing.
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid. Mezzanine loans are subordinate to senior debt but have priority over both preferred and common stock. Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt. However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year, and sometimes as high as 30%.
Why might two companies with identical growth and cost of capital trade at different P/E multiples?
Growth and cost of capital are not the only drivers of value. Another critical component is return on invested capital. All else equal, if one of the companies has a higher return on equity, you would expect its PE ratio to be higher. Other reasons may include relative mispricing or inconsistent calculations of EPS due to things like nonrecurring items and different accounting assumptions.
Discuss positive and negative working capital.
Having positive working capital can be a good sign of the short-term financial health for a company because it has enough liquid assets remaining to pay off short-term bills and to internally finance the growth of their business. Without additional working capital, a company may have to borrow additional funds from a bank or turn to investment bankers to raise more money. Negative working capital means assets aren't being used effectively, and a company may face a liquidity crisis. Even if a company has a lot invested in fixed assets, it will face financial challenges if liabilities come due too soon. This will lead to more borrowing, late payments to creditors and suppliers and, as a result, a lower corporate credit rating for the company.
How might operating a highly levered company be different from operating a company with little or no debt?
Highly leveraged companies have a lower margin of error due to high fixed debt related payments (interest and principal). This forces management to become extremely disciplined with costs, to become more conservative when it comes to capital spending and embarking on new initiatives and acquisitions. It increases the importance of effective planning and instituting better financial controls.
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
I would choose the Statement Cash Flows because it shows the inflows and outflows of cash over a period of time.
What ratios or metrics would you want to look at to figure out if a company is over-levered?
I would first look at its overall capital structure and compute its Debt/Equity ratio. Since rates of leverage that are considered acceptable can vary across industries, I would compare across companies of similar size and operating in the same industry. Next, I would look at interest coverage ratio (EBIT/Interest expense) and leverage ratio (Debt / EBITDA) and compare to my universe of comparable companies. If, for example, the company I'm looking at has some combination of a high Debt/Equity ratio, a low interest coverage ratio, and a high leverage ratio, that's an indication that the business might be over-levered.
Modified Duration
Measures the expected change in a bond's price to a 1% change in interest rates. Rising interest rates indicate that bond prices are likely to fall, while declining interest rates indicate that bond prices are likely to rise.
What's included in net debt?
Net debt includes all types of debt - short-term and long-term, loans and bonds. It includes other non-equity financial claims such as preferred stock and non-controlling interests. From this gross debt amount, cash and any other non-operating asset such as short-term investments and equity investments should be subtracted to arrive at net debt.
Is EBITDA a good proxy for cash flow?
Not really. That's because even though EBITDA does add back D&A - typically the largest non-cash expense - it does not capture any working capital changes during the period. It also doesn't capture cash outflows from taxes or interest payments. Those adjustments would need to be made to get to operating cash flows. EBITDA also doesn't capture stock-based compensation (SBC) expenses required to get to operating cash flows (although an increasingly used "adjusted EBITDA" calculation does add back SBC).
Should two identical companies but with different rates of leverage trade at different P/E multiples?
P/E multiples can vary significantly due to leverage difference for otherwise identical companies. All else equal, as a company borrows money (debt), the EPS (denominator) will decline due to higher interest expense. The impact on the share price, on the other hand, is harder to predict and depends on how the debt will be used. At the two most extreme cases, imagine the debt proceeds will go unused, generating no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment. In this scenario, the share price can be expected to decline to such a level that the PE ratio declines. On the other hand, if the debt is used to efficiently invest and grow the business, the P/E ratio will increase.
What are some common equity multiples?
P/E, Price/Book, Equity/Levered Cash Flows.
What is PIK interest or a PIK toggle?
PIK stands for Paid-in-Kind. PIK interest expense is interest charged by a lender that doesn't need to be paid right away in cash, but rather increases the debt owed and accrued the debt balance. For the borrower (the company), this conserves cash but compounds the obligation each year. In addition to loans set up as a PIK, some preferred stock investments allow the company to pay PIK dividends and let the dividends grow the preferred stock obligation. A PIK toggle allows the company to choose (or "toggle") between paying cash or PIK in any given period.
What are some reasons that a company might acquire another company?
Reasons to acquire another company include: Accelerate time to market with new products and channels Remove competition (buying a competitor is called horizontal integration) Achieve supply chain efficiencies (buying a supplier or customer is called vertical integration)
Why might one company trade at a higher multiple than another?
Superior fundamental performance such as better growth prospects, higher return on invested capital, lower cost of capital (WACC), stronger cash flows.
What are synergies? Why are they important in a deal? What are some examples of synergies?
Synergies are cost savings or incremental revenues arising from an acquisition. They are important because if any acquirer believes synergies can be realized, it would be willing to pay higher premiums. Examples of synergies are cost savings from eliminating overlapping workforces, closing redundant facilities, lower costs due to scale, cross selling opportunities, etc Achieved through an acquisition that provides more value than the financials would predict.
Why is LBO analysis used as a floor valuation when analyzing company value using several valuation methodologies?
The "hurdle rates" - that is, the rate of return that financial sponsors need to believe they can exceed in order to undertake an LBO tend to be in the 15-25% range. This is due to the risks associated with high leverage and relatively short investment horizons. These hurdle rates are usually higher than the cost of equity capital on the same business without those LBO-specific risks. As a result, the present value (or valuation) implied given those higher hurdle rates will be lower than the valuation of the company when analyzed through the traditional DCF and comps approaches.
What is the impact of share issuance on EPS?
The major impact to EPS is that the actual share count increases, thereby decreasing EPS. However, there is sometimes an impact on net income. That's because assuming share issuances generate cash for the company, there will be higher interest income, which increases net income and EPS slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the negative impact to EPS from a higher share count.
What is the impact of share repurchases on EPS?
The major impact to EPS is that the actual share count is reduced, thereby increasing EPS. However, there is sometimes an impact on net income. That's because assuming share repurchases are funded with the company's excess cash, any interest income that would have otherwise been generated on that cash is no longer available, thereby reducing net income - and EPS - slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the positive impact to EPS from a lower share count.
Walk me through a DCF
The most common approach to building a DCF is called the unlevered DCF approach and involves the following steps: First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage should be forecast explicitly for a period of 5-10 years. Next, the value of all unlevered FCFs beyond the initial forecast period need to be calculated - this is called the terminal value. This value should represent the present value at the end of the initial forecast period. The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach. Next, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital. At this point, you have enterprise value. To get to equity value, you then need to subtract net debt as of the valuation date. Lastly, to arrive at the DCF value per share, divide the equity value by diluted shares outstanding as of the valuation date.
How do you calculate offer value M&A?
The offer value in the context of M&A refers to the equity purchase price being offered by the buyer to acquire the seller. Like equity value, offer value is calculating by multiplying fully diluted shares outstanding (including options and convertible securities) times the offer price per share.
Since cost of equity is higher than cost of debt, why not finance with all debt?
The required return on debt will increase with the level of debt as a percentage of the capital structure because a more highly levered business has a higher default risk. As a result, an optimal capital structure for most companies includes some mix of debt and equity.
How many years would it take to double a $100,000 investment at a 9% annual return (no calculator)?
The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72 by the investment's annual return. In this case, the rule of 72 suggests that it would take approximately 72/9 = 8 years.
Factors in bond duration
Time to maturity. The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 5% and cost $1,000, but have different maturities. A bond that matures faster - say, in one year - would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk. Coupon rate. A bond's coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk
What can a transaction comps analysis tell you that a trading comps analysis cannot?
Transaction comps can provide insight into purchase premiums that buyers and sellers should expect when negotiating a transaction.
How do you calculate transaction value? M&A
Transaction value in the M&A context refers to the target's implied enterprise value given the offer vale. As such, the transaction value equals the target offer value plus the target's net debt.
Is it better to finance a deal via debt or via stock?
The answer depends on several factors: From the buyer's perspective, when the buyer's PE ratio is significantly higher than the target's, a stock transaction will be accretive which is an important consideration for buyers and may tilt the decision towards stock. When considering debt, the buyer's access to debt financing and cost of debt (interest rates) will influence the buyer's willingness to finance a transaction with debt. In addition, the buyer will analyze the deal's impact to its existing capital structure, credit rating and credit stats. From the seller's perspective, a seller will generally prefer cash (i.e. debt financing) over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration.
What's the difference between a bond's coupon rate and the bond's current yield?
The coupon rate ("nominal yield") represents a bond's coupon divided by its face (par) value. The current yield on a bond equals the bond's coupon payment divided by the bond's price. For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate and a current yield of 6.66% ($6/90). While the coupon rate is always the same, the current yield fluctuates based on the market price of a bond.
What's the difference between current yield and yield to maturity?
The current yield on a bond equals the bond's coupon payment divided by the bond's price. Current yield is a way to discuss coupon rates when bond price deviates from par. For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate and a current yield of 6.66% ($6/90). Unlike YTM, current yield is not the true yield of a bond as it does not capture any yield associated with principal recovery, nor does it assume the reinvestment of coupon payments. The yield to maturity ("YTM") is the internal rate of return of a bond. YTM takes into account coupon payments, principal recovery, assumes reinvestment at the same rate (an iterative process), and time to maturity.
What is working capital?
The definition of working capital is current assets less current liabilities. Since current liabilities represent payments that a company needs to make within the year while current assets are things that can be turned into cash within the year (things like accounts receivable, inventory and cash itself), working capital is used as a measure of a company's liquidity. Generally, the more current assets a company has relative to its current liabilities, the lower the company's liquidity risk.
How would you value a private company?
The main difference between valuing a private and public company is availability of data - private companies are usually not required to make their financial statements and details public. Historical data is critical for performing a DCF. If you're provided private company financials, the process is similar to public companies except that private company financial disclosures are often less complete, standardized and reliable. In addition, private companies are less liquid and should thus be valued lower all else equal to reflect the liquidity premium.
Can companies amortize goodwill?
Under GAAP, public companies are not allowed to amortize goodwill. Instead, it must be tested annually for impairment.
What's the difference between levered FCF (FCFE) and unlevered FCF (FCFF)?
Unlevered FCF represent cash flows a company generates from its core operations after accounting for all operating expenses and investments. To calculate those, you start with EBIT which is an unlevered measure of profit because it excludes interest and any other payments to lenders. Then you tax effect EBIT and add back non-cash items, make working capital adjustments and subtract capital expenditures. By contrast, levered FCF represent cash flows that remain after payments to lenders including interest expense and debt paydowns are accounted for. These are cash flows that belong to equity owners. Instead of starting with tax effected EBIT, you start with net income, add back non-cash items and make working capital adjustments, subtract capital expenditures and add cash inflows or outflows for cash from new borrowing, net of dept paydowns.
When valuing a company using multiples, what are the tradeoffs of using LTM vs. forward multiples?
Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT and EPS forecasts are subjective. This is particularly problematic for smaller public firms, whose guidance tends to be less reliable and generally harder to come. That said, LTM suffers from the problem that historical results are often distorted by nonrecurring expenses and income that were recognized during the period and distort the picture of recurring operating performance. That's why when using LTM results it is important to exclude nonrecurring items to get a clean multiple. That's why both LTM and forward multiples are often presented side by side, rather than picking just one.
What is the appropriate cost of capital when valuing a company using a DCF?
When doing an unlevered DCF, the WACC is the right cost of capital because it reflects cost of capital to all providers of capital. When doing a levered DCF, the right cost of capital is the cost of equity.
Are acquirers more likely to achieve revenue synergy or cost synergy expectations?
While both revenue and cost synergy expectations are often not fully achieved post transaction, revenue synergy assumptions tend to be less accurate than cost synergy assumptions. That's because cost synergies can map to specific cost cutting initiatives such as laying off workers and shutting down facilities while revenue synergies tend to be driven by higher-level, more uncertain assumptions around cross selling opportunities and new products.
What are the main weaknesses of comps as a valuation approach?
With comps, you're always comparing apples to oranges. Truly comparable companies are rare, and differences are hard to account for. Explaining value gaps between the company and its comparable involves judgment. In addition, thinly traded, small capitalization or poorly followed stocks may not reflect fundamental value. Lastly, many people feel that the stock market is emotional and that it sometimes fluctuates irrationally (i.e. the market can be wrong).
Can a company have negative net debt?
Yes. Negative debt simply means that a company has more cash than debt. For example, Apple and Microsoft have massive negative net debt because they hoard so much cash. In these cases, companies will have enterprise values lower than their equity value.
If a company trades at a forward PE of 20.0x, and acquires a company trading at a forward PE of 13.0x. Assuming the deal is 100% stock-for-stock, and a 20% premium is being offered, will the deal be accretive in year 1?
Yes: stock for stock deals where the acquirer's PE is higher than target's are always accretive. Don't get tricked - a 20% premium just brings the target's PE to 13 + (13 x 20%) = 15.6 PE, still below the acquirer's.
MacD
∑n CFf / (1 + y/k)^f x tf / PV f= fcf number CF= cf amount y= YTM k= compounding periods per year tf= time in years until cf received PV= pv of all future cf's
Why would a company buy back (aka repurchase) shares? What would be the impact on share price and the financial statements?
A company buys back shares primarily as a way to move cash from the company's balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash (in the case of dividends), a share repurchase removes shareholders, leaving a smaller shareholder base. The impact on share price is theoretically neutral - as long as shares are priced correctly, a share buyback should not lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can impact share price movement positively or negatively if they are perceived as a new signal about the company's future behavior or growth prospects. For example, cash-rich but otherwise risky companies could see artificially low share prices if investors are discounting that cash. In this case, a buyback should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator. Conversely, if shareholders view the buyback as a signal that the company's investment prospects aren't great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash AND lower perceived growth and investment prospects). On the financial statements, a $100 million share buyback would be treated as follows: Cash is credited by $100 million Treasury stock is debited by $100 million
What is a dividend recapitalization?
A dividend recapitalization (or dividend "recap") occurs when a financial sponsor, having acquired a company via an LBO, takes on additional debt while operating the company and uses the proceeds to pay itself a dividend. This usually occurs after the sponsor has been able to successfully pay down some of the debt raised on the LBO date creating additional debt capacity. A dividend recap is away for financial sponsors to monetize their investments. Unlike an outright exit via a sale or IPO, dividend recaps offer a partial monetization and might be implemented earlier than the typical 5-7 year holding period.
Walk me through an LBO.
A leveraged buyout is similar to purchasing a house. The purchase price is funded partially by an equity investor - which is the private equity firm also called the financial sponsor. The remainder is funded through loans and bonds that the financial sponsor secures ahead of the transaction. Once the sponsors gain control of the company, they get to work on streamlining the business - which usually means restructuring, layoffs and asset sales with the goal of making the company more efficient at generating cash flow so that the large debt burden can be slowly paid down. The investment horizon for sponsors is 5-7 years, at which point they hope to be able to 'exit' by either 1) Selling the company to another private equity firm or strategic acquirer 2) Taking the company public, or 3) Recapitalizing the business by taking on additional debt and issuing themselves a dividend with the debt proceeds. Accomplishing this can provide financial sponsors with a high internal rate of return. Financial sponsors usually target returns of 15-25% when considering making an investment. The keys to making this work include: Acquiring the company at a low multiple ("getting in cheap") Successfully restructuring and increasing cash flows Selling at a high multiple
What is a management buyout? (MBO)
A management buyout is a leveraged buyout where the major (or at least a significant) portion of the newco equity comes from oldco management. Management will usually provide cash equity and rollover any existing equity. In addition, equity financing can also include financial sponsors or other investors. The debt financing portion of the MBA is similar to that of an LBO.
Convexity
A measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes.
How would you value a painting?
A painting has no intrinsic value, generates no cash flows and thus cannot be valued in the traditional sense. The pricing of a painting is a function of what someone is willing to pay for it and not anchored by fundamentals.
What is the difference between a recapitalization and an LBO?
An LBO is accounted for as an acquisition, which means assets are written up and goodwill is recognized. A recapitalization is mechanically the same thing but accounted for not as an acquisition but as a simple recapitalization - asset bases carryover unchanged, with no goodwill recognized. Because no goodwill is recognized, negative equity is often created in a recapitalization because the offer price is often significantly higher than the book value of equity.
Walk me through an LBO model.
An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity as well as new borrowing as the two primary sources of capital. The specific impacts analyzed by the model include an equity valuation of the pre-LBO "oldco", the IRR to the various new debt and equity capital providers, impacts on the company's financial statements and ratios. To build an LBO, start with identifying the uses of funds - how much oldco equity will be paid, any oldco debt that needs to get refinanced, as well as any fees. Based on this, make assumptions about the sources of funds: How much and the type of debt capital needs to be raised, with the residual being funded by sponsor equity. Ideally, the operations are forecast over 5-7 years (the expected holding period), and a complete 3 statement model is built so that the LBO debt assumptions correctly impact the income statement and cash flow statement. In getting the correct cash flow forecasts, it is important to build a debt schedule that accurately modifies debt based on the flow of excess cash or deficits. Next, exit assumptions need to be made - most notably around what the exit EV/EBITDA multiple will be. Based on this assumption and the existing state of the balance sheet at the presumed exit date, IRR and cash on cash returns can be estimated for the sponsors (and any debt providers as well). Lastly, scenarios and sensitivity analysis can be added to provide users with different ways to look at the model's output - one common sensitivity is to back into the implied oldco equity value based on explicit sponsor hurdle rates and/or operating assumptions.
Walk me through an M&A model?
An M&A model takes two companies and combines them into one entity. First, assumptions need to be made about the purchase price and any other uses of funds such as refinancing target debt and paying transaction and financing fees). Then, assumptions about the sources of funds need to be made - will the acquirer pay for the acquisition using cash, take on additional debt or issue equity. Once those basic assumptions are in place, the acquirer's balance sheet is adjusted to reflect the consolidation of the target. Certain line items - like working capital can simply be lumped together. Others need a little more analysis - for example, a major adjustment to the combined target and acquirer balance sheet involves the calculation of incremental goodwill created in the transaction, which involves making assumptions about asset write ups, and deferred taxes created or eliminated. Lastly, deal-related borrowing and pay-down, cash used in the transaction, and the elimination of target equity all need to be reflected. In addition, the income statements are combined to determine the combined ("pro forma") accretion/dilution in EPS. This can be done as a bottom's up analysis - starting from the buyer's and seller's standalone EPS and adjusting to reflect incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write ups. Alternatively, the accretion dilution can be a top down, whereby the two income statements are combined starting with revenue and working its way down to expenses, while making the deal related adjustments.
Walk me through a cash flow statement.
Cash from operating activities starts with net income and adds back non-cash expenses like depreciation and amortization, stock based compensation as well as changes in working capital to arrive at cash flow from operations. Cash from investing activities captures capital expenditures and other investing activities like purchases of intangible assets or financial investments. Lastly, cash from financing activities captures cash inflows from borrowing and stock issuances and outflows from dividends, debt repayment and share repurchases.
How does buying a building impact the three statements?
Cash goes down by the purchase price and is reflected in the cash from investing section. On the balance sheet, the offsetting entry to the cash reduction is an increase in PP&E. There is no immediate impact on the income statement. Over the life of the asset, depreciation expense from the building is recognized on the income statement and reduces net income by the amount of depreciation expense net of tax expense saved due to the depreciation expense. That's because depreciation is generally tax deductible. On the cash flow statement, depreciation is added back since it is non-cash. On the balance sheet, PPE is reduced by the depreciation and is offset by a reduction to retained earnings for the depreciation expense.
How does selling a building impact the three financial statements?
If I sell a building for $10 million that has a book value of $6 million on my balance sheet, I will recognize a $4 million gain on sale on the income statement which will - ignoring taxes for a moment - increase my net income by $4 million. On the cash flow statement, since the $4 million gain is non-cash, it will be subtracted out from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. On the balance sheet, the $6 million book value of the building is removed, while retained earnings increases by $4 million. The net credit of $10 million is offset by a $10 million debit to cash that came from the cash flow statement. The gain on sale will also however result in higher taxes. Assuming a 25% tax rate, I will pay $1 million in additional tax - 25% of $4 million - which will be recognized on the income statement. This lowers retained earnings by $1 million and is offset by a $1 million credit to cash.
If the market is what matters, when valuing a public company, do we even need a comps analysis? Why not just use the market cap of the company directly to value it?
If the market was perfectly efficient, it stands to reason that it would price individual equities correctly rendering a comps analysis pointless. However, the thinking behind a comps analysis for a public company is that the market may be efficient on average, but it can be off when pricing individual companies.
What is management equity rollover?
In an LBO, cash is raised via debt financing and sponsor equity. Sometimes, management and owners of the pre-LBO company might choose to participate in the LBO by rolling over the value of their oldco equity into the newco rather than cashing out. In this way, oldco management gets to participate in the upside of LBO alongside the financial sponsors.
Why would a company issue equity vs debt and vice versa?
Perhaps the greatest advantage of equity is that it has no required payments, thus giving management more flexibility around the repayment of capital (equity eventually gets it back in the form of dividends, but timing and magnitude are entirely at the board and management's discretion). Another advantage in the case of public equity is that it gives companies access to a very large investor base. On the other hand, equity dilutes ownership, and is generally more expensive (i.e. higher cost of capital). In addition, public equity comes with more regulation and scrutiny. An advantage of debt is that unlike equity, debt is tax-deductible (although recent tax reform rules limit the deduction for highly-levered companies). In addition, debt results in no ownership dilution and generally has a lower cost of capital. Of course, the disadvantages are that debt means the company faces required interest and principal payments, and it introduces the risk of default. In addition, debt covenants can restrict management from undertaking a variety of activities.
When would a DCF be an inappropriate valuation method?
Practically speaking, when you don't have access to financial statements, a credible DCF analysis valuation is difficult and limited and a comps analysis might be more realistic. For example, if you have a data point such as revenue or EBIT, a comps analysis is easier to implement. Another scenario in which a DCF may be unfeasible company is not expected generate positive cash flows for the foreseeable future. In this case, much of the company's value is pushed out to distant time horizon making the DCF less reliable. Another example is a company that isn't valued as a going concern, but rather on a liquidation basis. In this case a DCF is inappropriate and a liquidation analysis is preferred.
How would you value a private equity firm?
Private equity firms generate two types of cash flows: management fees and performance fees. Each have different risk profiles and thus merit a sum of the parts approach. The first type of cash flow, and the easiest to model, is related to management fees. Private equity firms charge management fees of 1-2% on total capital raised. The most common valuation approach for this is to apply a market multiple to the current or next year forecast for management fees. The second cash flow comes from the far more difficult to predict performance fees. Private equity firms charge 15-20% of the returns on the investments (portfolio companies) they manage. Since these fees are realized when sponsors exit their investments, they are lumpy and difficult to forecast. The investments themselves are illiquid, highly leveraged and thus highly sensitive to future market conditions. Thus, the typical approach here is to also apply a multiple on these cash flows, but a much lower multiple than that applied to management fees.
What is the impact of the 2017 tax reform?
Probably the most significant thing that happened is that corporate tax rates were reduced from $35 to 21%. There were also reductions to S Corporations and LLCs, but the impact is a little murkier and not as significant as the corporate tax reduction. There were 3 other significant impacts: Companies now face limits on how much interest expense can be deducted for tax purposes. While the formula is a little more complicated, companies can roughly deduct interest up to 30% of the company's EBITDA. This offsets the lower tax rate benefits for highly levered companies like PE portfolio companies. Companies are now able to accelerate depreciate for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes even further for capital intensive businesses. Companies can no longer carryback NOLs, but they can carryforward indefinitely instead of just 20 years. Also, companies can use NOLs to offset only 80% of current period income (prior to tax reform, NOLs could be used to offset 100% of current period income).
Assume a company has ROA of 10% and a 50/50 debt-to-equity capital structure. What is the ROE?
Return on assets = net income/average assets, while return on equity = net income / average equity. Imagine a company with $100 in assets. An ROA of 10% implies $10 in net income. Since the debt/equity mix is 50/50, the return on equity is $10/$50 = 20%.
Quick bond duration analysis:
Rule of thumb is: For every 1% change in interest rates (increase or decrease), a bond's price will change approximately 1% in the opposite direction, for every year of duration. If a bond has a duration of 5 years and interest rates increase 1%, the bond's price will drop by approximately 5% (1% x 5 yrs). Likewise if interest rates fall by 1%, the same bond's price will increase by about 5% (1% x 5 yrs).
If 80% of a DCF valuation comes from the terminal value, what should be done?
The explicit forecast period may not be long enough - the explicit stage should range from 5-10 years. Alternatively, the terminal value assumptions are too aggressive and do not reflect stable growth. A related possibility is that the final year in the explicit stage doesn't reach normalized stable growth. For example, a company that is explicit to make significant investments over the next 5 years will show a very low present value of stage 1 cash flows.
How do you value a company?
The first is intrinsic valuation, where the value of a business is arrived at by looking at the ability of that business to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and says that the value of business equals the present value of its future free cash flows. The second is relative valuation, where the value of a business is arrived at by looking at comparable companies and applying the average or median valuation multiples derived from the peer group - often EV/EBITDA, P/E, or some other relevant multiple to value the target company. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called trading comps. Lastly, you can look at the multiples of comparable companies that have been recently acquired, which is called deal comps or precedent transaction.
How are the three financial statements connected?
The income statement is directly connected to the balance sheet through retained earnings. Specifically, net income (the bottom line in the income statement) flows through retained earnings as an increase each period less dividends issued during the period. The offsetting balance sheet adjustments to the increase in retained earnings impacts a variety of line items on the balance sheet, including cash, working capital and fixed assets. The cash flow statement is connected to the income statement through net income as well, which is the starting line of the cash flow statement. Lastly, the cash flow statement is connected to the balance sheet because the cash impact of changes in balance sheet line items like working capital, PP&E (through capex), debt, equity and treasury stock are all reflected in the cash flow statement. In addition, the final calculation in the cash flow statement - net change in cash - is directly connected to balance sheet, as it grows the beginning of the period cash balance to arrive at the end of period cash balance on the balance sheet.
What's the difference between the unlevered and levered DCF?
The unlevered DCF discount the unlevered FCFs to arrive directly at enterprise value. Then, when you have a present value, just add any non-operating assets such as cash and subtract any financing related liabilities such as debt. That will get you equity value. The appropriate discount rate for the unlevered DCF is the weighted average cost of capital because the rate should reflect the riskiness to both debt and equity capital providers (because UFCFs are cash flows that belong to both debt and equity providers). The levered DCF approach on the other hand, arrives at equity value directly - first you forecast and discount the levered FCFs which gets you directly to equity value. Then you can add back net debt to get to enterprise value. The appropriate discount rate on LFCFs is the cost of equity, since these cash flows belong solely to equity owners and should thus reflect the cost of equity capital. Both levered and unlevered DCF methods should theoretically lead to the same enterprise value and equity value at the end (though in practice it's pretty hard to get them to exactly equal). In practice, the unlevered DCF approach is the most common with some exceptions, most notably the valuation of financial institutions for which a levered DCF is more appropriate.
What is the relationship between bond prices and interest rates?
There is an inverse relationship between bond price and interest rates. For example, if market interest rates go up (due to a Fed interest rate raise or other market conditions), this has the impact of making the interest being offered by currently outstanding debt seem less attractive given the availability of comparable investments with now higher interest rates all else equal. The price of outstanding bonds will thus drop.
Describe accretion dilution analysis.
This analysis is used to gauge the impact of an acquisition to the acquirer's EPS and compare it with the company's EPS if the acquisition did not happen. Accretive = new EPS increase Dilutive = new EPS decreases
Walk me through the 3 financial statements.
This captures a company's performance over a period of time such as a quarter or year. The Income Statement shows 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. Unlike the IS, it shows a snapshot of a company at a specific point in time, such as end of quarter or year. 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.
