Equity value, enterprise value, and valuation metrics/multiples

Question 1

What is the ‘correct’ definition of enterprise value?

Answer 1

The value of a company’s core business operations to all the investors in the company

Question 2

What are the two main categories of company valuation?

Answer 2

1) Market-based approaches
2) Intrinsic value-based approached

Question 3

Why may a companies intrinsic value differ from the market valuation?

Answer 3

If you believe a characteristic of the business, such as the future revenue growth rate, is different to the value that is being prescribed by the market, then the intrinsic value will be ‘different’ to the market valuation

Question 4

Definition of equity value

Answer 4

The value of a company but only to equity investors

This is determined by total assets - total liabilities, which will only leave equity value (think of like a balance sheet)

Question 5

Definition of enterprise value

Answer 5

The value of the company’s core business operations (operating assets - operating liabilities), but to all investors (equity, debt, preferred, and possibily others)

You are removing the non-operating assets (cash) and non-operating liabilities (financial debt)

Question 6

When analysing companies, why do we often look at enterprise value rather than equity value?

Answer 6

As the company changes its equity vs debt allocation, its current equity value keeps changing because equity value depends on capital structure.

However, enterprise value stays the same because enterprise value does not depend on capital structure (to the same extent).

Best way to think of this is that when you are buying a house, the mix of debt and equity doesn’t matter, the price you end up paying for the house stays the same

Question 7

Best example of how to explain enterprise value vs equity value?

Answer 7

House - when buying a house, you are required to give the bank a downpayment (equity) and take out a mortgage for the rest (debt). The total value of the house is equity + debt, which is what is given to the seller of the house.

Question 8

For enterprise value, do you look at the market or book value of equity? How about debt?

Answer 8

Ideally, use the market value of both, although debt could be difficult to come by

Question 9

Why is cash deducted in enterprise value?

Answer 9

Because it is a non-operating asset

Question 10

Cash is deducted from enterprise value because it is a non-operating asset. What other non-operating assets should be deducted from enterprise value?

Answer 10

Financial investments, such as stocks and bonds
Owned properties from which the company earns rental income (i.e. not using them for internal operations)
Side businesses, that are not part of the enterprise’s main operations
Assets held for sale and assets associated with discontinued operations
Equity investments (i.e. when a parent company owns <50% other companies)
Net operating losses

Question 11

Do you account for operating and capital leases in enterprise value?

Answer 11

Theoretically, you should do as both of them are debt items. IFRS 16 also forces you to do this, as operating leases are split out into interest and depreciation, and are therefore being used in EBITDA.

Question 12

Why do we need to add non-controlling interests to other capital sources to get enterprise value?

Answer 12

Under accounting standards, financials from subsidiary companies that the parent has a majority holding in are consolidated into the overall financial statements. Therefore, to get an apples-to-apples comparison between EV and EBITDA, you need to add NCI.

Question 13

Under what conditions are pensions added in enterprise value?

Answer 13

When the company has a defined benefit scheme, and the liabilities of this scheme (what is owed to employees in the future) is greater than the assets currently in the scheme

Question 14

What would be the best estimate of the valuation of a private company’s equity?

Answer 14

The valuation at which the company most recently raised money, the price at which it was acquired, or another external number to estimate its current equity value

Question 15

From a theoretical perspective, what happens to enterprise value when you issue £100 of equity and then hold this on the balance sheet as cash?

Answer 15

Theoretically nothing, because the increase in equity value is cancelled out by the increase in cash. Similarly, all other financing events do not affect enterprise value. These events include:
- Issuing debt
- Repaying debt
- Issuing stock
- Repurchasing shares
- Issuing dividends

Question 16

If you use cash to purchase PP&E, what happens to equity and enterprise value?

Answer 16

Equity value remains unchanged, because net assets remain unchanged (cash down but PP&E up)

Enterprise value goes up, because you have exchanged a non-operating asset (cash) for an operating asset (PP&E)

Question 17

If you use cash to purchase inventory, what happens to equity and enterprise value?

Answer 17

Equity value remains unchanged, because net assets are the same in both cases, but enterprise value increases because you have exchanged a non-operating asset (cash) for an operating asset (inventory)

Question 18

Go to page 4 and page 5 and think about equity value / enterprise value changes

Answer 18

Go to page 4 and page 5 and think about equity value / enterprise value changes

Question 19

What happens if a company issues $100 of common stock and does nothing with the proceeds?

Answer 19

Equity value goes up by $100 because total assets have gone up

Enterprise value remains unchanged because equity value goes up by $100 but is offset by the $100 increase in cash (because it is a non-operating asset)

Question 20

What happens to equity value if a company issues $100 of common stock and issues $50 of dividends? What happens to enterprise value?

Answer 20

Equity value goes up by $100 initially, but then decreases by $50 because of the dividends paid. This is because total assets have gone up by $50

Enterprise value remains the same, because increase in equity value is offset by the increase in cash

Question 21

What happens to equity value and enterprise value if a company issues $100 of common stock and uses the proceeds to fund an acquisition?

Answer 21

Equity value goes up by $100, because assets go up.

Enterprise value goes up by $100, because operational assets also go up

Question 22

What happens to equity value and enterprise value if a company issues $100 of debt and does nothing with it?

Answer 22

Equity value does not change, because although assets go up, so do liabilities

Enterprise value doesn’t change, because although debt goes up, cash mitigates this

Question 23

How do equity value and enterprise value change if you use cash to do additional Capex?

Answer 23

Net assets stay the same, so equity value is flat.

Cash is not operating but PP&E is, so enterprise value will go up.

Question 24

How do equity value and enterprise value change if you purchase inventory with cash?

Answer 24

Equity value stays flat but enterprise value goes up.

Question 25

How do equity value and enterprise value change if you use $100 of inventory to produce $200 of goods?

Answer 25

Net assets goes up by $100, because although inventory goes down, cash (and net income) goes up

Enterprise value goes down by $100, because the operating asset (inventory) is used to produce cash (non-operating asset)

Question 26

If a CEO found £100 on the floor, how would equity value and enterprise value change?

Answer 26

Equity value goes up, but enterprise value remains flat

This would be recorded as an extraordinary gain on the income statement

Question 27

As a company issues more debt, what happens to WACC?

Answer 27

Initially, Wacc will decrease as cost of debt is lower than the cost of equity.

However, as the company takes on more debt, both the cost of debt and cost of equity increase, because additional debt makes the company riskier and riskier for new lenders

Therefore, it forms a U shape.

Question 28

One of MM theorems is that changing capital structure does not change firm value. Does this hold true in practice?

Answer 28

No, eventually as you issue more and more debt as a % of capital, firm value (i.e. EV) will decrease, which is because the WACC goes up significantly, greatly reducing the present value of future cash flows

Question 29

What are some of the reasons why capital structure does change the value of a company?

Answer 29

Taxes - interest paid on debt is tax-deductible, so enterprise value is affected differently by issuing the same amount of debt and equity

Bankruptcy risk - Higher leverage increases risk of bankruptcy, so over time the cost of debt and cost of equity will have to be higher. Therefore, as % of debt/total capital increases, enterprise value decreases.

Question 30

Is enterprise value truly capital structure neutral?

Answer 30

No, it is just much less sensitive to capital structure than equity value is

Question 31

Are restricted stock and restricted stock units included in a company’s common share count?

Answer 31

Restricted stock usually is, but RSUs are usually not

Question 32

Look up the mechanics of a capped call option strategy which mitigates dilution from convertible bonds

Answer 32

Look up the mechanics of a capped call option strategy which mitigates dilution from convertible bonds

Question 33

When calculating enterprise value, you deduct all non-operating assets. Other than cash, what are some other examples of non-operating assets?

Answer 33

Financial investments, non-core businesses, discontinued operations, equity investments (i.e. less than <50% ownership in a company)

Question 34

What are the investor groups that need to be considered when calculating enterprise value?

Answer 34

Financial debt, preferred stock, capital leases, non-controlling interests, unfunded (adjusted for tax) pensions, and (under IFRS) operating leases

Question 35

Are equity investments deducted or added in the enterprise value bridge? What about NCI?

Answer 35

Equity investments are deducted, because lower than the 50% threshold

Noncontrolling interests are added because they will be consolidated into the financial statements.

Question 36

Why do we compare companies using multiples rather than on a nominal basis?

Answer 36

Multiples are on a per-unit basis, which is a much fairer way of valuing companies

Question 37

In words, explain the intuition behind EV / Sales

Answer 37

Measures a companies price in relation to its sales

Question 38

In calculating EBITDA, where does D&A come from?

Answer 38

Always take D&A from cash flow statement

Question 39

What is EBIT a proxy for?

Answer 39

Free cash flow, as depreciation implicitly accounts for some of capex

Question 40

What is EBITDA a proxy for?

Answer 40

Cash flow from operations, as the depreciation add back means that Capex has not been considered

Question 41

What is the shortened formula for free cash flow?

Answer 41

Cash flow from operations - Capex

Question 42

What is the formula for NOPAT?

Answer 42

EBIT * (1 - Tax Rate)

Question 43

What is free cash flow to the firm?

Answer 43

Unlevered free cash flow, or the discretionary cash flow available to all investors in the company (not just equity)

Question 44

What is the formula for unlevered free cash flow?

Answer 44

NOPAT + D&A and other non-cash adjustments - increases in NWC - capex

Question 45

What is the formula for levered free cash flow?

Answer 45

Net income to common + D&A and other non-cash adjustments - increases in NWC - Capex - (mandatory) debt repayments + debt issuances (debatable)

Because a lot of the stuff in levered FCF is debatable, it is usually advised not to use this as a metric

Question 46

In LBO and transaction models, what cash flow metric do you often use?

Answer 46

Free cash flow, i.e. cash flow from operations - Capex

Question 47

What is EBITDAR used for?

Answer 47

Primarily used to normalise companies with different types of leases (operating vs capital) and to normalise companies following US GAAP vs IFRS

Question 48

Under IFRS, why can’t you (normally) just take the D&A from the cash flow statement?

Answer 48

Because this D&A will include the depreciation element of the lease expense

Question 49

What is the formula for invested capital

Answer 49

Equity + debt + preferred stock + other investor groups

Question 50

What is the formula for return on invested capital

Answer 50

NOPAT / (Equity + debt + preferred + other investor groups)

Question 51

Why is P / BV ratio not really used?

Answer 51

Market value of equity tends to be not linked directly to balance sheets

Question 52

Within FIG, what types of companies need different metrics/valuation methodologies?

Answer 52

Only commercial banks and insurance firms, because the concept of enterprise value is invalid because you cannot seperate operating assets and operating liabilities from total assets and total liabilities. A loan or investment is a non-operating asset to a normal company, but it is an operating asset to a bank

Question 53

How do you value (both relatively and intinsically) commercial banks and insurance firms?

Answer 53

Using P / E, P / BV, P / TBV multiples, the dividend discount model (rather than the dcm)

For life insurance, you should use the embedded value methodology (which is a super long-term variant of the dcm)

Question 54

How would you value asset management or, boutique financial advisory / investment banks?

Answer 54

You can use a dcm here, because they dont rely on interest to make a large proportion of their earnings / cash flow

Question 55

Valuation methodology for metals & mining businesses?

Answer 55

Operational metrics include things like reserves, resources and production

You also can use a NAV model, which is a super long-term DCF that doesn’t have a terminal value, as you assume that the mine runs out of resources that are “economically viable to extract”

Question 56

Valuation methodology for oil & gas businesses?

Answer 56

You can make operational metrics out of reserves and production

Some upstream (exploration & production) companies capitalise the cost of all exploration while theres expense the unsuccessful portion, so you use EBITDAX (EBITDA + exploration expense) to normalise these treatments

Downstream companies (ones that refine oil and gas and turn it into fuel) use the standard metrics and multiples

Question 57

Valuation methodology for real estate businesses?

Answer 57

xxx

Question 58

Valuation methodology for healthcare businesses?

Answer 58

Incorporate a probability of success

Question 59

Valuation methodology for airlines businesses?

Answer 59

xxx

Question 60

Check page 69 for others

Answer 60

Check page 69 for others

Question 61

Why do you often use forward multiples to value companies?

Answer 61

Because valuation is based on expectations of future performance

Question 62

When you use forward multiples, why do you use current numerators (such as equity value or enterprise value)?

Answer 62

because current equity value and current enterprise value represent past results as well as future expectations as of the valuation date

Question 63

Why would you use LTM multiples rather than based on historical fiscal years?

Answer 63

LTM tend to more accurately show current landscape, as could be 2-3 quarters past since the last FY

Question 64

Should the FY+1 P/E multiple be higher or lower than the FY+2 P/E multiple?

Answer 64

Assuming the company grows YoY, the FY+2 multiple should be lower as the numerator is the same, but denominator should grow.

Question 65

Should forward looking multiples be higher or lower than historical ones

Answer 65

All forward multiples should be lower than their historical multiples, assuming the companies are growing

Question 66

When identifying a peer set for comparable companies analysis, what characteristics would you consider?

Answer 66

Financial metrics, geography and industry

Question 67

When you have found comparable companies, how can you determine where to place the target within the valuation range implied by the comps?

Answer 67

The comp set has been selected using financial metrics, geography and industry, so you have not considered operational metrics.

You can then use operational metrics to place the target within the valuation range. For example, if the target has the same ebitda margin as the average from the comps, then you could place it at the mean. However, if the ebitda margin is much hgiher than the average (perhaps near the top of the range), then you could place at the 75th percentile

Question 68

If two companies are the same except from one having a higher cash flow growth rate, which would have the higher multiple?

Answer 68

One with higher cash flow growth rate

Question 69

Why do you deduct equity investments from enterprise value, but add non controlling interests

Answer 69

NCIs have financials consolidated into the parent, but equity investments do not. In addition, because a company owns less than 50%, these assets can also be considered non-core

Therefore, for apples to apples comparison, you need to add NCIs but subtract equity investments

Question 70

For equity investments and NCIs, why do we not adjust EBITDA, rather than adjusting EV?

Answer 70

Much easier to adjust EV; often, hard to find information to adjust EBITDA, as although segmental analysis may disclose revenue/operating income, they rarely disclose things such as business-line specific D&A

Question 71

What are right-of-use assets?

Answer 71

Assets that come from operating leases

Question 72

Under IFRS, how do you treat operating leases in relation to EBITDA and EBIT?

Answer 72

When you use EBITDA, you must pair it with TEV including operating leases.

However EBIT is now a problematic metric, because it deducts only part of the full lease expense (the depreciation element), so EBIT multiples are invalid unless you adjust EBIT

Question 73

Look into using EBIT post IFRS 16 because of operating leases

Answer 73

I think, if you include operating leases in metrics such as invested capital, you need to add back the operating lease’s interest to EBIT to get a comparative metric

Question 74

If a company obtains an operating lease and hence a right-of-use asset, does TEV change?

Answer 74

Yes, because under IFRS 16, lease assets are considered operational, but lease liabilities are not

Question 75

Why do you pair net assets with common shareholders in equity value, but net operating assets with all investors in enterprise value?

Answer 75

The logic is that common shareholders’ equity can be generated internally (via net income) or raised externally (stock issuances), so the company can use it for both operating and non-operating assets

But if the company raises funds via outside investors (debt, preferred stock etc), then most likely it will use those funds to pay for operating assets, rather than spending the money on random non-operating assets

Question 76

What is the difference between current enterprise value and implied enterprise value?

Answer 76

Current is the enterprise value insinuated by the markets current valuation, whereas implied is the enterprise value insinuated by your own valuation using methodologies like DCF, LBO, comps and precedent transactions

Question 77

Stopped at page 95

Answer 77

Stopped at page 95

Question 78

Why would P / E multiple be higher for one industry or another?

Answer 78

Expected higher earnings growth in the future.

Question 79

When would you value a business using the P / B ratio?

Answer 79

When the company’s book value. captures a substantial part of its real value.

Question 80

Why are banks valued using P / B ratio?

Answer 80

Most of their assets and liabilities are frequently re-valued and hence similar to market values

Question 81

For ROIC, if it maintained constant at 20% and you reinvested all of your NOPAT of 100, what would you expect NOPAT to be next year?

Answer 81

Your asset base would grow by 100, and you would expect NOPAT to grow by 20 to 120, because you get a 20% return on the 100 invested.

Question 82

How do share buybacks affect ROIC?

Answer 82

Depends how they are funded; if funded with debt, invested capital increases and hence ROIC goes down.

However, far likelier that they are funded with excess cash, and, if excess cash is not considered as a invested capital, ROIC will not change.

Question 83

What is ROIIC?

Answer 83

Return on incremental invested capital

Looks at how ROIC will change in the future

Question 84

Formula for ROIIC?

Answer 84

This is return on incremental invested capital

(Change in Nopat) / Change in Invested Capital

Question 85

Should you use ROIC when evaluating M&A deals?

Answer 85

No - the cost (invested capital) is reflected immediately but the NOPAT should come over time

Question 86

What is the difference between market value of equity and book value of equity?

Answer 86

Market value - market capitalisation which fluctuates

Book value - listed on equity section of balance sheets; changes based on net income minus dividends

Question 87

What is formula for market cap?

Answer 87

Stock price * Fully diluted shares outstanding

Question 88

What is the treasury stock method?

Answer 88

Summing up the number of in-the-money options and warrants and then adding that figure to the number of basic shares outstanding

Question 89

What is enterprise value conceptually?

Answer 89

Represents the value of the operations of a company to all stakeholders including common shareholders, preferred shareholders, and debt lenders

Question 90

What does free cash flow represent?

Answer 90

Money that can be discretionally allocated, as it accounts for all costs of running the business

Question 91

Why would you usually exclude non-operating income or expenses in a valuation?

Answer 91

EV represents the operating value of core business operations, and hence income that comes from a one-time event such as tax windfall or sale of division should not be included

Question 92

How is a share buyback shown on a balance sheet?

Answer 92

Thought the line item ‘treasury stock’

Question 93

When is a share buyback appropriate?

Answer 93

When a company has spare cash on hand and believes the market is undervaluing its shares

Question 94

Why might a company prefer to repurchase shares over the issuance of a dividend?

Answer 94

• double taxation of dividends is a major negative
• share repurchases artificially inflate EPS numbers
• many companies now use SBC, and therefore want to counteract the dilutive impact from employees owning stock

Question 95

When would it be most appropriate for a company to distribute dividends?

Answer 95

Usually low-growth with fewer profitable projects in their pipeline. Therefore, the management opts to pay out dividends to signal the company is confident in tis long-term profitability and appeal to a different shareholder base (i.e. long-term dividend investors)

Question 96

When valuing a company using multiples, what are the trade-offs of using LTM vs forward multiples?

Answer 96

Using historical profits have the advantage of being actual results, which can be especially useful when valuing smaller companies, given that estimates can be quite hard to obtain

Question 97

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Answer 97

Growth and cost of capital are not the only drivers of value. Another critical component is ROIC. Besides having different ROICS, the two campaigns could very well just be in different industries or geographies

Question 98

When would a PEG ratio be appropriate?

Answer 98

Used to standardise the P/E ratio and enable comparisons among companies with different expected long-term growth rates.

Question 99

Why is calendarising a required step when performing comps analysis?

Answer 99

General convention is to adjust the financials so that all the fiscal years end in December to avoid cyclicality and seasonality from skewing results

Question 100

What are the two category of liabilities?

Answer 100

Operating and financial

Question 101

How would you define an operating liability?

Answer 101

A liability that has come from the day-to-day operations of the business (e.g. accounts payable)

Question 102

Why would a company do a share buyback rather than issue a dividend?

Answer 102

Represents a more flexible approach to returning excess cash back to shareholders - reducing a dividend is usually interpreted negatively, so you dont want to increase dividends unless you can maintain this level in the future

Question 103

How can a share buyback affect P/E?

Answer 103

Really depends.

Theoretically, buyback indicates shares are undervalued, which should hopefully push up share price and hence P/E. However, the reduction in cash could also decrease the share price.

Additionally, the buyback could signal that the company has less growth opportunities, which could reduce the stock price if there was high growth priced in

Question 104

Under IFRS, should you add back operating and financing leases when moving from equity value to enterprise value?

Answer 104

Usually yes, because revenue and EBITDA already exclude or add back the lease interest and lease depreciation (although EBIT is more problematic)

Question 105

Why is accounting for operating leases when moving from equity to enterprise value difficult under US GAAP?

Answer 105

You usually cannot add back operating leases because, under US GAAP, a rental expense will be included above EBITDA, and hence the expense incurred that is owed to this stakeholder has already been implicitly accounted for

Question 106

Under US GAAP, what change could be made to EBITDA that would allow you to include operating leases in the equity to enterprise value bridge?

Answer 106

Using EBITDAR - so adding back rental expense onto EBITDA