Ask Ivy Flashcards
- What is a P/E (Price/Earnings) ratio and why do analysts use it? What quantitative and
qualitative factors drives the P/E multiple? Explain the difference between two companies with
identical earnings but different multiples.
P/E Ratio (or earnings multiple) = Price of Stock / Earnings per Share
The P/E multiple is used in comparing the relative attractiveness of stocks.
It gives investors an idea of how much the market is paying for a company’s earning
generating capability. For each unit of stock price, a certain amount of earnings is
expected. The higher the P/E, the more investors are paying, and therefore the more
earnings growth they are expecting. A P/E multiple above 20x generally implies high
growth.
Quantitatively, P/E is moved by changes in share price and earnings through the
numerator and denominator, respectively.
Qualitatively, share price is affected by market perceptions/expectations of risk,
growth, quality of earnings (margins), and general investor confidence.
- In a perfect (tax free) world, if you have a company with an enterprise value of $5bn and
you take out $2bn in debt, what is the new enterprise value? What is the enterprise value if you
subsequently use the $2bn to pay out a dividend? What is the enterprise value if instead of
paying out the dividend you invest the $2bn in a new project with an NPV of $3bn?
When you answer enterprise value related question, remember the Enterprise Value
and Equity Value chart we showed above
AskIvy Technical Questions Guide | 2011/12 edition | Copyright 2008-2011 ® All rights reserved
9
Issuing the $2bn in debt increases cash by $2bn but also increases debt by $2bn.
Cash and debt net out. Thus firm value remains the same at $5bn.
Paying out a dividend of $2bn eliminates cash on the balance sheet and, in doing so,
eliminates $2bn in equity value. Thus firm value remains the same at $5bn.
Using the $2bn to invest in a project with an NPV of $3bn increases the enterprise
value of the firm by the investment amount ($2bn) and the investment’s NPV ($3bn).
Thus firm value is $10bn.
3 differences between preferred stock and common
seniority, interest rate, tax shield
- What is the calculation for EPS? Does that include preferred stock? What about convertible
bonds?
Net Earnings-Per-Share (EPS) is the portion of a company’s net earnings allocated to
each share of common stock. It is calculated by dividing net earnings by common
shares outstanding adjusted for the assumed conversion of all potentially dilutive
securities.
EPS does not include preferred stock.
Securities having a dilutive effect may include convertible debentures, warrants,
options, and convertible preferred stock.
- In a world with taxes, if you issue debt for $100 and pay it out as a dividend how does it
affect your enterprise value?
Enterprise value is discounted un-levered cashflow to the firm as a whole.
If there is no tax there is no impact on the enterprise value. When the company issues
debt, both debt and cash are going up, there is no effect. Paying dividend is cash
getting out so equity down but offset by increased net debt so there is no effect either
However, in a tax environment, there will be tax shield related to the additional debt.
When new debt is issued the company has to pay higher interest which will offset net
income, as a result lower tax. The tax shield is Debtinterest ratetax rate. Tax shield
will add more value on the company.
- What are the pros and cons of a purchase of a target’s assets as opposed to a target’s
equity?
There are two key issues: taxes and risk.
A stock purchase is preferred by sellers because the buyer pays the taxes in the future
on the assets. The seller also transfers all real and contingent risk to the buyer.
AskIvy Technical Questions Guide | 2011/12 edition | Copyright 2008-2011 ® All rights reserved
31
An asset purchase is more favourable to the buyer for tax purposes because it is
taxable for the seller but deductible for the buyer because of depreciation. It also
allows the buyer to pick and choose what it wants to acquire, including avoiding some
liabilities (such as environmental damages or pending litigation) to minimize risk.
- How would you value a bond, and what interest rate would you use?
A bond value is equal to the present value of its future cash flows (coupon payments
and principle repayment) discounted at the prevalent market interest rate. The discount
interest rate is dependent on treasury rate plus premium for default/operational risk of
issuing entity.
