TEV

Question 1

1. What do Equity Value and Enterprise Value MEAN? Don’t explain how you calculate them – tell me what they mean!

Answer 1

Equity Value represents the value of EVERYTHING a company has (its Net Assets) but only to the EQUITY INVESTORS (i.e., the common shareholders).
Enterprise Value represents the value of the company’s CORE BUSINESS OPERATIONS (its Net Operating Assets) but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

Question 2

2. That sounds complicated. What do these concepts mean in plain English? Can you give a real-life analogy?

Answer 2

If you buy a house for $500K with a $100K down payment, $500K is the Enterprise Value, and
$100K is the Equity Value.
Enterprise Value does not change when the capital structure changes, so if you use $250K for the down payment, the Equity Value is now $250K, but the Enterprise Value is still $500K.

Question 3

3. Why do you need both Equity Value and Enterprise Value? Can’t you just value companies using one of them?

Answer 3

We need both because some valuation methodologies and analyses produce Equity Value for the output, but others produce Enterprise Value, so we must be able to move back and forth to make proper comparisons.
Enterprise Value has some advantages because it is not affected by capital structure changes (e.g., a company using less Debt and more Equity); people often call it “capital structure- neutral” for this reason.
However, Equity Value is still important because most valuations are conducted from the perspective of the common shareholders, who mostly care about what their shares are worth.

Question 4

4. What is the difference between “Current” and “Implied” Enterprise Value? Can you give a real-life example to explain it?

Answer 4

“Current” means that you are calculating the Enterprise Value based on the company’s current share price, share count, and Balance Sheet (subtract Cash, add Debt, add Preferred Stock, etc.).

“Implied” means that you are using a valuation methodology, such as the DCF, to value the company and determine what you think it should be worth.
Let’s say that you search for houses in real life and find one you like with a “list price” of $500K. However, you research the area, similar properties, and demographic trends, and believe it’s worth more like $450K.
$500K is the Current Enterprise Value of the house, and $450K is the Implied Enterprise Value.

Question 5

5. What is the difference between Basic Equity Value and Diluted Equity Value?

Answer 5

Basic Equity Value is Common Shares Outstanding * Current Share Price, while Diluted Equity Value includes the impact of dilutive securities, such as options, warrants, restricted stock units (RSUs), and convertible bonds; it equals Diluted Shares Outstanding * Current Share Price.
Companies create and issue these dilutive securities to incentivize employees to stay at the company (and to raise funds, in the case of convertible bonds).
You factor in these dilutive securities via different methods, such as the Treasury Stock Method for options and warrants and the “If Converted” method for convertible bonds.
Diluted Equity Value more accurately measures what the company’s Net Assets are worth to the common shareholders.

Question 6

6. Let’s say you have a company’s Diluted Equity Value. How do you move from Equity Value to Enterprise Value?

Answer 6

At a basic level, Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interests, so you could say that in an interview and be fine.
The more technical answer is that you should take Equity Value and subtract Non-Operating Assets and add Liability & Equity lines that represent other investor groups beyond the common shareholders.
Examples of Non-Operating Assets include Cash, Investments, Equity Investments (Associate Companies), Assets Held for Sale, and Net Operating Losses.
Examples of L&E lines representing other investor groups include Debt, Preferred Stock, Underfunded Pensions, Noncontrolling Interests, and sometimes Leases (it’s complicated).

Question 7

7. Why do you subtract Equity Investments and add Noncontrolling Interests in the Enterprise Value calculation?

Answer 7

The short, simple answer is that Equity Investments (< 50% stakes the parent company owns in others) are considered non-core assets, and Noncontrolling Interests (when a parent owns more than 50% in another company, the portion it does not own) are considered another “investor group” (the minority shareholders of this other company).
The longer answer is that you also do this for comparability purposes. For example, let’s say that Company A owns 30% of Company B and 75% of Company C.
Company A’s EBITDA includes 0% of Company B’s EBITDA but 100% of Company C’s EBITDA due to accounting rules around the consolidation of the financial statements.
However, Company A’s Equity Value reflects 30% of Company B and 75% of Company C.
Therefore, to use Enterprise Value with EBITDA in metrics such as TEV / EBITDA, you must adjust Enterprise Value to reflect 0% of Company B and 100% of Company C.
To do this, you subtract the Equity Investments, which represent 30% of Company B, and you add the Noncontrolling Interests, which represent the 25% of Company C that Company A does not own.

Question 8

8. Can you explain the proper treatment of pensions in Enterprise Value?

Answer 8

Only Defined-Benefit Pension plans factor in because Defined-Contribution Plans do not appear on the Balance Sheet.
You should add the Unfunded or Underfunded portion, i.e., MAX(0, Pension Liabilities – Pension Assets), in the TEV bridge because the employees represent another investor group when they are promised future payments.
They agree to lower pay and benefits today in exchange for fixed payments once they retire, and the company must fund the pension and invest the funds appropriately.
If contributions into the pension plan are tax-deductible, you should multiply the unfunded portion by (1 – Tax Rate) in the Enterprise Value bridge.

Question 9

9. Should you add Operating Leases in the Enterprise Value calculation? What about Finance Leases?

Answer 9

This is a question of comparability and the valuation multiples you’re using. Generally, you should add Finance Leases because metrics such as EBITDA exclude the Finance Lease Interest and Finance Lease Depreciation.
If a metric excludes certain expenses, then the Enterprise Value paired with this metric should
add or include the corresponding Liability.
Operating Leases are trickier because the accounting differs under U.S. GAAP vs. IFRS. Under
U.S. GAAP, it’s best not to add them because the corresponding expense is “Rent” on the Income Statement, which is deducted to calculate EBIT, EBITDA, etc.
If you add them to Enterprise Value, you must pair it with a metric like EBITDAR that adds back the Rental Expense.
Under IFRS, it’s easiest to add Operating Leases because metrics like EBITDA exclude the full Lease Interest and Lease Depreciation from all Lease types, so the corresponding Lease Liabilities should be in Enterprise Value.
NOTE: We do not view Leases as true “financial” items representing “outside investor groups”; this treatment is for comparability and ease of calculation.

Question 10

10. Can you give examples of company actions that affect Equity Value but NOT Enterprise Value, Enterprise Value but NOT Equity Value, and BOTH Enterprise Value and Equity Value?

Answer 10

This “compound question” tests how well you understand these concepts beyond simple definitions. There are many possible answers, but a few simple ones include:
* Affects Equity Value But Not Enterprise Value: A company issues $100 of Stock and lets it sit in Cash on its Balance Sheet (Net Operating Assets are unchanged).

• Affects Enterprise Value But Not Equity Value: A company issues $100 of Debt and uses it to buy a factory, boosting its Net PP&E (Net Operating Assets increase by $100).
• Affects Both Equity Value and Enterprise Value: A company issues $100 of Stock and uses it to buy a factory, boosting its Net PP&E (Net Operating Assets increase by $100, and Common Shareholders’ Equity is also up by $100).

Question 11

11. Could Equity Value ever be negative? What about Enterprise Value?

Answer 11

Since Equity Value is based on Share Price * Share Count, and neither component can be negative, effectively, it cannot be negative (the Implied Equity Value from a valuation methodology could still be negative, but you typically set it to $0 when this happens).
Enterprise Value could be negative since Cash could exceed Equity Value for certain types of companies, such as “busted biotech” firms that trade at a discount to their cash.

Question 12

12. You are comparing Companies A and B. Each operates in the same industry with the same revenue, EBITDA, and other financial metrics.
    Company A is financed with 100% Equity, and Company B is financed with 50% Equity and 50% Debt.
    In theory, their Enterprise Values should be the same. Will they be the same in real life?

Answer 12

No, most likely not. Although people claim that Enterprise Value is “capital structure-neutral,” it’s more accurate to say that it is less affected by capital structure than Equity Value.
The specific issue is that a company’s capital structure affects its Discount Rate because a shifting Debt and Equity mix changes its risk and potential returns.
Using more Debt increases the company’s default risk, which affects all the investors – even the common shareholders.
So, if investors value these companies based on their future cash flows and separate Discount Rates (WACC), the Discount Rate differential could explain valuation differences.
The companies’ “Current” Enterprise Values might still be close, but you will see more of a difference with the “Implied” versions, which may grow over time.

Question 13

1. A company issues $200 in Common Shares. How do Equity Value and Enterprise Value change?

Answer 13

CSE increases by $200, so Eq Val increases by $200.
NOA does not change because neither Cash nor CSE is operational, so TEV stays the same. Alternatively, in the TEV formula, the extra Cash offsets the higher Equity Value.

Question 14

2. This same company decides to use the $200 in Common Stock proceeds to acquire another business for $100 instead. How does everything change?

Answer 14

CSE increases by $200 from this issuance, so Eq Val increases by $200.
Of this $200 in proceeds, $100 remains in Cash, and $100 is allocated to Acquired Assets from the other business.
These Acquired Assets are Operating Assets, and no Operating Liabilities change, so NOA
increases by $100. TEV, therefore, increases by $100.

Question 15

3. What if the company uses that same $100 from the $200 of new Common Stock to acquire an Asset rather than an entire company?

Answer 15

CSE still increases by $200, so Eq Val is up by $200.

If this Asset is considered “Operating” or “Core,” such as a factory, then NOA increases by $100, so TEV also increases by $100.
If not – for example, the Asset is a short-term investment – then NOA does not change, and TEV stays the same.

Question 16

4. A company issues $100 in Debt to purchase a new factory. How do Equity Value and Enterprise Value change?

Answer 16

CSE does not change because Debt, not Equity, is the financing source here. Therefore, Eq Val stays the same.
The new factory is a Net Operating Asset, so NOA increases by $100, and TEV, therefore, also increases by $100.
Alternatively, in the TEV formula, Equity Value stays the same, and Debt increases, so TEV goes up.

Question 17

5. A company issues $100 of Common Stock and $100 of Preferred Stock and lets the proceeds sit in Cash. How do Equity Value and Enterprise Value change?

Answer 17

CSE increases by $100 due to the Common Stock issuances, so Eq Val is up by $100. The Preferred Stock issuance does not affect Common Shareholders’ Equity!
Net Operating Assets are unchanged, so TEV stays the same.
In the TEV formula, Equity Value is up by $100, Cash is $200 more negative, and Preferred Stock is up by $100, so TEV stays the same.

Question 18

6. This same company now issues $10 in Common Dividends and $10 in Preferred Dividends. What happens in JUST THIS STEP?

Answer 18

CSE decreases by $20 due to these Dividend issuances. Yes, both Common and Preferred Dividends flow into Common Shareholders’ Equity on the Balance Sheet. Therefore, Eq Val is down by $20.
Net Operating Assets are unchanged, so TEV stays the same.

Question 19

7. A company issues $150 of Debt and $50 of Common Stock to acquire $175 of PP&E and $25 of Short-Term Investments. How do Equity Value and Enterprise Value change?

Answer 19

CSE increases by $50 because of the Common Stock Issuance, so Eq Val increases by $50. The $175 of PP&E counts as an Operating Asset, and no Operating Liabilities change, so NOA
increases by $175, and TEV also increases by $175.

Question 20

8. A company issues $50 of Debt to buy a new factory. However, AFTER this purchase, its Enterprise Value increases by $100 rather than $50.
   Your co-worker claims it is because the company issued Debt to make this purchase, and Debt increases Enterprise Value. Is he correct?

Answer 20

No. The purchase method does not matter when determining how Enterprise Value changes. All that matters is how the Net Operating Assets change.
The most likely explanation here is that the book value of this factory is $50, but its market value is $100 because market participants believe the Present Value of its future cash flows is closer to $100. Therefore, Enterprise Value increases by $100 rather than $50. The company effectively got a discount on a new asset.

Question 21

9. A company purchases $100 of Inventory using Cash. How do Equity Value and Enterprise Value change?

Answer 21

There are no changes on the Income Statement in this initial step because the Inventory has not yet been sold. Therefore, Net Income does not change.
On the Balance Sheet, CSE stays the same in this initial step (no changes to Net Income, Stock Issuances/Repurchases, Dividends, etc.), so Eq Val stays the same.
NOA increases by $100 since Inventory is an Operating Asset, and no Operating Liabilities change, so TEV increases by $100.

Question 22

10. Now assume the Inventory is sold for $200 and walk me through how the entire process from beginning to end affects Equity Value and Enterprise Value.

Answer 22

On the Income Statement, Revenue is up by $200, and Pre-Tax Income is up by $100 (due to the
$100 of Inventory now being recognized as COGS). Net Income increases by $75 at a 25% tax rate.
On the CFS, Net Income is up by $75, and there are no other net changes (Inventory went up by
$100 and then went down by $100), so Cash is up by $75 at the bottom.
On the Balance Sheet, Cash is up by $75 on the Assets side, and CSE is up by $75 on the L&E side.
Since CSE is up by $75, Eq Val increases by $75.
NOA does not change because Cash is not an Operating Asset, and no Operating Liabilities change, so TEV stays the same.
Intuition: This 2-step process represents the company generating Net Income and letting it sit in Cash; that process does not make its core business more valuable, so TEV does not increase.

Question 23

11. A company has 200 outstanding shares at a current price of $10.00. It also has 50 options at an exercise price of $8.00 each. What is its Diluted Equity Value?

Answer 23

The Basic Equity Value is 200 * $10.00 = $2,000. To calculate the diluted shares, note that the options are all “in the money” – their exercise price is less than the current share price – and apply the Treasury Stock Method.
When these options are exercised, 50 new shares are created.
The investors paid the company $8.00 to exercise each option, so the company gets $400 in cash. It uses that cash to buy back $400 / $10.00 = 40 of the new shares, so the diluted share count is 200 + 50 – 40 = 210, and the Diluted Equity Value is $2,100.

Question 24

12. A company has 10,000 shares outstanding and a current share price of $20.00. It also has 100 options at an exercise price of $10.00, 50 Restricted Stock Units (RSUs), and 100 convertible bonds at a conversion price of $10.00 and a par value of $100.
    What is its Diluted Equity Value

Answer 24

For this type of question, you should ask to write down the numbers.
Since the options are in-the-money, you assume they get exercised, so 100 new shares are 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. There are now 50 net additional shares outstanding.
You add the 50 RSUs as if they were common shares, so now there’s a total of 100 additional shares outstanding.
The company’s share price of $20.00 exceeds the conversion price of $10.00, so the convertible bonds can convert into shares.
Divide the par value by the conversion price to determine the shares per bond:
$100 / $10.00 = 10 new shares per bond
There are 100 individual convertible bonds, so they create 100 * 10 = 1,000 new shares.
These changes create 1,100 additional shares, so the diluted share count is now 11,100, and the Diluted Equity Value is 11,100 * $20.00, or $222,000.

Question 25

1. Public companies already have Market Caps and Share Prices. Why do you need to “value them” at all? You already know how much they’re worth.

Answer 25

Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong! You value companies to see if the market’s views are correct and whether a company’s value might change based on your views. It’s like going home shopping, finding a house with a list price of $500K, but then negotiating a lower price because you believe it is worth only $450K based on your research.

Question 26

2. What are the advantages and disadvantages of the 3 main valuation methodologies?

Answer 26

Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions. However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential. Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps. However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples. DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends. However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.

Question 27

3. Which of the 3 main methodologies will produce the highest Implied Values?

Answer 27

This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions. That said, Precedent Transactions often produce higher Implied Values than Public Comps because of the control premium – the extra amount that buyers must pay to acquire sellers. But it’s tough to say how a DCF compares because it’s far more dependent on the long-term assumptions used. The safest answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”

Question 28

4. Which one should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company? Assume the growth rates and margins are the same.

Answer 28

In all likelihood, the healthcare company will be worth more because healthcare is a less asset- intensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its cash flow will be higher. Healthcare, at least in some sectors, also tends to be more of a “growth industry” than industrials. The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates could offset that. This answer is an extreme generalization, so you would need more information to give a detailed answer.

Question 29

5. Can you walk me through how you use Public Comps and Precedent Transactions in a valuation?

Answer 29

First, you select the companies and transactions based on industry, size, and geography (and time for the transactions). 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 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 these numbers to the financial metrics of the company you’re analyzing to estimate its Implied Value. For example, if the company you’re valuing has $100 million in LTM EBITDA, and the median LTM TEV / EBITDA multiple in a set of comparable companies is 7x, then the company’s implied Enterprise Value is $700 million. You then calculate its Implied Value for all the other multiples to get a range of possible values.

Question 30

6. Can you give a few examples of how you might screen for “similar” Comparable Public Companies and Precedent Transactions?

Answer 30

You screen based on geography, industry, and size (and time for Precedent Transactions). Here are a few example screens: * Comparable Company Screen: U.S.-based steel manufacturing companies with over $500 million in revenue. * Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA. * Precedent Transaction Screen: Latin American M&A transactions over the past 3 years involving consumer/retail sellers with over $1 billion USD in revenue. * Precedent Transaction Screen: Australian M&A transactions over the past 2 years involving infrastructure sellers with over $200 million AUD in revenue.

Question 31

7. How do you decide which metrics and multiples to use in these methodologies?

Answer 31

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability- based metrics and their multiples. For example, you might use Revenue, EBITDA, and Net Income and their corresponding multiples: TEV / Revenue, TEV / EBITDA, and P / E. You do this because you want to value a company in relation to how much it sells and how much it keeps from those sales. Sometimes, you’ll drop the sales-based multiples and focus on the profitability or cash flow- based ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Question 32

8. Why do you look at BOTH historical and projected metrics in these methodologies?

Answer 32

Historical metrics are useful because they’re based on what happened in real life, but they can also be deceptive if there were non-recurring items or if the company made acquisitions or divestitures. Projected metrics are useful because they assume the company will operate in a “steady state” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because they’re based on predictions rather than historical events.

Question 33

9. When calculating the forward multiples for the comparable companies, should you use each company’s Current Equity Value or Current Enterprise Value, or should you project them to get the Year 1 or Year 2 values?

Answer 33

You always use the Current Equity Value or Current Enterprise Value. NEVER “project” either one. A company’s share price, and, therefore, both Current Equity Value and Current Enterprise Value, reflects past performance and future expectations. So, to “project” these metrics, you’d have to jump into the future and see what future expectations are at that point in time and then time travel back to the present.

Question 34

10. How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you’re valuing?

Answer 34

The interpretation depends on how your company's growth rates and margins compare to those of the comparable companies. Public Comps are most meaningful when the growth rates and margins are similar, but the multiples are different. This could mean that the company you’re valuing is mispriced. For example, maybe all the companies are growing at 10 – 15%, and they all have EBITDA margins of 10 – 15%. Your company also has growth rates and margins in these ranges. However, your company trades at TEV / EBITDA multiples of 6x to 8x, while the comparable companies all trade at multiples of 10x to 12x. This result could indicate that your company is undervalued since its multiples are lower, but its growth rates, margins, industry, and size are comparable.

Question 35

11. What is a Liquidation Valuation, and when is it useful and not so useful?

Answer 35

In a Liquidation Valuation, you value a company by estimating the market values of all its Assets, adding them up, and subtracting its Liabilities (i.e., you assume full repayment of all Liabilities based on the proceeds from the sale of all its Assets). It gives you the company’s Implied Equity Value because you’re valuing its Net Assets, not its Net Operating Assets. This methodology is useful for distressed companies because it tells you how much they might be worth if they liquidate and how much different lender groups might receive. It’s less useful for healthy, growing companies because it undervalues them significantly; assets like Net PP&E are always worth more to “going concern” companies.

Question 36

12. How does a Dividend Discount Model (DDM) differ from a DCF?

Answer 36

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually based on a per-share figure or a percentage of Net Income. You then discount the Dividends to their Present Value using the Cost of Equity and add them up. To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E, and you discount it to Present Value using the Cost of Equity. You add the PV of the Terminal Value to the PV of the Dividends to calculate the company’s Implied Equity Value rather than its Implied Enterprise Value (there’s no “bridge”), and you divide it by the diluted share count to get the company’s Implied Share Price. The DDM is essential in some industries, such as commercial banks and insurance, useful in other industries that pay regular dividends, such as utilities, and not so useful for most others.

Question 37

13. Why might you use an M&A Premiums analysis to value a company?

Answer 37

The M&A Premiums analysis applies only to public companies because you look at acquisitions of similar public companies and calculate the “premium” each buyer paid for each seller. For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00 per share, that represents a 25% premium. You then use these percentages to value your company. If the median premium in a set of deals is 20%, and your company’s share price is $10.00, it’s worth $12.00 per share. This analysis is typically a supplement to Precedent Transactions and gives you another way to value your company besides the standard multiples. But it’s also limited because M&A Premiums cannot indicate that a company is currently undervalued.

Question 38

14. What are the advantages and disadvantages of a Sum-of-the-Parts Valuation?

Answer 38

The Sum-of-the-Parts methodology, in which you value each division of a company separately and add them to determine the company’s Implied Value, works well for conglomerates that have very different divisions (e.g., retail vs. transportation vs. digital media segments). The divisions operate in such different industries that it would be meaningless to value the company as a whole – no other public company would be comparable. But Sum-of-the-Parts also takes far more time and effort to set up because you must find comparable companies and transactions for each division, build a separate DCF for each division, and so on. Also, you might not have enough information to use it. Companies sometimes don’t disclose EBIT, CapEx, or Working Capital by division, and they may not disclose the corporate overhead expenses that must be counted in the final step.

Question 39

15. How do you set up an LBO valuation, and when is it useful?

Answer 39

You set up the LBO valuation by creating a leveraged buyout model in which a private equity firm acquires a company using Debt and Equity, holds it for several years, and then sells it for a certain multiple of EBITDA. Most private equity firms target an internal rate of return (IRR) in a specific range, so you work backward and determine the maximum price the PE firm could pay to achieve a targeted IRR. You could use the “Goal Seek” function in Excel to do this, and you solve for the purchase price based on constraints for the IRR, exit multiple, and Debt / Equity split. This methodology is most useful for screening LBO candidates; it can also help a company understand what PE firms vs. normal companies might pay for it.

Question 40

1. What IS a valuation multiple? Explain the theory and give a real-life analogy.

Answer 40

A valuation multiple is shorthand for a company’s value based on its Cash Flow, Cash Flow Growth Rate, and Discount Rate. You could value a company with this formula: Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate Valuation multiples let you use a number like “10x” to express this in a condensed way. You can also think of valuation multiples as “per-square-foot” or “per-square-meter” values when buying a house: They help you compare houses or companies of different sizes and see how expensive or cheap they are relative to similar houses or companies.

Question 41

2. You’re valuing a mid-sized manufacturing company. This company’s TEV / EBITDA multiple is 15x, but the median TEV / EBITDA for the comparable companies is 10x. What’s the most likely explanation?

Answer 41

The most likely explanation is that the market expects this company’s cash flows to grow faster than comparable companies. For example, other companies might be expected to grow at 5%, but this company might be expected to grow at 15%. The Discount Rate is unlikely to differ significantly because these companies are in a similar size range in the same industry, which means the risk and potential returns should be similar. “Current events” could also affect the multiples, but it’s hard to say what they might be without additional information.

Question 42

3. Walk me through how you calculate EBIT and EBITDA for a public company.

Answer 42

With EBIT, you start with the company’s Operating Income on its Income Statement and then add back any non-recurring charges that have reduced Operating Income. With EBITDA, you do the same thing and then add Depreciation & Amortization from the company’s Cash Flow Statement to get the all-inclusive number (since D&A on the Income Statement may be embedded in other line items there).

Question 43

4. How do you decide whether to use Equity Value or Enterprise Value in valuation multiples?

Answer 43

If the financial metric in the denominator of the valuation multiple deducts Net Interest Expense, it pairs with Equity Value because the Debt Investors can no longer be “paid” after earning their interest; only Equity Investors can earn something now. If the metric does not deduct Net Interest Expense, it pairs with Enterprise Value. This rule applies to financial metrics (EBIT, EBITDA, etc.) and non-financial ones (Unique Users, Subscribers, etc.).

Question 44

5. A company has $100 in Revenue, a 15% EBIT margin, and D&A that is 5% of its Revenue. The company’s Equity Value is $100, and it has $20 of Cash, $40 of Debt, and $30 in Lease Liabilities. What is its TEV / EBITDA multiple?

Answer 44

EBITDA = $100 * 15% + $100 * 5% = $20. TEV = $100 – $20 + 40 = $120. Therefore, TEV / EBITDA = 6x. The treatment of the Lease Liabilities here is uncertain because we don’t know if this company follows U.S. GAAP or IFRS or if these are Operating or Finance Leases. To explain the correct treatment, you must request these details (see the next question).

Question 45

6. For clarity, the company I just described followed U.S. GAAP, and the Lease Liabilities were for Operating Leases. Now, imagine that this company followed IFRS rather than U.S. GAAP. How would the EBIT margin and D&A percentages change, and how would the TEV / EBITDA change?

Answer 45

Under IFRS, the EBIT margin would be higher because only one component of the Operating Lease Expense would be deducted: The Lease Depreciation. Under U.S. GAAP, the entire Rental Expense is deducted. The D&A percentage would also be higher because D&A under IFRS includes Lease Depreciation as well. So, the EBITDA margin would be higher under IFRS because it would exclude or add back the entire Operating Lease Expense so that the EBITDA would be higher than $15. The TEV / EBITDA multiple would likely stay about the same because under IFRS, you would add the Lease Liabilities to calculate Enterprise Value (you would need more numbers to predict the exact change).

Question 46

7. What are the advantages and disadvantages of TEV / EBITDA vs. TEV / EBIT vs. P / E?

Answer 46

TEV / EBITDA is better when you want to ignore the company’s CapEx and capital structure completely. TEV / EBIT is better when you want to ignore capital structure but partially factor in CapEx (via the Depreciation, which comes from CapEx in previous years). So, TEV / EBITDA is more about normalizing companies and is more useful in industries where CapEx is not a huge value driver, while TEV / EBIT is better when you want the implied values to have some relationship with CapEx. The P / E multiple is affected by different tax rates, capital structures, non-core business activities, and more, so it is less useful for “normalization” purposes than the others (though it has the advantage of being widely understood). P / E is more important in specific industries, such as banks and insurance firms, that use Equity Value as the leading valuation metric.

Question 47

8. A company is currently trading at 10x TEV / EBITDA. It wants to sell an Operating Asset for 2x the Asset’s EBITDA. Will that transaction increase or decrease the company’s Enterprise Value and its TEV / EBITDA multiple?

Answer 47

The sale will reduce the company’s Enterprise Value because the company is trading an Operating Asset for Cash, which is a Non-Operating Asset. Even though the company’s Enterprise Value decreases, its TEV / EBITDA multiple increases because the Asset’s multiple was lower than the entire company’s multiple. To understand this, pretend the company’s total EBITDA was $100, and this Asset contributed $20 of that EBITDA. Therefore, the company’s Enterprise Value before the sale was $1,000. The company now sells the Asset for 2x * $20 = $40. After the sale, the company’s Enterprise Value falls by $40, and its EBITDA falls by $20. So, its new TEV / EBITDA is $960 / $80, or 12x.

Question 48

9. What happens to the company’s Equity Value and P / E multiple in this scenario?

Answer 48

We can’t say for sure, but based on the information provided here, Equity Value does not change because the Net Assets stay the same (Operating vs. Non-Operating Assets do not matter for Equity Value). It would change only if there were a Gain or Loss recorded on the sale, as that would flow into Common Shareholders’ Equity via Net Income. Most likely, the P / E multiple would increase because this company is most likely trading at a higher P / E multiple than this specific asset if it’s a 10x vs. 2x difference for the EBITDA multiples. However, we can’t say for sure because there could be a huge capital structure difference between the company and this specific asset.

Question 49

10. How do you calculate and use Unlevered FCF and Levered FCF?

Answer 49

Unlevered Free Cash Flow equals Net Operating Profit After Taxes (NOPAT) + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx. Levered Free Cash Flow equals Net Income to Common + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx +/- Net Change in Debt. You normally use UFCF in DCF-based valuations because it lets you evaluate a company independently of its capital structure, which produces more consistent numbers. LFCF is far less widely used (and people disagree about the basic definition), but it is more common in certain specialized contexts/industries (e.g., equity REITs).

Question 50

11. If a company is valued mostly based on its cash flow, why do you also use metrics such as EBIT and EBITDA that may not represent its true cash flow?

Answer 50

You use these metrics mostly for convenience and comparability. Free Cash Flow measures a company’s cash flow more accurately, but it also takes more time to calculate since you need to review the full Cash Flow Statement and make adjustments. Also, the individual items within FCF vary widely for different companies, regions, industries, and accounting systems. As a result, EBIT and EBITDA are better for comparability/normalization purposes since they are based primarily on the Income Statement (and one line of the CFS for EBITDA).

Question 51

12. Give an example of a company change that affects UFCF but not EBITDA.

Answer 51

Additional spending on CapEx or a higher-than-normal Change in Working Capital (e.g., due to a large Inventory purchase) would affect UFCF but not EBITDA since UFCF deducts CapEx and reflects the Change in Working Capital (which could be either positive or negative).

Question 52

13. Company A has a P / E multiple of 15x, with a Net Income of $120 and a TEV / EBITDA multiple of 15x. Its EBITDA is $150. Company B has the same 15x P / E multiple but a Net Income of $100, a TEV / EBITDA of 10x, and an EBITDA of $200. Which one has a higher Net Debt balance?

Answer 52

Company A’s Equity Value is 15x * $120 = $1800, and its Enterprise Value is 15x * $150 = $2250. Company B’s Equity Value is 15x * $100 = $1500, and its Enterprise Value is 10x * $200 = $2000. Therefore, Company A’s Net Debt is $2250 – $1800 = $450, and Company B’s Net Debt is $2000 – $1500 = $500, so Company B has a higher balance.

Question 53

14. A company’s Operating Income is $100, and it has a $500 Debt balance at a 4% interest rate. It also has Cash of $100, currently earning 0% interest. If the company’s Equity Value is $600, its P / E multiple is 12x, and its tax rate is 25%, what can you conclude about its Enterprise Value?

Answer 53

An Equity Value of $600 and a P / E multiple of 12x means the company’s “apparent” Net Income is $600 / 12 = $50. The company’s Operating Income is $100, and it pays $500 * 4% = $20 in Interest Expense per year, with no Interest Income. So, its Pre-Tax Income is $80, and its Net Income “should be” $60 at a 25% tax rate. However, it is clearly lower than that, so the most likely explanation is that the company has Preferred Stock in its capital structure. For example, if the company had $10 in Preferred Dividends, the Net Income would be $60, and the Net Income to Common would be $50 (which you use in the P / E multiple). We don’t know the exact amount of Preferred Stock, but the company’s Enterprise Value must be higher than $600 – $100 + $500 = $1000 due to it.

Question 54

15. Suppose you are building a set of “global” comparable companies operating in the logistics/delivery sector in the U.S., Europe, and Asia. What is the SAFEST valuation multiple in this scenario?

Answer 54

Given the lease accounting differences under U.S. GAAP vs. IFRS, the safest multiple is (Enterprise Value Including All Lease Liabilities) / EBITDAR, where EBITDAR equals EBITDA + Rental Expense. Under IFRS, EBITDA already adds back or excludes the full Lease Expense, so the Rental Expense is minimal. But under U.S. GAAP, there is still Rental Expense for the Operating Leases. Therefore, this multiple normalizes accounting and lease composition differences and allows for a proper comparison.