Valuation Flashcards

Question

When do you use an LBO analysis as part of your valuation?

Answer 1

You use this whenever you're analyzing a Leveraged Buyout, but it is used to "set a floor" on the company's value and determine the minimum amount a PE firm could pay to achieve its targeted returns. You often see it used when both strategics (normal companies) and financial sponsors (PE firms) are competing to buy the same company, and you want to determine the potential price if a PE firm were to acquire a company.

Answer 2

You present valuation in a "Football Field" graph with a range of minimum to maximum, showing the interquartile range and median of each set (2-3 years of comps and the transactions, for each different multiple used) and then multiply by the relevant metrics for the company you're analyzing. For public companies, you will also work backwards to calculate the Equity Value and implied share price.

Answer 3

EBIT is a company's Operating Income on its IS. It includes COGS, Operating Expenses, and non-cash expenses like D&A and therefore indirectly reflects a company's CapEx. EBITDA is EBIT + D&A. The idea of EBITDA is to move closer to a company's "cash flow" by including D&A impact, but an issue bc you're ignoring CapEx.

Answer 4

Unlevered FCF = EBIT * (1-Tax Rate) + D&A - Change in Operating Working Capital - CapEx Unlevered FCF excludes net income expense, and mandatory debt repayments. Levered FCF = Net Income + D&A - Change in Operating Working Capital - CapEx - Mandatory Repayments

Answer 5

1) TEV/Revenue = how valuable a company is to its overall sales 2) TEV/EBITDA = how valuable a company is relative to its approximate cash flow 3) TEV/EBIT = how valuable a company is relative to its operating income (pre-tax profit it receives from business operations) 4) P/E = price per share/earnings per share, how valuable a company is relative to its after-tax profits, inclusive of net income expense and other non-core business activities Other multiples include * P/BV = price per share / book value per share, not terribly meaningful for most companies * EV/Unlevered FCF = closer to true cash flow than EV/EBITDA but harder to calculate * EqV/Levered FCF = even closer to true cash flow but influenced by capital structure and time-consuming

Answer 6

1) Usually there is a correlation between growth and valuation multiples. If one company is growing revenue or EBITDA more quickly, its multiples may be higher as well. 2) Math component = actual numerator or denominator differences. 3) real world factors.

Answer 7

If a profitability metric includes net interest expense, it is only available to Equity Investors. Excluding this impact means the metric is available to ALL investors in the company. Equity Value is available to only equity investors, while EBITDA is available to all investors, so it's an apple-to-oranges comparison.

Answer 8

Unlevered FCF = EV Levered FCF = EqV

Answer 9

Dislikes EBITDA because it hides the impact of CapEx and disguises how much cash they truly require to operate. EBIT doesn't directly show CapEx, but includes D which is linked to CapEx.

Answer 10

Problems with EBITDA approximation of cash flow 1) hides debt principal and interest 2) hides CapEx and D&A impact 3) ignores working capital requirements (which can be large) 4) companies are inconsistent with what they "add back", so comparability is warped Used 1) for convenience, has become a standard over time 2) for comparability, better for comparing than other metrics

Answer 11

P/E depends on capital structure, while EV/EBIT and EV/EBITDA do not. You can use P/E in industries where the capital structure is similar, like banks or insurance. EV/EBIT includes D&A impact, while EV/EBITDA does not. EBIT multiples more common in industries with high D&A, where CapEx and fixed assets are important (like Industrials). EBITDA multiples are more common where D&A is low and CapEx/fixed assets are less important (tech companies).

Answer 12

No. D&A is always zero or positive. Therefore EBIT will always be equal or smaller than EBITDA. An EBITDA multiple with the same EV will always be equal or smaller than the corresponding EBIT multiple.

Answer 13

Industrials example: EV/EBITDAR for Airlines (+Rental expense) Oil & Gas: EV/EBITDAX (+Exploration expense) Tech: EV/Unique Visitors

Answer 14

Technically it could go either way, but in most cases an LBO will give you a lower valuation. With an LBO you receive no cash flows between Year 1 and the final year -- you only get value out of its final year. With a DCF, by contrast, you include FCF during the period and the terminal value, so values tend to be higher. Note: unlike a DCF, a LBO model does not give a specific valuation. Instead you set a desired IRR and back-solve for how much you could pay for the company (the valuation) based on that.

Answer 15

This is unusual, but could happen if a company has substantial hard assets but the market is severely undervaluing it (such as earnings miss of cyclicality). As a result, the Comps and Precedent Transaction would likely produce lower values.

Answer 16

Because they're based on real market data, as opposed to far-in-the-future assumptions. However, even in Public Comps & Precedent Transactions you do use future assumptions for immediate forward years. Also , you might not have good or comparable data for these, in which case a DCF might produce better results.

Answer 17

1) no company is 100% comparable to another company 2) the stock market is "emotional" - your multiples may be dramatically higher or lower depending on the market's movements 3) share prices for small companies with thinly traded stocks may not reflect their full value

Answer 18

This would be unusual, but could happen if there is a substantial mismatch between the M&A market and public market. This could happen if no public companies have been acquired recently, or lots of private companies have been acquired for smaller valuations.

Answer 19

1) past transactions are rarely 100% comparable (transaction structure, size of company, and market sentiment all make a huge impact) 2) data on precedent transactions is generally more difficult to find than for public company comparables, especially for small private companies

Answer 20

You would present valuation as a Football Field charge with an implied range with each methodology. You could use valuation for 1) Pitch Books & Client Presentations - telling companies what you think they're worth, updates to clients 2) Parts of Other Models (Defense analyses, merger models, DCF, LBO) 3) Fairness Opinions - right before a deal with a public seller closes, a financial advisor creates a "Fairness Opinion" that justifies the acquisition price and directly estimates the company's valuation

Answer 21

Multiple Reasons 1) company reported earnings well above analyst expectations and stock price has risen in response 2) has some type of competitive advantage not reflected in its financials, such as key patent or IP 3) just won a favorable ruling in a lawsuit 4) market leader in its industry (greater market share than its competitors)

Answer 22

1) Highlight a 75% percentile or higher multiple rather than the median 2) add in a premium to multiples 3) use more aggressive projections for company

Answer 23

Nope, in fact you always use a range. You can make the median the center of that range, but you could also use 25th or 75th percentile if the company is under or overperforming for some reason.

Answer 24

1) One process was more competitive, and that competitive tension increased the purchase price 2) one company recently had bad news or a depressed stock price so it was acquired at a discount 3) two industries with different median multiples 4) two different accounting standards, different adding back into EBITDA. Multiples are not truly comparable.

Answer 25

Owning the machines means EBITDA would be higher than leasing, where the leasing expense would decrease pre-tax income. Therefore, the EBITDA multiple in owning would be smaller.

Answer 26

1) use Comps or Precedent Transactions to look at more "creative" multiples like EV/Unique Visitors or EV/Pageviews rather than Revenue or EBITDA denominators (more common in tech) 2) use far-in-the-future DCF and project a company's financials out until it actually earns revenue and profit (more common biotech & pharma companies)

Answer 27

It depends on how it's performing relative to the index, and relative to companies in its own industry. If it has higher growth/margins, you could assign a higher multiple to it -- say 25x or 30x, making EqV 25m or 30m If it's on par with everyone else, maybe 20m It's it's underperforming, perhaps even lower than that.

Answer 28

Theoretically hey don't. Stock split doubles the number of shares and halves their price and EPS = same Equity Value and P/E. In practice however, a stock split is seen as a good sign and might spike the share price, increasing Equity Value and P/E.

Answer 29

In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name. However, this valuation is not a science but an art -- valuation is often based not just on strict financial criteria, but other factors such as brand name, perceived "trendiness", etc.

Answer 30

In theory, intrinsic valuation like DCF should equal relative valuation like a Comps analysis. Possible reasons 1) Comps = maybe the given cash flows have different growth prospects, or relative riskiness 2) DCF = maybe too aggressive/conservative with forecasts than what the market values the peer group

Answer 31

My answer: it would increase the multiple. TEV / EBITDA EBITDA wouldn't change = earnings before interest, taxes, depreciation, amortization. Total Enterprise Value = might increase because this would increase NOPAT, increasing UFCF in a DCF.

Answer 32

The purpose of this analysis is to look through precedent transactions and calculate the premiums that buyers have paid over PUBLIC sellers' share prices when acquiring them. For example, if a company is trading at $10/share and the buyer acquires it for $15/share, that's a 50% premium. You ONLY use this analysis when valuing a PUBLIC company, bc a private company doesn't have a share price. Sometimes the set of companies here is exactly the same as Precedent Transactions, but typically it's broader. 1) select precedent transactions based on industry, date, and size 2) for each transaction, get the seller's share price at different intervals before the transaction was announced (1 day, 20, 30, 90) 3) calculate the premium for each of those intervals by dividing the *per-share purchase price* with the share price of that day 4) get the medians for each set and apply to your company's share price at the same time intervals

Answer 33

1) all the sellers in a M&A premiums analysis must be PUBLIC 2) Usually we use a broader set of transactions in M&A Premiums bc industry and financial screens are less stringent Aside from those screening criteria is similar (financial metrics, geography, date)

Answer 34

The purpose of this analysis is to project what a company's share price might be 1-2 years from now, and then discount it back to its present value. 1) get the median historical (usually Trailing Twelve Months TTM) P/E multiple of the public company comparables 2) Apply this P/E multiple to your company's 1-year forward or 2-year forward projected EPS to get to its implied future share price. 3) Then, discount this share price back to its present value by using a discount rate in-line with the company's COE. You normally look at a range of P/E multiples as well as a range of discount rates for this type of analysis, and create sensitivity tables with these as inputs. Technically you could use other multiples but P/E is most common.

Answer 35

In a Sum-of-the-Parts analysis, you value each division of the company using separate Comparables and Precedent Transactions, get to separate multiples, then add each division's value to get the total of the company. Once again, picking a RANGE of multiples is crucial and you would never say a single value.

Answer 36

You determine how much the NOLs will save the company in taxes in the future years, then calculate the net present value of the total future tax savings.

Answer 37

This would artificially increase Net Income. EqVal/Net Income multiples would increase.

Answer 38

Precedent Transactions – typically highest valuation because of purchase premium to transfer ownership Good  LBO – typically the floor, calculated backwards from target IRR, PE firm will pay less than strategic buyer due to lack of synergies Good

Answer 39

You value a company to determine its Implied Value according to your views. If this Implied Value is very different from the company’s Current Value, you might be able to invest in the company and make money if its value changes. If you are advising a client company, you might value it to tell management the price that it might receive if the company sells, which is often different from its Current Value.

Answer 40

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 or incorrect.

Answer 41

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.

Answer 42

This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions. Precedent Transactions often produce higher Implied Values than the Public Comps because of the control premium – the extra amount that acquirers must pay to acquire sellers. But it’s tough to say how a DCF compares because it’s far more dependent on your assumptions. 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.”

Answer 43

You should pretty much always build a DCF since it is valuation – the other methodologies are supplemental. But it’s especially useful when the company you’re valuing is mature and has stable, predictable cash flows or when you lack good Public Comps and Precedent Transactions.

Answer 44

If the company you’re valuing is early-stage and you cannot estimate its future cash flows, or if the company has no path to positive cash flows, you must rely on the other methodologies. These other methodologies can also be more useful when you run into problems in the DCF, such as the inability to estimate the Discount Rate.

Answer 45

In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA). 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 would likely make up for that. However, this answer is an extreme generalization, so you need more information to give a detailed answer.

Answer 46

The same way you value a company: comparable apple trees and a DCF. You’d look at what similar apple trees have sold for and calculate the expected future cash flows from this tree. You would then discount these cash flows to Present Value, discount the Terminal Value to PV, and add everything to determine the apple tree’s Implied Value. The Discount Rate would be based on your opportunity cost – what you might be able to earn each year by investing in other, similar apple trees.

Answer 47

No, not exactly. The DCF is based on the company’s expected future cash flows, so in that sense, it is “intrinsic valuation.” But the Discount Rate used in the DCF is usually linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer companies. The DCF depends less on the market than the other methodologies, but there is still some dependency. It’s more accurate to say that the DCF depends more on your views of the company’s long-term prospects and less on market data than the other methodologies.

Answer 48

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 you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply 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.

Answer 49

Because the comparable companies and transactions should have similar Discount Rates and Free Cash Flow figures (in theory…). Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate. If the companies in your set all have similar Discount Rates and Free Cash Flows, it’s easier to conclude that one company trades at higher multiples because its expected growth rate is higher. If the companies do not have similar Discount Rates and Free Cash Flows, it’s harder to draw meaningful conclusions In practice, it’s almost impossible to find multiple companies with “similar” FCF figures, so this exercise is more important for getting similar Discount Rates.

Answer 50

You screen based on geography, industry, and size, and also 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.

Answer 51

You should not screen by both financial metrics and Equity Value or Enterprise Value. For example, you should NOT use this screen: “Companies with revenue below $1 billion and Enterprise Values above $2 billion.” If you use that screen, you artificially constrain the multiples because TEV / Revenue must be above 2x for every company in the set.

Answer 52

The idea is similar – you use Current valuation multiples from similar companies or deals to value a company – but the execution is different. Here are the differences for Precedent Transactions: Screening Criteria: In addition to industry, size, and geography, you also use time because you only want transactions from a specific period, which could be the past few years or even as long as 10-15 years ago. You might also use Transaction Size, and you may use broader screening criteria in general. * Metrics and Multiples: You focus on historical metrics and multiples, especially LTM revenue and EBITDA, because it’s difficult to find projections as of the deal announcement date. * Calculations: All the multiples are based on the purchase price as of the announcement date of the deal. * Output: The multiples produced tend to be higher than those from Public Comps because of the control premium. But the multiples also tend to span wider ranges because deals can be done for many different reasons.

Answer 53

You start by finding each company’s most recent annual and interim (quarterly or half-year) filings. You calculate its diluted share count and Current Equity Value and Current Enterprise Value based on the information there and its most recent Balance Sheet. Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent annual results, adding the results from the most recent partial period, and subtracting the results from the same partial period the last year. For the projected figures, you look in equity research or find consensus figures on Bloomberg, Capital IQ, Finviz, Google/Yahoo, etc. And then, you calculate all the multiples by dividing Current Equity Value or Current Enterprise Value by the appropriate metric

Answer 54

You find the acquired company’s filings from just before the deal was announced, and you calculate the LTM financial metrics using those. To calculate the company’s Transaction Equity Value and Enterprise Value, you use the purchase price the acquirer paid, and you move from Equity Value to Enterprise Value in the same way you usually do, using the company’s most recent Balance Sheet as of the announcement date. You calculate all the valuation multiples the same way, using Transaction Equity Value or Transaction Enterprise Value as appropriate.

Answer 55

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitabilitybased metrics and their multiples. For example, you might use Revenue, EBITDA, and Net Income, and the 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 of those sales. Sometimes, you’ll drop the sales-based multiples and focus on the profitability or cash flowbased ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Answer 56

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 future predictions.

Answer 57

You always use the Current Equity Value or Current Enterprise Value. NEVER “project” either one. A company’s share price, and, therefore, both of these metrics, 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 the future and then jump back to the present.

Answer 58

You have to “calendarize” by adjusting the companies’ fiscal years so that they match up. For example, to make everything match a December 31st year-end date, you take each company with a June 30th fiscal-year end and do the following: * Start with the company’s full June 30th fiscal-year results. * Add the June 30th – December 31st results from this year. * Subtract the June 30th – December 31st results from the previous year. Normally, you calendarize to match the fiscal year of the company you’re valuing. But you might pick another date if, for example, all the comparable companies have December 31st fiscal years but your company’s ends on June 30th

Answer 59

The interpretation depends on how the growth rates and margins of your company 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 and that there’s an opportunity to invest and make money. For example, maybe all the companies are growing their revenues at 10-15% and their EBITDA at 15-20%, 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. If the growth rates and margins are very different, it’s harder to draw conclusions.

Answer 60

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed yet, the simple announcement of the deal reflects what one company believes another is worth. Note that you base all the metrics and multiples on the financial information as of the announcement dates.

Answer 61

The problem is that the circumstances surrounding each deal might be very different. For example, one company might have sold itself because it was distressed and about to enter bankruptcy – but another company might have sold itself because the acquirer desperately needed it and was willing to pay a high price. Some deals are competitive and include multiple acquirers bidding against each other, while others are targeted and involve no auction processes.

Answer 62

You generally don’t factor in expected synergies because they’re quite speculative. If you do include them, you might increase the sellers’ projected revenue or EBITDA figures so that the valuation multiples end up being lower – assuming that you’re using projected metrics. Opinions differ about earn-outs, but you could assume they have a 50% chance of being paid out, multiply the earn-out amounts by 50%, and add them to the purchase prices. Other people ignore earn-outs or add the full earn-out amounts to the Purchase Equity Value and Purchase Enterprise Value

Answer 63

Ideally, your set of Precedent Transactions will include only 100% acquisition deals. However, you may need to go beyond that and also include majority-stake deals (ones where the acquirer buys more than 50% but less than 100% of the seller). You can include those because the dynamics are similar, but you should not include minoritystake deals because acquiring 10% or 20% of a company is quite different. Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically include all deals regardless of the form of consideration. However, you may note whether each deal was cash, stock, or a mix of both.

Answer 64

The multiples are always based on 100% of the seller’s value. So, if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value would be $500 million / 80% = $625 million. And then, you would calculate the Purchase Enterprise Value based on that figure and 100% of the usual Balance Sheet line items. You would then calculate the valuation multiples based on those figures and the financial stats for 100% of the seller.

Answer 65

Median multiples are better than average multiples because of outliers. If there are 5 companies in your set with multiples of 8x, 10x, 9x, 8x, and 25x, you don’t want the 25x multiple to push up the average when it’s clearly an outlier. However, there’s no “rule” that you have to use the median rather than other percentiles, so you could make an argument for using the 25th percentile or 75th percentile. For example, you could argue that your company’s growth rates and margins are in-line with those of companies in the 75th percentile of your set and that the 75th percentile multiples are, therefore, most applicable to your company.

Answer 66

In a Liquidation Valuation, you value a company by determining the market values of all its Assets, adding them up, and subtracting its Liabilities (i.e., full repayment of all Liabilities). It gives you the company’s Implied Equity Value because you’re valuing the company’s 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 shut down and how much different lender groups might receive. It’s less useful for healthy, growing companies because it tends to undervalue them significantly; assets like Net PP&E are always worth more to “going concern” companies.

Answer 67

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 its Present Value using the Cost of Equity. You add the PV of the Terminal Value to the PV of Dividends o calculate the company’s Implied Equity Value at the end 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 for other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so useful for most others because it takes more time and effort to set up and tends to undervalue companies that do not distribute high percentages of their cash flows.

Answer 68

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 just the standard multiples. But it’s also a bit limited because M&A Premiums cannot indicate that a company is currently undervalued.

Answer 69

The idea is to project a company’s stock-price appreciation and its Dividends between today and some future date, discount them to Present Value, and add them up (since these are the two “returns sources” if you buy a company’s shares). The Dividend projections are based on Net Income or per-share figures; to project a company’s future stock price, you normally take the company’s current NTM multiple, the median from the comps, or something similar, and apply it to a future figure, such as its EBITDA in Year 3. You then back into the future Implied Equity Value based on this future Implied Enterprise Value and divide by the share count on that date to get the “future share price,” which you discount to PV using the Cost of Equity. You then compare this to the current share price. This analysis adds little over traditional Public Comps, but it can be useful if a company wants to assess the valuation impact of changing its capital structure or Dividend policy.

Answer 70

The Sum-of-the-Parts methodology, in which you value each division of a company separately and add them up to determine the company’s Implied Value, works well for conglomerates that have very different divisions (e.g., retail vs. transportation vs. digital media). 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 have to find comparable companies and transactions for each division, build a separate DCF for each division, and so on. Also, you may 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 you must factor in at the end of the analysis.

Answer 71

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 as a way to screen LBO candidates and see which ones might warrant further attention; it can also be useful for helping a company compare its options and see what different types of acquirers (e.g., PE firms vs. normal companies) might pay.

Answer 72

The present value concept is based on the premise that "a dollar in the present is worth more than a dollar in the future" due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today. PV = (CF) / (1 + r)^t For intrinsic valuation methods, the value of a company will be equal to the sum of the present value of all the future cash flows it generates. Therefore, a company with a high valuation would imply it receives high returns on its invested capital by investing in positive net present value ("NPV") projects consistently while having low risk associated with its cash flows.

Answer 73

Theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised shouldn't impact the enterprise value, as the cash and debt balance would increase and offset the other entry. However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact the company's profitability and lead to a lower valuation from the higher cost of debt.

Answer 74

Minority interest represents the portion of a subsidiary in which the parent company doesn't own. Under US GAAP, if a company has ownership over 50% of another company but below 100% (called a "minority interest" or "non-controlling investment"), it must include 100% of the subsidiary's financials in their financial statements despite not owning 100%. When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest must be added to enterprise value for the multiple to be compatible (i.e., no mismatch between the numerator and denominator).

Answer 75

Intrinsic Valuation: For an intrinsic valuation, the value of a business is arrived at by looking at the business's ability to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and is based on the notion that a business's value equals the present value of its future free cash flows. Relative Valuation: In relative valuation, a business's value is arrived at by looking at comparable companies and applying the average or median multiples derived from the peer group - often EV/EBITDA, P/E, or some other relevant multiple to value the target. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called "trading comps," or by looking at the multiples of comparable companies recently acquired, which is called "transaction comps."

Answer 76

DCF DCF Advantages * The DCF values a company based on the company's forecasted cash flows. This approach is viewed as the **most direct and academically rigorous way** to measure value. * Considered to be **independent of the market** and instead based on the fundamentals of the company DCF Disadvantages * The DCF suffers from several drawbacks; most notably, it's **very sensitive to assumptions**. * **Forecasting the financial performance of a company is challenging**, especially if the forecast period is extended. * Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around three- quarters of the implied valuation. Comparable Companies CC Advantages * Trading comps value a company by looking at how the market values similar businesses. Thus, comps relies much more heavily on market pricing to determine the value of a company (i.e., the most recent, actual prices paid in the public markets). = **Good, real data. Bad, dependent on market** * In reality, there are very few truly comparable companies, so in effect, it's always an "apples and oranges" comparison. CC Disadvantages * While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced, it's **vulnerable to how the market is not always right**. Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company's fundamentals. * Comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF).

Answer 77

Free cash flow ("FCF") represents a company's discretionary cash flow, meaning the cash flow remaining after accounting for the recurring expenditures to continue operating. Extra info: The simplest calculation of FCF is shown below: Free Cash Flow (FCF) = Cash from Operations - Capex The cash from investing section, other than capex, and the financing section are excluded because these activities are optional and discretionary decisions up to management.

Answer 78

For both DCF analysis or comps analysis, the intent is to value the operations of the business, which requires you to set apart the core operations to normalize the figures. When performing a DCF analysis, the cash flows projected should be strictly from the business's recurring operations, which would come from the sale of goods and services provided. A few examples of non- operating income to exclude would be income from investments, dividends, or an asset sale. Each example represents income that's non-recurring and from a discretionary decision unrelated to the core operations. When performing comps, the core operations of the target and its comparables are benchmarked. To make the comparison as close to "apples to apples" as possible, non-core operating income/(expenses) and any non-recurring items should be excluded.

Answer 79

EQUITY Equity Advantages * No required payments, unlike debt, giving management more flexibility around repayment. Dividends to equity shareholders can be issued, but the timing and magnitude are at the board and management's discretion. * gives companies access to a vast investor base and network. Equity Disadvantages * Issuing equity dilutes ownership, and equity is a high cost of capital. * Public equity comes with more regulatory requirements, scrutiny from shareholders and equity analysts, and full disclosures of their financial statements. * The management team could lose control over their company and be voted out by shareholders if the company underperforms. DEBT Debt Advantages * The interest expense on debt is tax-deductible, unlike dividends to equity shareholders (although recent tax reform rules limit the deduction for highly levered companies). * Debt results in no ownership dilution for equity shareholders and has a lower cost ofcapital. * Increased leverage forces discipline on management, resulting in risk-averse decision-making as a side benefit. Debt Disadvantages * Required interest and principal payments that introduce the risk of default. * Loss of flexibility from restrictive debt covenants prevents management from undertaking a variety of activities such as raising more debt, issuing a dividend, or making an acquisition. * Less room for errors in decision-making, therefore poor decisions by management come with more severe consequences.

Answer 80

A stock repurchase (or buyback program) is when a company uses its cash-on-hand to buy back some of its shares, either through a tender offer (directly approach shareholders) or in the open market. Ideally, the right time for a share repurchase to be done should be when the company believes the market is undervaluing its shares. The impact is the reduced number of shares in circulation, which immediately leads to a higher EPS and potentially a higher P/E ratio. The buyback can also be interpreted as a positive signal by the market that the management is optimistic about future earnings growth

Answer 81

A company buys back shares primarily 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 as with dividends, a share repurchase removes shareholders. The impact on share price is theoretically neutral - as long as shares are priced correctly, a share buyback shouldn't 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 positively or negatively affect share price movement, depending on how the market perceives the signal.

Answer 82

1) The so-called "double taxation" when a company issues a dividend, in which the same income is taxed at the corporate level (dividends are not tax-deductible) and then again at the shareholder level. 2) Share repurchases will artificially increase EPS by reducing the number of shares outstanding and can potentially increase the company's share price. Many companies increasingly pay employees using stock-based compensation to conserve cash, thus share buybacks can help counteract the dilutive impact of those shares. 3) Share buybacks imply a company's management believes their shares are currently undervalued, making the repurchase a potential positive signal to the market. 4) Share repurchases can be one-time events unless stated otherwise, whereas dividends are typically meant to be long-term payouts indicating a transition internally within a company. Cutting a dividend can be interpreted very negatively by the market, as investors will assume the worst and expect future profits to decrease (hence, dividends are rarely cut once implemented).

Answer 83

If we assume that the P/E multiple stays the same after the dividend and a cost of debt of 5%, the impact to shareholders is as follows: Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million] Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million) Although there's a tax impact since interest is mostly deductible, it can be ignored for interviewing purposes. That's a $150 million drop in equity value. However, shareholders are immediately getting $200 million. So ignoring any tax impact, there's a net benefit of $50 million ($200 million - $150 million) to shareholders. The assumptions we made about taxes, the cost of debt and the multiple staying the same all affect the result. If any of those variables were different - for example, if the cost of debt was higher - the equity value might be wiped out in light of this move. A key assumption in getting the answer here was that P/E ratios would remain the same at 15x. A company's P/E multiple is a function of its growth prospects, ROE, and cost of equity. Hence, borrowing more with no compensatory increase in investment or growth raises the cost of equity via a higher beta, which will pressure the P/E multiple down. While it appears based on our assumptions that this is a decent idea, it could easily be a bad idea given a different set of assumptions. It's possible that borrowing for the sake of issuing dividends is unsustainable indefinitely because eventually, debt levels will rise to a point where the cost of capital and P/E ratios are adversely affected. Broadly, debt should support investments and activities that will lead to firm and shareholder value creation rather than extract cash from the business.

Answer 84

Companies that distribute dividends are 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 its long-term profitability and appeal to a different shareholder base (more specifically, long-term dividend investors).

Answer 85

The main difference between valuing a private and public company is the availability of data. Private companies are not required to make their financial statements public. 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 to reflect an illiquidity discount (usually ranges between ~10-30%).

Answer 86

The illiquidity discount used when valuing private companies is related to being unable to exit an investment quickly. Most investors will pay a premium for an otherwise similar asset if there's the optionality to sell their investment in the market at their discretion. Therefore, a discount should be applied when performing trading comps since shares in a public company include a premium for being sold in the public markets with ease (called the "liquidity premium").

Valuation Flashcards

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