Valuation

Question 1

What do valuation multiples represent? Why do we use them?

Answer 1

They tell how how much a company is worth relative to its earnings
They help us compare different companies

Question 2

What are some commonly used multiples?

Answer 2

EV/EBITDA
EV/EBIT
EV/Rev
P/E = stock price/earnings per share

Question 3

All else equal, would you rather buy a company at 15x EBITDA or one at 10x multiple?

Answer 3

It depends on how this company compares to the rest of the industry

Question 4

Why do companies trade at different multiples?

Answer 4

Growth rate, growth strategy
Profitability, margins
Industry
Size
Moat
Special events e.g. hit by scandal

Question 5

List five uses of free cash

Answer 5

1. Reinvest in the biz, Capex
2. Pay off debts early so its easier to secure financing in the future
3. Fund an M&A
4. Issue dividends to increase optimism about the company
5. Buy back shares to give value to investors

Question 6

What are the advantages of EV/EBITDA, EV/EBIT, and P/E?

Answer 6

EBITDA excludes capex, capital structure, and D&A, good for non-capital intensive businesses

EBIT excludes capital structure but includes D&A

P/E factors in capital structure. Reflects market conditions

Question 7

What does it mean to be capital structure neutral?

Answer 7

It doesn’t matter if the company is financed by debt or equity.
EV/EBITDA and EBIT are cap neutral because they aren’t impacted by interest
they’re helpful for valuing companies in different industries

Question 8

A company issues $1000 of shares, how does EV/EBITDA and P/E change?

Answer 8

EV/EBITDA doesn’t change because EQV increases and cash increases
P/E increases bc EQV increased

Question 9

A company issues $1000 in debt, how does EV/EBITDA and P/E change?

Answer 9

EV/EBITDA doesn’t change, bc debt +1000 and cash +1000
P/E doesn’t change because EQV doesn’t change

Question 10

Why can’t we use EV/NI?

Answer 10

Apples to Apples, or else its inconsistent
There could be an arbitrary change in the num or denom and it’ll affect the multiple

Question 11

What are some common leverage ratios?

Answer 11

Debt/EBITDA: because EBITDA is used as a proxy for cash flow

EBITDA/interest expense: measures how well a company can pay interest

D to E ratio: Debt/Equity

Current ratio: Current assets/current liabilities, measure company’s ability to pay off debt without additional financing

Question 12

A company is trading at 4x Debt/EBITDA and has an interest coverage ratio (EBITDA/interest expense) of 5x. The tax rate is 30%, what is the company’s after tax cost of debt?

Answer 12

We need to know the effective interest rate
EBITDA is 1/4 of the principal
Interest expense if 1/5 of EBITDA
so interest expense is 5% of the principal
the pre-tax cost of debt is 5%, so the after tax cost is 3.5%

Question 13

You’re analyzing two companies. One has a higher P/E ratio, one has a higher EV/EBITDA, why could this be?

Answer 13

1. Capital structure: a less levered company will have higher P/E, bc interest payments reduce NI
2. Difference in business model. A company with high D&A will have a lower P/E
3. One time expenses will affect P/E, but not EV/EBITdA
4. Different tax rates: tax affects P/E

Question 14

What does WACC represent?

Answer 14

The company’s effective discount rate.
It tells us the cost of raising new capital, which reflects the company’s risk

Question 15

Why is cost of D tax shielded, but cost of E and P aren’t?

Answer 15

The cost of D are interest payments, which are paid before tax on the IS

The cost of E and P are dividend payments, which are taken out of RE and not tax deductible

Question 16

Why is D cheaper than P, which is cheaper than E?

Answer 16

Risk is proportional to return
- The company is obligated to repay debt, but not issue dividends
- position in the ownership hierarchy. Debtholders are paid first in a bankrupcy scenario

Question 17

What are the pros and cons of raising D?

Answer 17

Pros
1. D is cheaper than E, debtholders are paid lower returns in exchange for seniority in the cap structure
2. Interest is tax deductible
3. issuing D doesn’t dilute current shareholder ownership

Cons
1. if a company can’t meet debt payments, it must declare bankruptcy
2. debt gets more expensive as a company becomes more levered
3. debt has covenants

Question 18

What are the pros and cons of raising E?

Answer 18

Pros:
1. no repayment
2. reduction of credit risk. Having more E doesn’t increase risk of bankruptcy
3. signaling: issuing credit signals confidence

Cons:
1. ownership dilution of current shareholders
2. higher cost: investors demand a higher rate of return
3. it takes more time to issue E than D

Question 19

How do you calculate cost of E?

Answer 19

cost of E = risk free rate + levered beta * market risk premium

RFR: 10 year treasury
levered b: idiosyncratic risk
market risk premium: risk of an index, usually 6%

Question 20

What does beta represent?

Answer 20

Measure of a stock’s volatility in relation to the overall market
Calculated with the CAPM model

Question 21

What’s the difference between levered and unlevered b?

Answer 21

Levered beta represents both the inherent business risk and default risk.
Unlevered beta doesn’t account for default risk.

Question 22

How to unlever and relever b?

Answer 22

1. Screen for levered beta for comparable companies
2. unlevered b = levered b/ (1+ (1-tax rate) * (D/E))
3. relevered b = unlevered b * (1+ (1-tax rate) * (D/E))

Question 23

What types of companies have a beta greater than 1 ? Between 1 and 0? Negative?

Answer 23

• > 1: startups, emerging markets, risky industries (biotech, software)
• 0>b>1: lower risk than broader market, industrials, consumer staples
• negative b: countercyclical companies, gold, silver

Question 24

Rank a Gold ETF, Tesla, and Walmart’s b

Answer 24

Gold< Walmart < Tesla

Question 25

What would be the beta of a lottery ticket?

Answer 25

0

Question 26

What happens to WACC when a company raises more debt?

Answer 26

WACC initially decreases because cost of D is lower than cost of E BUT beyond the point of financial distress, there's too much risk. Both the cost of E and D rises So there's an optimal point

Question 27

Is cost of E higher in a $5B or $500M company? What about WACC?

Answer 27

Cost of E is higher for a $500M company because there's more risk. Smaller companies are also expected to outperform larger ones BUT for WACC, it depends on capital structure

Question 28

How do you calculate WACC for a private company?

Answer 28

Cost of E: use the CAPM model we can estimate b by looking at public comparables Cost of D: use the effective interest rate

Question 29

When interest rates increase, what happens to bond yields? How will it impact WACC?

Answer 29

Yields go up because newly issued bonds have to have competitive returns if they want to be competitive This increases WACC

Question 30

Should a early stage company raise D or E?

Answer 30

E, because 1. E gives investors greater upside if the company is successful 2. D will lead to interest expense, which is hard for a startup to pay 3. a lot of startups don't have hard assets, so their cost of raising D is high

Question 31

What happens to EPS when you buy back shares with debt?

Answer 31

Immediately it increases But it depends on the interest rate If you pay so much interest that NI decreases a greater proportion than the number of shares, then EPS decreases

Question 32

How does a change in the tax rate affect a DCF?

Answer 32

1. NOPAT 2. cost of D goes down, WACC down 3. beta is in the same direction as tax higher tax -> better tax shield -> firms take on more debt -> higher beta