Accounting
Why does Depreciation affect the cash balance?
Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.
When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?
Enterprise Value, because that’s how much an acquirer really “pays” and includes the often mandatory debt repayment.
What are the 3 major valuation methodologies?
Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.
Would an LBO or DCF give a higher valuation?
Technically it could go either way, but in most cases the LBO will give you a lower valuation.
Walk me through a DCF.
“A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.
First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the Weighted Average Cost of Capital.
Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.
Finally, you add the two together to determine the company’s Enterprise Value.”
What happens when Inventory goes up by $10, assuming you pay for it with cash?
No changes to the Income Statement.
On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.
What’s the formula for Enterprise Value?
EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest – Cash
Rank the 3 valuation methodologies from highest to lowest expected value.
In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. However, there's no ranking that always holds.
How would you value an apple tree?
The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation).
What do you usually use for the discount rate?
Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF.
Could you ever end up with negative shareholders’ equity?
1. Leveraged Buyouts with dividend recapitalizations – it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders’ Equity.
Could a company have a negative Enterprise Value?
Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with:
1. Companies on the brink of bankruptcy.
2. Financial institutions, such as banks, that have large cash balances – but Enterprise Value is not even used for commercial banks in the first place so this doesn’t matter much.
When would you not use a DCF in a Valuation?
You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role.
How do you select Comparable Companies / Precedent Transactions?
The 3 main ways to select companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography
How do you calculate WACC?
Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred).
Under what circumstances would Goodwill increase?
Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare.
1. The company gets acquired or bought out and Goodwill changes as a result, since it’s an accounting “plug” for the purchase price in an acquisition.
2. The company acquires another company and pays more than what its assets are worth – this is then reflected in the Goodwill number.
Could a company have a negative Equity Value?
No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.
What are the most common multiples used in Valuation?
The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).
What are the flaws with public company comparables?
• No company is 100% comparable to another company.
• The stock market is “emotional” – your multiples might be dramatically higher or lower on certain dates depending on the market’s movements.
• Share prices for small companies with thinly-traded stocks may not reflect their full value.
How do you calculate the Cost of Equity?
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
Walk me through what flows into Retained Earnings.
Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued
Are there any problems with the Enterprise Value formula?
Yes – it’s too simple.
• Net Operating Losses – Should be valued and arguably added in, similar to cash.
• Long-Term Investments – These should be counted, similar to cash.
• Equity Investments – Any investments in other companies should also be added in, similar to cash (though they might be discounted).
• Capital Leases – Like debt, these have interest payments – so they should be added in like debt.
• (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well.
• Unfunded Pension Obligations – Sometimes these are counted as debt as well.
When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?
You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.
Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?
Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.
Why do you have to un-lever and re-lever Beta?
“Apples-to-apples” theme. When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company.
But each company’s capital structure is different and we want to look at how “risky” a company is regardless of what % debt or equity it has.
To get that, we need to un-lever Beta each time.
But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.