Valuation Flashcards

Question

To calculate Unlevered FCF in a DCF, which items do you need to project?

Answer 1

1) Revenue 2) COGS and Operating Expenses 3) Taxes 4) Depreciation & Amortization 5) The Change in Working Capital 6) Capital Expenditures * all regularly occurring and relate to all investors These items all correspond to Unlevered FCF = NOPAT + Non-Cash Adjustments and Change in Working Capital from CFS - Capex

Answer 2

WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred * % Preferred * WACC always pairs with Unlevered FCF b/c both represent all investors in a co * If you invest proportionally in co's entire capital structure, WACC gives you expected, long-term annual return * If it's expected to change in explicit forecast period, you should reflect that in DCF (i.e. a co's risk profile can change as it matures over time)

Answer 3

Can take risk-free rate, and then add a default spread based on company's expected credit rating after it issues additional debt

Answer 4

Look at how much co would have to pay if it issued additional Preferred Stock

Answer 5

You have to un-lever it ... and then re-lever it, to make it reflect the risk from the leverage of the company you are valuing ``` Bu = Bl / [1 + ((1-tax rate)*(D/E))] Bl = Bu * [1 + ((1 - tax rate)*(D/E))] ```

Answer 6

- should be low; below the GDP growth rate of the country, and perhaps in-line with rate of inflation - in developed mkts, percentages should be in low single digits (i.e. 1-3%) - even in emerging mkt, percentage should be closer to 3-4% (not dramatically higher)

Answer 7

- Perpetuity Growth Method: assume company's Cash Flow Growth Rate stays the same in perpetuity (and that Discount Rate stays the same) - Gordon Growth Method: Terminal Value = [Last FCF in forecast period x (1 + Terminal Growth Rate)] / (WACC - Terminal Growth Rate) - Exit Multiple Method: value business as a multiple of an operating statistics (useless if no truly comparable companies) - Just, e.g., take Terminal EBITDA/EBIT/NOPAT, multiply it by multiple, and discount it to PV

Answer 8

- add non-core business Assets and subtract Liability and Equity line items that represent other investor groups - then, you divide by the co's diluted share count to calculate it's Implied Share Price, which you compare to its Current Share Price

Answer 9

- cost of equity: Higher - cost of debt: Higher - WACC: Higher - Implied Value from Unlevered DCF: Lower

Answer 10

- cost of equity: Lower - cost of debt: Lower - WACC: Lower - Implied Value from Unlevered DCF: Higher

Answer 11

- cost of equity: Higher - cost of debt: Higher - WACC: Lower, then Higher - Implied Value from Unlevered DCF: Higher, then Lower

Answer 12

- cost of equity: Higher - cost of debt: Higher - WACC: Higher - Implied Value from Unlevered DCF: Lower

Answer 13

- cost of equity: Lower - cost of debt: Lower - WACC: Depends - Implied Value from Unlevered DCF: Depends * Depends on what "some Debt" means

Answer 14

- cost of equity: Higher - cost of debt: Higher - WACC: Higher - Implied Value from Unlevered DCF: Lower

Answer 15

- cost of equity: Lower - cost of debt: Lower - WACC: Lower - Implied Value from Unlevered DCF: Higher

Answer 16

- cost of equity: Higher - cost of debt: N/A - WACC: Higher - Implied Value from Unlevered DCF: Lower

Answer 17

- cost of equity: Lower - cost of debt: N/A - WACC: Lower - Implied Value from Unlevered DCF: Higher

Answer 18

- cost of equity: Higher - cost of debt: N/A - WACC: Higher - Implied Value from Unlevered DCF: Lower

Answer 19

- cost of equity: Lower - cost of debt: N/A - WACC: Lower - Implied Value from Unlevered DCF: Higher

Answer 20

- cost of equity: Lower - cost of debt: Lower - WACC: Lower - Implied Value from Unlevered DCF: Depends, usually Lower * Assuming co has Debt. If it does not, taxes won't make an impact because there won't be any tax savings from interest paid on Debt. * Reduces Cost of Equity b/c you use that tax rate when re-levering Beta ... Higher tax rate enhances cost benefits of Debt, which means addtl Debt is also less risky for Equity investors * Implied Val usually decreases b/c a higher tax rate also reduces co's Free Cash Flow

Answer 21

- cost of equity: Higher - cost of debt: Higher - WACC: Higher - Implied Value from Unlevered DCF: Depends, usually Higher * Assuming co has Debt. If it does not, taxes won't make an impact because there won't be any tax savings from interest paid on Debt.

Answer 22

Discount Rate and Terminal Value B/c DR affects everything and PV of TV often represents over 50% of co's Implied Value Assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above

Answer 23

Instead of projecting and analyzing a company’s cash flows, you compare the company to other, similar companies (or similar companies that were acquired) and use the valuation multiples from those companies to value the one you’re looking at.

Answer 24

In most industries, you'll look at 1 sales-based metric, and 2 profitability-based metrics EV / Revenue, and Revenue Growth EV / EBITDA, and EBITDA Growth and Margins Net Income, P / E, and Net Income Growth and Margins

Answer 25

By picking "similar companies," you're ensuring that the Cash Flow and Discount Rate for the companies are in similar ranges. Therefore, if one company trades at higher multiples than another, its Cash Flow Growth Rate should be higher. ____ longer answer Because the comparable companies and transactions should have similar Discount Rates and Free Cash Flow figures. 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.

Answer 26

1) Start with the revenue on its income statement for the full year 2024, i.e., what the co has earned between Jan 1 2024 and Dec 31 2024 2) Then, add revenue for the 6 months from Jan 1 2025 through June 20 2025 3) Then, subtract the revenue for the 6 months between Jan 1 2024 and June 30 2024 If co has non-recurring charges (e.g. restructuring, write-downs, legal expenses, goodwill impairment), you'll add back these charges in the calculations for the metrics affected by these non-recurring items

Answer 27

1) main difference is that with pres trx, you calculate valuation multiples based on what acquirers have paid to acquire other co's, not what those co's shares are currently trading at on the stock market 2) you still screen based on industry, geography, and size, but each rule is based on the seller 3) M&A mkt changes rapidly over time, so you need to look at co's from recent past (2-3 yrs, ideally) 4) When calculating metrics and multiples with pres trx, everything is based on the purchase price / balance sheet as of the announcement date of the deal

Answer 28

- probably not a good time to sell: the co trades at a premium to its intrinsic value, and acquirer would have to pay even more to acquirer the co. A standard 30% premium would make the co even more overvalued, meaning that an acquirer would need to realize massive synergies to make the math work - but it might be a good time to raise equity: co's benefit from raising Equity when they trade at higher multiples and premiums to their intrinsic values; Equity produces less dilution in those cases because the co can issue fewer shares to raise the same amt of capital

Answer 29

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. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies.

Answer 30

- EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. - Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part available to equity investors.

Answer 31

Enterprise Value -Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors

Answer 32

Equity Value - Levered Free Cash Flow already includes Interest and the money is therefore only available to equity investors - Debt investors have already "been paid" with the interest payments they received.

Answer 33

1. The company has just reported earnings well-above expectations and its stock price has risen recently. 2. It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. 3. It has just won a favorable ruling in a major lawsuit. 4. It is the market leader in an industry and has greater market share than its competitors.

Answer 34

1. Look at the 75th percentile or higher for the multiples rather than the Medians. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. - rarely do all of above in practice

Answer 35

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.

Answer 36

Possible reasons: 1. One process was more competitive and had a lot more companies bidding on the target. 2. One company had recent bad news or a depressed stock price so it was acquired at a discount. 3. They were in industries with different median multiples.

Answer 37

EBITDA excludes the often sizable Capital Expenditures companies make and hides how much cash they are actually using to finance their operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a big disparity.

Answer 38

P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it - you're more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).

Answer 39

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher

Answer 40

Public comps are useful because they're based on real market data, are quick to calculate 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 41

Kind of a trick question The best 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 42

First, confirm we're talking about unlevered Subtract COGS and Operating Expenses from Revenue to reach EBIT Then, multiply EBIT * (1 - Tax Rate), add back D&A, and factor in Changes in Working Capital Finally, subtract CapEx to calculate Unlevered FCF Levered FCF (FCF to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 - Tax Rate), and you also factor in changes in Debt principal

Answer 43

The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry. A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate means lower risk and lower potential returns. A higher Discount Rate makes a company less valuable because it means the investors have better options elsewhere; a lower Discount Rate makes a company more valuable.

Answer 44

1) Multiples Method, or 2) Gordon Growth Method With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF in the final year of the forecast period. For example, if you apply a 10x EV / EBITDA multiple to the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000. With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free Cash Flows in the Terminal Period and assume they’ll grow at that rate forever. Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate) The Gordon Growth Method is better because growth always slows down over time; all companies’ cash flows eventually grow more slowly than GDP.

Answer 45

WACC is the expected annual return if you invest proportionally in all parts of the co's capital structure To a co, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time Investors might invest in a co if their expected IRR exceeds WACC, and a co might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC

Answer 46

This q tests ability to make a guesstimate based on common sense and knowledge of current market rates You might say, "The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta around 1.5. So, if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%."

Answer 47

In a valuation, you're estimating the co's Implied Value -- what it should be worth The historical Beta corresponds more closely to the co's Current Value -- what the market says it's worth today By un-levering Beta for each comparable co, you isolate each co's inherent business risk. Each co might have a different capital structure, so its important to remove the risk from leverage and isolate just the inherent business risk You then take the median Unlevered Beta from these co's and re-lever it based on the capital structure (targeted or actual) of the co you are valuing This way the re-levered beta reflects what the volatility of this co's stock should be, based on the median business risk of its peer co's and THIS CO's capital structure

Answer 48

Assuming the company has only Equity and Debt: Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 - Tax Rate)) Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 - Tax Rate)) - you use a "1+" in front of Debt / Equity Ratio * (1 - Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta - and you multiply the Debt / Equity Ratio by (1 - Tax Rate) because the tax-deductibility of interest reduces the risk of Debt The formulas REDUCE Levered Beta to represent the removal of risk from leverage, but they INCREASE Unlevered Beta to represent the addition of risk from leverage

Answer 49

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula. But if the bonds are not currently convertible, you count them as Debt and use the coupon rate (or YTM, or another method) to calculate their Cost.

Answer 50

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt

Answer 51

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rate doesn’t matter because there’s no tax benefit to interest paid on Debt. If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt, and WACC. It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher rate always reduces the after-tax cost. But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower. However, the Implied Value from a DCF will also be lower because the higher tax rate reduces FCF and the company's Terminal Value. Those changes outweigh a lower WACC. The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and WACC are all higher, and the Implied Value is also higher.

Answer 52

1) Select the companies and transactions based on criteria such as industry, size, and geography (and time for the transactions) 2) 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 3) Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum or each valuation multiple in the set 4) Finally, apply these numbers to the financial metrics of the company you're analyzing to estimate its Implied Value

Answer 53

1. Liquidation Valuation 2. Replacement Value 3. LBO Analysis 4. Sum of the Parts 5. M&A Premiums Analysis 6. Future Share Price Analysis

Answer 54

- company has completely different, unrelated divisions - a conglomerate like General Electric, for example - use comps for each different division

Answer 55

Used to establish how much a private equity firm could pay, which is usually lower than what strategic buyers will pay. It is often used to set a "floor" on a possible Valuation for company.

Answer 56

1. EV/Revenue 2. EV/EBITDA 3. EV/EBIT 4. P/E (Share Price / EPS) 5. P/BV (Share Price / Book Value).

Answer 57

if the company you're valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it's doing well.

Answer 58

Instead of projecting and analyzing a company’s cash flows, you are comparing the company to other, similar companies, and use valuation multiples from those companies to value the one you’re looking at

Answer 59

Often, pres trx produce higher multiples than public comps because of the control premium built into M&A deals Also, M&A deals can be structured in different ways, creating problems for this valuation method (e.g. some deals include earn outs, where a portion of purchase price is paid out several years into the future)

Answer 60

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. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

Answer 61

in most cases, LBO will give lower valuation with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value. With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher.

Answer 62

The same way you would value a company: Comparables and DCF / by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation). 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. Yes, you could do a DCF for anything – even an apple tree.

Answer 63

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

Answer 64

It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead.

Answer 65

• 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.

Answer 66

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences: • You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps. • Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies. • A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.

Answer 67

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Answer 68

If the company you’re valuing is early-stage, and it is impossible to estimate its future cash flows, or if the company has no path to positive cash flows, you have to rely on the other methodologies. These other methodologies can also be more useful when you run into problems in the DCF, such as an inability to estimate the Discount Rate or extremely volatile cash flows.

Answer 69

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 Free Cash Flow will be higher (i.e., closer to EBITDA) as a result. 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 would need more information to make a real decision.

Answer 70

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value. You start by projecting the company’s Free Cash Flows over the next 5-10 years (by making assumptions for revenue growth, margins, Working Capital, and CapEx). Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything. Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity. You then discount the Terminal Value to Present Value using the Discount Rate and add it to the sum of the company’s discounted cash flows. Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.

Answer 71

Unlevered FCF must capture the company’s core, recurring line items that are available to ALL investor groups (bc it corresponds to TEV) So, exclude - Net Interest Expense – Only available to Debt investors. - Other Income / (Expense) – Corresponds to non-core-business Assets. - Most non-cash adjustments besides D&A – They’re non-recurring. - All Items in Cash Flow from Financing – They’re only available to certain investors. - Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.

Answer 72

If you include an income or expense line item in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you exclude). For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher. This rule also explains why you factor in Cash and Debt when moving to the Implied Equity Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

Answer 73

It tells you the average percentage a company’s stock “should” return each year, over the very long term, factoring in both stock-price appreciation and dividends. In a valuation, it represents the percentage an Equity investor might earn each year (averaged over decades). To a company, the Cost of Equity represents the cost of funding its operations by issuing additional shares to investors. The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting existing investors (thereby giving up stock-price appreciation potential).

Answer 74

The biggest issue is that EBITDA ignores CapEx. Two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if they have similar EV / EBITDA multiples. You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those multiples create other issues, such as less comparability across peer companies.

Answer 75

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 plus the usual adjustments. You would then calculate the valuation multiples based on those figures and the financial stats for 100% of the seller.

Valuation Flashcards

(103 cards)