Valuation Questions (Corporate Finance Theory) Questions and Answers

Valuation Questions (Corporate Finance Theory) Questions and Answers Could you explain the concept of present value? 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 is that money currently in possession can earn interest by being invested today. How do you calculate present value? Present Value (t=0) = Cash Flow^t=1 / (1 + r)^t=1 How does the concept of PV relate to company valuations? For intrinsic valuation methods, the value of a company will equal to the sum of the present value of all future cash flows it generates. Therefore, a company with a high valuation would imply it receives high returns on its invested capital by consistently investing in positive net present value (NPV) projects while having low risk associated with its cash flows. What is equity value? Often used interchangeably with the term market capitalization (market cap), equity value represents a company's value to its equity shareholders. A company's equity value is calculated by multiplying its latest closing share price by its total diluted shares outstanding, as shown below: How is equity value calculated? Equity Value = Latest closing share price x Total diluted shares outstanding How do you calculate the fully diluted number of shares outstanding? The treasury stock method (TSM) is used to calculate the fully diluted number of shares outstanding based on the options, warrants, and other dilutive securities that are currently "in-the-money" (profitable to exercise). / It involves summing up the number of ITM options and warrants and then adding that figure to the basic number of shares outstanding. / In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact. What is enterprise value? Conceptually, it represents the value of a company's operations to all stakeholders including common shareholders, preferred shareholders, and debt lenders. It is considered capital structure neutral. How do you calculate enterprise value? EV = Market Cap + Net Debt + Preferred Stock + Minority Interest What's Net Debt? Net Debt is the amount by which a company's total short- & long-term debt exceeds its total cash and cash equivalents. How do you calculate Net Debt? Net Debt = Short- + Long-term Debt - Cash & equivalents Why do we add net debt when calculating EV? The underlying idea is that the cash on a company's balance sheet could pay the outstanding debt if needed. For this reason, CCE is netted against the company's debt, and many leverage ratios use net debt rather than the gross amount. How do you calculate equity value from EV? To get equity value from enterprise value, you would first subtract net debt, where net debt equals the company's gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets. Could a company have a negative net debt balance and have an enterprise value lower than its equity value? Yes, negative net debt means that a company has more cash than debt. Think of AAPL or Microsoft. / Remember, EV represents the value of a company's operations, excluding non-operating assets like cash. No surprise that these companies have a lower EV than equity values. Can the EV of a company turn negative? While negative EVs are uncommon, it can happen. It means a company has a negative net debt that exceeds its equity value. If a company raises $250m in additional debt how would its EV change?, Theoretically, there would be no impact as EV is capital structure neutral. However, the costs of financing could negatively impact the company's profitability and lead to a lower valuation from the higher cost of debt. Why do we add minority interest to equity value in the calculation of EV? Minority interest represents the portion of a subsidiary that 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 its financial statements despite not owning 100%. / When calculating multiples using EV, the numerator will be a consolidated metric; thus, minority interest must be added for sake of compatibility with the multiple. How are convertible bonds and preferred equity with convertible features accounted for when calculating enterprise value? If the convertible bonds and the preferred equities are "in-the-money" as of the valuation date (the current stock price is greater than their strike price), then the treatment will be the same as additional dilution from equity. However, if they're "out-of-the-money," they would be treated as a financial liability (similar to debt). What are the two main approaches to valuation? 1. Intrinsic Valuation - the value of the business is arrived at by looking at the business's ability to generate cash flows. The DCF method is the most common and is based on the notion that a business's value equals the present value of its future free cash flows. 2. Relative Valuation - A business's value is arrived at by comparing to relative companies and applying the average or median multiples derived from the peer group. What are the most common valuation methods? Trading Comps value a company based on how similar publicly-traded companies are currently being valued at by the market. / Transaction comps value a company based on the amount buyers paid to acquire similar companies in recent years. / DCFs value a company based on its projected cash flows, discounted at an appropriate rate that reflects the risk of those cash flows. / LBOs will look at a potential acquisition target under a highly leveraged scenario to determine the maximum purchase price the firm would be willing to pay. / Liquidation analysis is used for companies under (or near) distress and values the assets of the company under a hypothetical, worst-case scenario liquidation. Which approach yields the highest valuation? Transaction comps often yield the highest valuations because it looks at valuations for companies that have been acquired, which factor in control premiums. They can be quite significant and as high as 25% to 50% above market price. Which approach is the most variable in terms of output? Due to the reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of the different approaches. What are the advantages and disadvantages of DCF? It is viewed as the most direct and academically rigorous way to measure value. It's considered independent of the market and instead based on the company's fundamentals. / However, it is very sensitive to assumptions. (Garbage in garbage out) Forecasting a company's financial performance is challenging, especially for an extended period. Many criticize the use of beta in the WACC calculation and how the terminal value comprises around 3/4s of the implied valuation. What are the advantages and disadvantages of Trading Comps? Comps rely much more heavily on market pricing to determine the value of a company (the most recent, actual prices paid in the public markets). There are very few truly comparable companies, so in effect, its always an apples-and-oranges comparison. / While it is a more realistic assessment, its vulnerable to how the market isn't always right. It is simply pricing instead of being based on fundamentals. How can you determine which valuation method to use? Every valuation has its shortcomings and advantages. Therefore, it is best practice to utilize a combination of approaches to arrive at a range of valuation estimates. / All valuation methods contain some degree of inherent bias; thus, various methods should be used in conjunction. What does free cash flow (FCF) represent? FCF = Cash from operations - Capex / It represents a company's discretionary cash flow, meaning the CF remaining after accounting for the recurring expenditures to continue operations. The cash from investing and financing are excluded because these activities are optional and discretionary decisions up to management. Why are periodic acquisitions excluded from FCF calculation? The calculations of FCF should only include inflows/(outflows) of cash from the core, recurring operations. That said, the periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and apart of operations. Explain the importance of excluding non-operating income/(expenses) for valuations. It is because the intent is to value the business's operations, which requires you to set apart the core operations to normalize the figures. Define free cash flow yield (FCFY) and compare it to dividend yield and P/E ratios. FCFY is calculated as the FCF per share divided by the current share price. / FCFY = (FCF/share) / Current share price / - Similar to the dividend yields, FCFY can gauge equity returns relative to a company's share price. Unlike dividend yield, FCFY is based on cash generated instead of cash actually distributed. FCFY is more useful as a fundamental value measure because many companies don't issue dividends. Could you define what the capital structure of a company represents? The capital structure is how a company funds its ongoing operations and growth plans, a mixture of debt and equity. As companies mature and build a track record of profitability, they can usually get debt financing easier and at more favorable rates since their default risk has decreased. The optimal capital structure is the D/E mix that minimizes the cost of capital, while maximizing the firm value. What are the advantages and disadvantages to issuing equity? There are no required payments. Dividends to equity shareholders can be issued. It gives companies access to a vast investor base and network. / However, 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 disclosure of financials. The mgmt. team could lose control and be voted out if shareholders lose confidence. What are the advantages and disadvantages of issuing debt? The interest expense on debt is tax-deductible. There is no ownership dilution with a lower cost of capital. Increased leverage forces discipline on management, resulting in risk-averse decision-making. / However, the required interest & principal payments introduce the risk of default. Loss of flexibility from restrictive debt covenants and limits mgmt. from raising more debt, issuing dividends, or acquiring. Less room for errors in decision-making. What are share buybacks and under which circumstances would they be most appropriate? Stock repurchases happen when the business has excess cash to buy back its shares, either through a tender offer (directly approaching shareholders) or in the open markets. The repurchase will be shown as a cash outflow on the CFS and be reflected on the treasury stock line items. / 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 higher P/E ratio. The market can also interpret the buyback as a positive signal that the management is optimistic about future earnings growth. Why would a company repurchase shares? What would the impact on the share price and financial statements be? A company buys back shares primarily to move cash to shareholders, similar to dividends. / 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 is reduced, the equity value is reduced by the lower cash balances. That said, its dependent on how the market perceives the signal. / We know the positive impact, however, if shareholders view the buyback as a signal that the company's investment prospects aren't great (otherwise, why not pump cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash, lower perceived growth and investment prospects). Why might a company prefer to repurchase shares over issuing a dividend? The so-called "double taxation" when a company issues a dividend, in which the same income is taxed at the corporate level and then again at the shareholder level. / 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 SBC to conserve cash, thus, share buybacks can help counteract the dilutive impact of those shares. / Share buybacks imply a company's management believes their shares are currently undervalued, making the repurchase a potential positive signal to the market. / 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) A company with $100m in net income and a P/E multiple of 15x is considering raising $200m in debt to pay out a one-time cash dividend. How would you decide if this is a good idea? 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 $100m to $90m [($200m new borrowing x 5%) = $10m - Equity value drops from $1,500m (15 x $100m) to $1,350m (15 x 90m) / That's a $150m drop in equity value. However, shareholders are immediately getting $200m. So, ignoring tax impact, shareholders have a net benefit of $50m. / The assumptions we made about taxes, cost of debt, and the PE multiple staying the same all affect the result. A key assumption is the PE ratio remains the same. It is a function of the company's growth prospects, ROE, and cost of equity. Hence, borrowing more with no compensatory increase in investment or growth raises the cost of equity from a higher beta, which will pressure the PE multiple down. / Given a different set of assumptions, it could easily be a bad idea. 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 PE 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. When would it be most appropriate for a company to distribute dividends? Companies that distribute dividends are usually low growth with fewer profitable projects in the pipeline. Therefore, management opts to pay out dividends to signal the company is confident in its long-term profitability and appeals to a different shareholder base. What is CAGR? The compound annual growth rate (CAGR) is the rate of return required for an investment to grow from its beginning balance to ending balance. Put another way, CAGR is the annualized average growth rate. CAGR Formula CAGR = (Ending value / Beginning value)^(1/t) - 1 What is the difference between CAGR and IRR? The CAGR and IRR are both used to measure the return on investment. However, CAGR is only the investment's ending & beginning values and the number of years. IRR (XIRR) can handle more complex formulas with the timing of cash inflows and outflows. / CAGR is for historical reference, whereas IRR is used for investment decision-making. How would you evaluate the buy vs. rent decision in NYC? 1. I would have to make assumptions to allow for a proper comparison, such as having enough upfront capital to make a down payment and the ten-year investment period. / 2. To buy, I must pay the monthly mortgage, real estate tax, and maintenance fees (which will be offset by some tax deductions). Then, I'll assume that I can sell the property that reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to sale, I can calculate my IRR and compare this IRR to the renting. / 3. For the 2nd option, I would start by estimating the rental cost of comparable properties, factoring in rent escalations over ten years. Since there's no initial down-payment, I would invest that money and assume an annual return over 10 years being consistent with historical return on stock market (5-7%). Compare IRRs / 4. I would keep in mind that this isn't apples to apples. NYC property is riskier due to leverage and lower liquidity. NYC real estate is not as liquid as public stocks. If they were identical, I would choose to rent because it does not appear that I am being compensated for the added risk.