Other Valuation Questions and Answers

Other Valuation Questions and Answers When we say we "triangulate" to a value, what does that mean? What methods might we use? When valuing a business, we typically look at multiple valuation approaches (DCF, Trading Comps, Transaction Comps, LBO, etc.) and make a judgment call about the most appropriate valuation range. What is Terminal Value? Reflects the discounted value of all Cash Flow beyond the explicit projection project period (Stage 1) for a DCF analysis. Why do we use the 10 Year US Treasury? We typically use the 10 Year US Treasury for two reasons: 1. The US is the reserve currency of the world and as such we assume the US will always repay, thus making an investment in US securities 'Risk Free.' 2. We use a long-dated Treasury Security like the 10 Year Treasury to match the time frame of the cash flows we are attempting to value. In short, because our valuation assumes the business will last for a long period of time, we use a risk free security with a longer life. What is the Equity/Market Risk Premium...in Plain English? The Equity (or Market) risk premium reflects the excess reward for investing in Equities (i.e. Stocks) versus risk-free bonds. What is Enterprise Value...in Plain English? Enterprise Value reflects the Purchase Price of an entire Business without taking into account how the business was funded. What is Equity Value...in Plain English? Equity Value reflects the value attributable to the owner of a Business after accounting for payments to lenders (i.e. Debt) and any excess Cash in the bank that belongs to the owner of the Business. Walk me through the Cost of Equity (i.e. CAPM) formula...in Plain English. The formula starts with the Risk-Free Rate (usually the 10 Yr US Treasury). This gives us a baseline for the Minimum Return we should expect if we're taking zero risk. We then add a reward for taking incremental Risk in the form of Beta (which characterizes the volatility/riskiness of an individual stock) and multiply Beta by the Equity Risk Premium (which reflects the historical Reward for investing in Stocks vs Bonds over time). Why is WACC characterized as an 'Opportunity Cost of Capital?' WACC is characterized as an opportunity cost of capital because it represents the level of risk and foregone investments taken by investors What is the formula to un-lever Beta? The formula to un-lever Beta is: Levered Beta / (1 + [D/E])*(1-T)) What is the formula to re-lever Beta? The formula to re-lever Beta is: Unlevered Beta (1 + [D/E])(1-T)) How do we find the Beta of a Private Company? To find the Beta of a Private company, we find the Beta for several publicly traded peers. We then un-lever the peer Betas, take the average of the peer Betas, and re-lever the average with the target capital structure of the company we are valuing. A business has an EV of $100, Debt of $40, and Cash of $10. What is the company's Equity Value? Enterprise Value of $100 - $40 of Debt + $10 of Cash = $70 Equity Value How do you value a business that is losing money? For comparables analysis, you could use EV/Revenue multiples. For a Discounted Cash Flow analysis, you'd have to project out until the business makes money and ultimately hits a steady-state level of growth. Explanation: This is a variant of, what multiple would you use to value a money-losing/earlystage business. It also tests whether you understand the overarching goal/process of building out a DCF analysis. When would you use EV/Revenue as opposed to EV/EBITDA? You generally use EV/Revenue when a company doesn't have EBITDA (i.e. EBITDA is negative) and/or hasn't when the business hasn't fully matured. EV/EBITDA is used when a business is near or at maturity with stable earnings. First, if you have negative EBITDA, the multiple is meaningless, so interviewers want to see if you understand that. Second, a common follow-up here is...What would you use if a company just became profitable? The answer is that you'd probably still use EV/Rev because EBITDA likely doesn't reflect mature margin levels. A startup business just became profitable in the most recent year reported. What is the right EV metric to use? Because this company is still in the early stages of its development, an EV/Revenue multiple would likely be more appropriate until the company achieves a normalized (or 'mature') level of profitability. The typical delineation between when to use EV/Revenue multiples as opposed to EV/EBITDA multiples is that you use EV/Revenue when a company is losing money. But there's a bit of a grey area between initial profitability and full/mature margins in which judgment is required, which is what this question is testing. On some occasions, Preferred Stock is included in the WACC formula. Why is that the case? The goal of WACC is to blend the cost of capital (i.e. the expected returns) of all of our capital providers. So if a company has Preferred Stock, we have to include the proportional costs of the Preferred Stock as well as regular Debt and Equity. EV is Equity + Net Debt. A business has a $100 EV, $40 of Debt, and $10 of cash and generates an extra $2 of cash, what's the EV? The overall purchase price of the business should remain the same, so the Enterprise Value is still $100. If the question were asking about Equity Value, then we could say that Equity Value increased by $200. There are a lot of red herrings in this question, but the key is to understand that Enterprise Value reflects the overall sale price of the Business. Why would two identical companies in the same sector be trading at different valuation multiples? The most important reason why two companies are trading at different PE ratios or EV/EBIT multiples is because of the underlying growth in profitability. Investors are willing to pay a higher multiple for the same dollar of earnings for a company with a higher growth in profits versus another company in the same sector. Other less important reasons of why multiples differ is because of sustainability in earnings, unsystematic risk profile of the company and potential acquisition premium to list a few. How does an analyst value a loss-making company? Firstly, the company could be a fast-growing technology company which needs to reinvest all its profits into marketing to fuel its high growth and win as many customers before competition kicks in. Using a DCF valuation technique, the analyst could build a longer-term model of 10 years than the typical five-year model (if relevant) and assume that profits of the company normalises to that of similar companies in the same sector or technology companies in a different sector. For example, this technique is used to value even behemoths such as Amazon which operate on wafer thin margins but trade on PE multiples of more than 50x which is significantly higher than the multiple of other technology companies operate with high operating margins. Secondly, the analyst could use a simple Price to Sales ratio to value the company. An analyst can compare the company's price to sales ratio with similar companies in the sector which already operate on a normalised operating profit margin. Finally, Price to Subscriber or some other matrix such as Price to Website Visitors etc allow investors to quantify revenue and profitability potential of the company. The advantage of this method is that it allows investors to value companies in the early stage which are currently pre-revenue but have several free subscribers or repeated website visitors. Why do analysts use EBITDA versus net income to value a company? EBITDA is a popular measure of profitability amongst investors and analysts. It is widely used to value companies for public comparables, and sllows for comparability of profitabilits across sectors. Since EBITDA is income before Interest Tax, Depreciation and Amortisation - it ignores financing, taxation and capital decisions of the company and projects the true operating profitability of the company. Companies with different capital structures i.e. capital light such as software and IT versus capital heavy such as autos are not differentiated when comparing EBITDA. EBITDA also ignores the tax structure of the company. If a company has tax advantages such as REIT versus normal companies which are paying taxes, the company will be considered equal when comparing EBITDA across the companies in these sectors. Another important ratio includes EBITDA margins or EBITDA/Sales. EBITDA can also be used in debt related ratios such as Debt/EBITDA and EBITDA/Interest (interest coverage ratio) to convey riskiness of a company's leverage. What are some of the shortcomings of using EBITDA to value a company? At times, EBITDA is used as a quick and dirty proxy of the firm's free cash flow. But free cash flow includes capital investment, changes in tax assets and liabilities and changes in working capital. Given that EBITDA ignores the company's debt, tax and capital obligations it remains open to manipulation by the management and gives an incomplete picture of profitability. Therefore, many investors/analysts who use EV/EBITDA to value companies compliment this by using EV/EBIT as well to value the company. Capital intensive industries such as autos, shipping, telecom and transportation amongst others are extremely capital heavy industries and using EBITDA measures to analyse profitability of these companies ignores a critical component that weighs on valuation i.e. capex. Why do you need to subtract cash from the enterprise value formula? Cash gets subtracted when calculating the value of the enterprise as it is considered a non-operating asset. Further, cash is always included in equity value. Why do you add NCI/subtract cash? ○ Own over 50% of company → need to consolidate 100% of its financial statements with your own ○ ...but Equity Value only reflects the value of the percentage that you own (which is not 100%), so you need to reflect 100% of that other company in Enterprise Value → if you did not add NCI, you would only be reflecting 60%, or 70%, or however much you own ○ You subtract cash because you are receiving this when you purchase a company (technically you should only subtract away excess cash / cash excess of what you need to operate the company, but this is fine for entry-level interviews) Difference between Equity Value versus Shareholders' Equity? ○ Equity Value is the market value and Shareholders' Equity is the book value ○ Equity Value could never be negative because shares outstanding and share prices can never be negative, whereas Shareholders' Equity could be positive, negative, or 0 How does ____ affect Enterprise Value? Raise $200m in Debt, use cash to buy a new piece of equipment. ■ EV +200m ■ +200m Debt ■ -200m Cash (borrowing in form of debt) ■ +200m Cash (purchase is a decrease in cash, which is subtracted from EV thereby boosting it) How does ____ affect Enterprise Value? Issue $200m in Equity for an IPO. ■ EV unchanged ■ +200m Equity Value ■ -200m Cash (increase is subtracted) What are some multiples you could use for a company with a negative Net Income? ○ Revenue-based multiples (e.g. EV / Revenue) ○ Cash-flow multiples (e.g. EV / FCF) ○ Industry-specific multiples (e.g. EV / Unique Users for internet companies) Company A and Company B have identical EV/EBITDA. Company A has a higher P/E multiple. Why might this be the case? Pay attention to the "ITDA" in EBITDA ■ Different capital structures (e.g. one has more debt and thus more interest expense) ■ Different Depreciation / Amortization ■ Different tax rates You have a company with an EV/Revenue of 2x and an EV/EBITDA of 10x. What is the EBITDA margin? 20% (EBITDA margin = EBITDA / Revenue) A company has a stock price of $20 a share and a P/E of 20x (so EPS is 1). The company has 10M shares outstanding. How does a 2-for-1 stock split affect EV? Does not affect EV, there are now 20m shares outstanding and EPS is now 0.5 A company has 10,000 shares at $20 a share. There are 100 call options at an exercise price of $10, 50 restricted stock units (RSUs) and 100 convertible bonds at a price of $10 and par value of $100. What is the diluted equity value? ○ Options: Company receives $1000, 100 new shares created, company able to buy back 50 shares (50 new shares) ○ Add 50 restricted stock units (so far 100 new shares) ○ Convertible Bonds ■ Par Value / Price = # of shares per convertible bond → $100/10 = 10 shares per convertible bond * 100 convertible bonds = 1000 new shares ■ 1000 + 100 (from prev. steps) = 1,100 → diluted share count is 11,100 ○ Diluted Equity Value = 11,100 * 20 = 222,000 What metrics do you look at for comparable companies? What additional metric do you look at for precedent transactions? ○ FIG → Financials, Industry, and Geography ○ Precedent → Time frame (e.g. past 2 years) Why does a DCF almost always produce a higher valuation than an LBO? ○ LBO = only valued based on TV no value from cash flows in holding period) ○ DCF = takes into account both cash flows in projection period and terminal value How would leverage affect P/E if earnings stayed the same? If a company employed leverage and earnings were the same, it would be perceived as more risky so investors would likely be willing to pay a lower price for it. Hence, the PE would likely be lower as well. The reduction in equity value would also become evident in the event of bankruptcy, where lenders would be paid out first. Is EV / Sales more relevant for trading comps or precedents? EV / Sales is likely to be a more relevant metric in precedents-based valuation, because an acquirer is more likely to pay attention to an EV / Sales metric than public market investors. When an acquirer takes over a company, they have flexibility to change the cost structure, and take steps to bring operating margins of the acquired business in line with their existing business or industry standards. As such, they might be more focused on the incremental impact of top line sales growth than looking purely at the pro-forma increase in EBITDA. Would you use book value or market value of minority interest for EV? To the extent available, I would look up the market value of the minority interest, since it provides a more accurate indication of the price you would need to pay if you were to purchase all of the assets the company owns. How might you account for significant capex using trading comps? I would estimate the upcoming capital expenditures and then subtract them from enterprise value. The rationale is that the company will have to make these capital expenditures in order to generate ongoing cashflows and as such, the value to capital providers will be reduced. Are forward P/E multiples more likely to compress or expand? Forward multiples are generally expected to compress, since more often than not, EBITDA or Earnings are expected to grow over time. In cases where EBITDA or Earnings are forecasted to decline, this obviously would give rise to an expansion in forward multiples. Why might bankers prefer EV/EBITDA over P/E as key metric? Bankers typically focus on understanding the cashflows a company generates and evaluating the most suitable capital structure alternatives to maximize shareholder value. As such, their analysis is not confined to capital structure management currently in place, but rather focused on how that capital structure could be optimized. EV/EBITDA is capital structure neutral, meaning that the multiple isn't affected by changes to capital structure, which from a banking perspective, provides for a more useful and comparable metric between companies. It should be noted, however, that for certain companies like banks or financial institutions, certain other multiples such as P/Nav, P/BV or PE may be more relevant. Can you use market Cap/EBIITDA ass a valuation multiple? No - this is not an apples-to-apples comparison. Market cap represents the cash ows to equity while EBITDA is a pre-leverage metric (before capital structure). Theoretically, sales are to the whole @rm, so EV to Sales is academically correct while Price to Sales is not. Where we see this ignored is with tech companies, who often are valued on Price/Sales. However, the amount of debt in their capital structure is non-existent or negligible, so this is OK. How woulld you valluee a ccompany wiitth no rreeveenuee?? Companies with no revenue is common for stocks listed on TSX Venture (especially junior mining companies). You can project their future cash ows based on their reserves and resources, and discount it back at a rate appropriate for a company with no revenue (a much higher discount rate than a producing asset). Pre-revenue tech stocks may be valued on their user base (EV - although it is unlikely there is any debt in the capital structure if there is no revenue, so effectively equity value - to DAU/MAU daily average users/monthly average users, or pageviews). Pharmaceuticals may be in stages of drug testing and assumptions can be made should the trials be successful. If that is the case, these cash ows must be probability weighted (with a higher risk discount). Whatt iiss tthee eequiitty valluee off a diissttrreesssseed ccompany iin bankrrupttccy?? Equity value is most likely zero for a company in bankruptcy. Why sshoulld you ussee tthee marrkeett valluee off deebtt tto ccallccullattee EV fforr diissttrreesssseed ccompaniieess?? If you use the face value of debt and the equity value of the company you may not have an accurate look at how the market is valuing the company. For example, if bonds are trading at 60 cents on the dollar, the market is predicting that there may not be full recovery on the bonds. Now if the bonds are trading below par and shareholders are only paid after bondholders are paid in full, why is there a market cap for the company (equity value)? The answer is that it is option value. Can tthee grrowtth rrattee eexcceeeed tthee diissccountt rrattee ((g rr))?? Not in the long run as this will give you a negative perpetuity value - if growth is higher than the discount, the discount is inappropriate as people will come and bid up the stock. Accccounttss rreecceeiivabllee iinccrreeasseess - doeess tthiiss affffeecctt valluattiion?? Yes - AR rising means a positive change in NWC, which reduces free cash ow thus reducing the valuation of the @rm. These working capital changes are dif@cult to forecast and the question is meant to test knowledge of @nance identities rather than spark a real discussion Whatt iiss ccapiittall ssttrrucctturree lliikee fforr a ccompany wiitth no rreeveenuee?? Likely little to no debt although could have security against land or intangibles, but these will tend to be overcollateralized for lender comfort. Whatt happeenss tto EV iiff wee add $100 miilllliion iin deebtt?? Debt + 100, EV + 100 Cash + 100, EV - 100 IIff a ccompany iiss matturree whatt iiss wrrong wiitth ussiing Prriiccee//Salleess?? Price is post-leverage (equity is stripped out from EV) and sales are pre-leverage Whatt sshoulld ttrradee a hiigheerr mullttiipllee,, Peepssii orr Cokee?? Coke - higher brand value and best in class. Same as Starbucks trading above other coffee shops. Can the enterprise value of a company turn negative? While negative enterprise values are a rare occurrence, it does happen from time to time. A negative enterprise value means a company has a net cash balance (total cash less total debt) that exceeds its equity value. If a company raises $250 million in additional debt, how would its enterprise value change? 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. Why do we add minority interest to equity value in the calculation of enterprise value? 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). Why are periodic acquisitions excluded from the calculation of FCF? The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and a normal part of operations (i.e., capex is required for a business to continue operating). What does free cash flow (FCF) represent? 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. 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. Explain the importance of excluding non-operating income/(expenses) for valuations. 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. Define free cash flow yield and compare it to dividend yield and P/E ratios. The free cash flow yield ("FCFY") is calculated as the FCF per share divided by the current share price. For this calculation, FCF will be defined as cash from operations less capex. Free Cash Flow Yield (FCFY) = Free Cash Flow Per Share / Current Share Price Similar to the dividend yield, FCF yield can gauge equity returns relative to a company's share price. Unlike dividend yield, however, FCF yield is based on cash generated instead of cash actually distributed. FCF yield is more useful as a fundamental value measure because many companies don't issue dividends (or an arbitrary fraction of their FCFs). If you invert the FCF yield, you'll get share price/FCF per share, which produces a cash flow version of the P/E ratio. This has the advantage of benchmarking prices against actual cash flows as opposed to accrual profits. However, it has the disadvantage that cash flows can be volatile, and period-specific swings in working capital and deferred revenue can have a material impact on the multiple. What are share buybacks and under which circumstances would they be most appropriate? 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. The repurchase will be shown as a cash outflow on the cash flow statement and be reflected on in the treasury stock line items on the balance sheet. 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. 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 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. Cash-rich but otherwise risky companies could see artificially low share prices if investors discount that cash in their valuations. Here, buybacks should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator. Conversely, if shareholders view the buyback as a signal that the company's investment prospects are not great (otherwise, why not pump the 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). On the financials, the accounting treatment of the $100 million share buyback would be treated as: Cash is credited by $100 million Treasury stock is debited by $100 million Why might a company prefer to repurchase shares over the issuance of a dividend? 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. 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. 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 $100 million in net income and a P/E multiple of 15x is considering raising $200 million 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 $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. 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 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). What is CAGR and how do you calculate it? The compound annual growth rate ("CAGR") is the rate of return required for an investment to grow from its beginning balance to its ending balance. Put another way, CAGR is the annualized average growth rate. CAGR = ( Ending Value / Beginning Value)^(1/t) - 1 What is the difference between CAGR and IRR? The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the return on an investment. However, the calculation of CAGR involves only three inputs: the investment's beginning and ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can handle more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the multiple cash flows) accounted for, rather than just smoothing out the investment returns. CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making. What is the purpose of using multiples in valuation? A valuation multiple is a financial ratio that reflects how valuable a particular company is in relation to a specific metric. The numerator will be a measure of value such as equity value or enterprise value, whereas the denominator will be a financial or operating metric. Since absolute values cannot be compared, multiples are used to standardize a company's value on a per-unit basis. This enables comparisons in value amongst similar companies, which is the premise of relative valuation. For any valuation multiple to be meaningful, a contextual understanding of the target company, such as its fundamental drivers and general industry knowledge, is required. Besides incentivizing existing shareholders to sell, what other factors lead to higher control premiums being paid? Competitive Deals: In M&A, nearly all acquirers pay a control premium due to the competitive elements of sale processes. As a general rule, the control premium paid will be higher the more buyers are involved, as competition directly drives up the price. Synergies: If there are potential synergies that can be realized by the acquirer and the management team has high conviction in its occurrence, then the acquirer might be justified in paying a higher premium. Asset Scarcity: Many acquirers (strategics in the majority of cases) might pay a higher premium if the specific asset is a centerpiece to their future plans and there are no other acquisition targets in the market that meet their criteria. Oftentimes, this acquisition could lead to a meaningful competitive advantage for the acquirer over the rest of the market, making the completion of this acquisition a necessity. Undervalued Target: The target company might be perceived to be significantly undervalued from the buyer's viewpoint. From their perspective, the purchase price could be a moderate premium when compared to their own fair value assessment of the target, whereas to others the buyer paid an unreasonably high premium. Mismanagement: A mismanaged company coincides with the previous point, as this typically leads to underperformance. The acquirer will most likely be under the impression that the management should be replaced, and through operational improvements, a significant amount of value that is currently not being fully taken advantage of could be derived. Thus, a target acquired for this reason will be immediately restructured, beginning with the management team being replaced post-closing. Should two identical companies with different leverage ratios trade at different EV/EBITDA multiples? You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company's value and profits independent of its capital structure. Technically, they won't be exactly equal because enterprise value depends on the cost of capital, so there'll be some variation. Should two identical companies with different leverage ratios trade at different P/E multiples? P/E multiples can vary significantly due to leverage differences for otherwise identical companies. All else being equal, as a company borrows debt, the EPS (denominator) will decline due to higher interest expense. The impact on the share price, on the other hand, is hard to predict and depends on how the debt is used: If the debt proceeds go unused and generate no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment. In this scenario, the share price and P/E ratio can be expected to decline. But if that debt were used to invest and grow the business, the P/E ratio should increase. Simply put, debt adds more risk to equity investors (given their junior position in the capital structure) with little potential return, and investors will value the company at a lower P/E. A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back P/E ratio, and how would you interpret this situation? The company's P/E ratio would be higher. The company's four year-back P/E ratio was 5.0x and its current P/E ratio is 10.0x. Therefore, its P/E doubled after its EPS declined by $1.00. One potential interpretation is that the company is now overvalued and shouldn't be trading at a 10.0x multiple given the deteriorated EPS. Realistically, the market would view a decrease in EPS negatively, resulting in a lower share price and valuation. But since the share price didn't change, there are a few possible explanations: 1. The company could have issued more shares to raise capital that had a dilutive impact on EPS. 2. The company might have made a dilutive acquisition with stock as the main purchase consideration. In both cases, the cause of the lower EPS is the increase in the denominator. The share price remaining constant suggests the market reaction to how the company plans to use the newly raised capital or the M&A deal was positive, otherwise, the share price would've dropped. Similar to how EPS can be artificially boosted from share buybacks, it can decrease without there being an actual drop in performance. The issuance of additional shares typically results in the per-share value decreasing from the dilution, but the $10 share price is the post-dilution share price (meaning, the price was upheld despite the dilution). When would the use of the PEG ratio be appropriate? The PEG ratio is used to standardize the P/E ratio and enable comparisons among companies with different expected long-term growth rates (g). As a broad rule of thumb, a stock is fairly valued when the PEG ratio is 1, undervalued when the PEG ratio is below 1, and overvalued when above 1. PEG Ratio = (P/E) / g There are two approaches for the growth rate used: 1. Trailing PEG: In the first option, the growth rate can be based on a company's historical growth. For example, the LTM growth rate could be used, or the annualized growth rate over the past 3-5 years. 2. Forward PEG: The other, more commonly used option calculates the growth rate from a 1-3 year projection based on consensus estimates or an annualized version of those growth rates.