Introduction To Financial Markets And Business Valuation PDF

Introduction to Financial Markets and Business Valuation Purpose of Business Businesses serve two main stakeholders: customers and investors The primary goal is to maximize value for investors Value is derived from future cash flows CASH FLOW IS IMPORTANT ( to do thr...

Introduction to Financial Markets and Business Valuation Purpose of Business Businesses serve two main stakeholders: customers and investors The primary goal is to maximize value for investors Value is derived from future cash flows CASH FLOW IS IMPORTANT ( to do three things ) Pay off debt Pay equity holders ( DIVIDENDS OR STOCK REPURCHASE) Reinvest in the business Business Value Maximization Value = Present value of future cash flows Businesses aim to either: 1. Return cash to investors 2. Reinvest for greater future profits Cash flow calculation: Cash Inflows (Revenue) - Cash Outflows (Costs)1 Financial Markets Capital - Money or cash invested and available for a business to run Two main types: 1. Money Markets( not very concerned about this ) Short-term lending and borrowing ( Intrinsic Value: Don’t invest! In other words, if the Asking Price < Present Value, then IRR > WACC if Asking Price > Present Value, IRR < WACC. Internal rate of return : The discount rate that brings NPV to 0. When not compared to the discount rate of other similar risk investments, the higher the IRR the better. It is the discount rate used in the NPV formula above that will make NPV 0. Think about it, if you need a higher IRR that means I am trying to decrease the present value of those cash flows, so that it breakeven my investment. This is because my current discount rate is low, so I already have a high present value of my future cash flows. If the bond is sold a discount IRR > Coupon rate If the bond is sold at a premium IRR< Coupon rate In this scenario the IRR would be 41%. If I discount all of the cash flows by 41 percent each year then I would get 20 dollars of present value. This means that even if investors are wanting a 41% rate of return on their investment, I will still have an NPV of 0. Now think about it in terms of investors. Even if i spend 20 dollars on an investment and I demand an internal rate of return of 40% on future cash flows, given tehse cash flows ( 41% IRR) I will still have positive NPV. So essentially this means that other similar risk alternatives have to be offering that 41% , for me to be operating at NPV of 0. If a company can not do anything to bring NPV to positive. This means they cant do anything to make their present value of future cash inflows and outflows a profit for them. Then they have to return money to shareholders through dividends or buybacks. NPV positive investments are only way to increase present value of future cash flow Businesses seek to make NPV positive investments to increase shareholder value. This makes sense because if I make it so that I can afford to have lower discount rates, that means my investors get a higher present value from investing in my business. LOWER DISCOUNT RATE IS BETTER, and LOWER DR means I will have a higher IRR( which is good) Return on Invested Capital (ROIC) is simply profits/invested capital It measures the reinvestment ability of my company (rate of return on an annual basis)- In the last example, 0.20 investment and $1 return, what would ROIC be? ROIC > WACC = NPV Positive ROIC < WACC = NPV Negative Think about it. My return on invested capital should be higher than my WACC( cost of capital). That means that the money i return from investments should be greater than the cost of my initial investment ( WACC). Bonds Current Yield: Current yield : It is just a measurement to see the how my annual coupon payment is in relation to the price my bond is CURRENTLY trading at YTM: Yield to Maturity is essentially the annual interest rate I would earn on my loan each year if I held it to maturity. It is like the coupon rate but it accounts for the the price you buy the bond at ( premium, discount or face value). Your Yield to Maturity (YTM) will be: Higher than the coupon rate if you buy the bond at a discount (below face value), since you’ll gain additional value when the bond matures at its face value. Lower than the coupon rate if you buy the bond at a premium (above face value), because you’ll incur a loss at maturity (the face value is less than what you paid). Equal to the coupon rate if you buy the bond at face value (par). In this case, there’s no gain or loss at maturity; your return consists only of the coupon payments. Summary: Discount bond → YTM > Coupon Rate Par bond → YTM = Coupon Rate Premium bond → YTM < Coupon Rate Think about it. My face value is just how much I will earn at maturity, so if my face value of a 5 year bond of $1000. Then at the end of 5 years Ill get paid $1000. But lets say i get a discount and buy the bond for 900, then my YTM will be higher than coupon rate, because I will need a greater interest rate on the $1000 to account for the money I saved with the discount. - - Accounting - LOOKING BACKWARDS IFRS: accounting principles outside of US GAAP: Generally accepted accounting principles Reports to the SEC: S1 : when they initially go public 10K: every year 10Q: quarterly report Accrual : When the good or service is provided It is pretty straightforward for when you are selling something, but what about buying. Essentially when I am buying something such as inventory, I do not want to put this expense on my balance sheet until I am actually selling my inventory. So even if lose cash in that month, I will not put it into my income statement until I have sold that inventory, so that my income statement is still accurate. Why accrual? So that companies can alter that income statement. Companies could just make customers pre pay them and alter their revenue. Instead accrual allows for you to see the actual value. Public traded companies have to release 3 every year Income Statement Income Statement - It reports increases in shareholders equity over a period of time, so revenue is an increase in SE, and expense is decrease in Se Revenue recognition : - Needs to be earned ( provided goods and services) - Realized( paid in cash or some kind of invoice) Expense recognition: - Is not an expense until goods and service is used to provide revenue (COGS) - If you can't make it directly involved in making revenue they would go under SGA  Income Statement (profit and loss): Top line (revenue) to bottom line (net income) Certain period Revenue ( top line) - COGS Gross Profit - Sales, General, Administrative (SG&A) Opex - Stock based compensation is under here - Marketing - Research and Development (R&D) - Depreciation and Amortization(D&A) Operating Profit (EBIT) + Asset write up + Gains ( More than book value) + Non-operating income - Loss ( Less than book value) - Asset write down or write off - Goodwill Impairment - Deferred interest and tax liabilities - Interest expense - PIK interest ( increase debt amount instead of paying interest rate). + Interest profit ( stocks, bonds , or dividends too) + Deferred interest and tax assets Pre-tax income (EBT) - Tax ( if pre tax increases I will decrease tax, if pre tax decreases I will increase tax) Net income(Bottom Line or Earnings) Some of these items, such as SBC, Amortization, Write-Downs, and Impairments, are not deductible for Cash-Tax purposes.So, instead of saying that Cash increases, it’s more accurate to say that the Deferred Tax Asset increases and then we would put a decrease in the deferred tax line item. Think about it. Sometimes these things arent deductible for that year because of various tax codes. So even if it is on income statement they may have to pay the taxable income before that is subtracted. Lets say 15,000. But technically when it is subtracted I should only be paying 7,500. This will give me a DTA of 7,500 for a later year. Depreciation is tangible assets. This is because things eventually lose value, as they require upgrades or replacements. Amortization is intangible assets. This is like patents, trademarks or software.This is because with patents, other competitors may come up with new products. Software may need to upgraded or replaced,Trademarks may lose bran appeal and may need more marketing  EBIDTA is calculated as you get EBIT( operating income) and you have to extrapolate D&A and add it back to operating income. As D&A is mixed into SGA/operating expenses. Gains or loss is just when you sell or gain an asset or liability for less than its book value. This can be really any asset or debt , or anything. Asset write down is when the book value of an asset goes down because of a hurricane or fire, and a write off is when the value goes down to 0. Goodwill Impairment. Goodwill is when the company decides that they bought, An asset or another company, something at a price that is higher than its book value. The Impairment is the realization which makes them decrease this realization that the asset was overvalued, and decrease this amount that they think it is overvalued by and decrease it. Gross margin/revenue = Gross Margins EBIT( Operating Profit) / Revenue = Operating Margin EBIT is simply Operating Income on the Income Statement, adjusted for any non-recurring or one-time charges (e.g., Impairments or Write-Downs if they’ve affected Operating Income). Balance Sheet Balance sheet : Assets and claims on those assets (liabilities and shareholders equity) Any point in time Assets : Resources owned by Business that are going to provide future benefits Must be a past exchange or transaction Reason for value Liabilities : Claims on those assets by creditors ( non-owners), an obligation to make a future payment good or service Obligation is based on benefits or services received currently or past Amount and timing is reasonable Stockholders Equity: Claims on assets by owners of business = Retained earnings(net income) + Contributed capital ( buying shares) Retained earnings is here because the money produced gets put back into the company which will increase the equity of the owners  Retained earnings : prior retained earnings + net income( rev- exp) - dividends Essentially saying that the money getting reinvested does not include the dividends I would be paying out to my owners. Dividends are not expenses, counted as dividend payable liability if not paid Contributed Capital : Preferred stock Preferred Stock tends to be more expensive than Debt, but cheaper than Common Equity because Preferred Coupon Rates tend to be higher than Interest Rates on Debt, but lower than average annualized returns on stocks. With preferred dividends you can subtract it from net income to make it net income to common. And then add that net income to common back to retained earnings. Essentially the same thing as common stock but instead of including it in CFF , you put into the income statement. Common Stock Only for par value of stock which is usually very low like a $1 Par value * # of shares in each issuance; the rest goes to APIC APIC: money paid anova par value for the stocks (Market Value – Par Value) * # of shares in each issuance Par value is the minimum dollar amount that the stock can be sold at Treasury stock is the amount bought back by the company. Because when I do a share buy back I am decreasing the amount of outstanding shares, I am decreasing equity thus its a minus. This can be a share buyback( buy it from open market) or stock repurchase ( buy it from current investors usually at a premium Assets ( debit accounts) Contra asset : Sits on the asset but is actually a credit account. Keeps track of reductions on assets: Accumulated depreciation and sometimes amortization PPE - D & A = net book value Land is not depreciated Straight line Depreciation: Depreciation expense= ( Original cost - salvage value)/ useful life SE and Liabilities ( credit ) Expenses ( contra shareholders equity account) Meaning dr. increases and cr. decreases but it still on the credit side Liabilities + Common stock + Preferred stock + Net income- Treasury stock+ APIC ( credit accounts) Shows overall financial health (totality of how its doing currently) Net change in cash Net PPE = Previous PPE - D&A Working Capital = Current Assets - Current Liabilities Net operating Working capital = Current Assets - Current Liabilities - debt - cash - financial investments This is because working capital is things that are being used for core operations, and debt and cash really aren't doing anything, they are rather just a balance. Operating Current Assets : Accounts receivable, inventory, prepaid expenses Operating Current lIabilities : accounts payable, accrued expenses, deferred revenue Assets Liabilities SE  + Net change in cash + Short termDebt + Common Stock + PPE ( reduced by Dep) + Deferred Revenue + Preferred Stock + Accounts receivable + Accounts Payable + APIC ( Additional Paid + Prepaid expenses + Accrued Expenses- in Capital) + Inventory + Interest Payable - Treasury Stock + Short term + Dividends Payable + Retained Earnings investments + Tax payable + Intangible assets( + Long term debt reduced by am) - Debt Pay Down + Goodwill Cash Flow Statement Best for valuations : Present and Future Value Cash Based Accounting : True cash from core business operations. NCA: Non Cash Assets : Parentheses on a cash flow statement means its being subtracted Depreciation and Amortization is added because even though the asset was decreased, their is no cash leaving us until we actually sell it. So since the income statement subtracted it, we have to add it back Inventory is subtracted. Think about it, we said that even for expenses of buying like lemonade inventory( lemons, water, sugar), those expenses are not recorded on the income statement until they sell that inventory. But cash floe statements adjusts this as these expenses is still a lost in cash Deferred Revenue is the opposite of prepaid expenses. This is for revenue that we gained even though we didnt do the good or service Accounts receivable u subtract because you didn't get that cash yet. And accounts payable you add because you didn't lose or pay that cash yet. Accrued Expenses is the opposite of prepaid expenses. These are expenses that are coming up in the future but haven't been paid yet. Capex is essentially when you buy a long term asset. But instead of putting that entire purchase of another factory, or another hotel or any capital producing asset, you would put a portion of it every year. This would spread it out over time making my cash flow statement not be overpowered by capex. Sale of LT assets, is just the selling of any cap ex or long term assets CFO ( Non cash ADJUSTMENTS and changes in Operating capital) Net Income + Depreciation amortization CFI (LONG TERM assets SELLING AND + Accounts payable BUYING) + Deferred revenue Net Income + Accrued expenses - Accounts receivable - Capital expenditures ( Plant, - Prepaid expenses property, Equipment) - Inventory - Purchase of securities - Deferred interest assets - Acquisitions - Deferred tax assets + Sales of Long term and short term + Deferred tax liabilities assets + Deferred interest liabilities CFF ( ways that business raise capital or + Losses repay stakeholders) + Interest gained ( stocks or bonds) Net income + Paid in kind(PIK) interest( adding more debt to pay off interest + Common Equity expense) + Preferred Equity + Goodwill impairment ( up to + APIC management) + Debt Issuance + Stock based compensation ( stocks - Dividends instead of wages, increases # of - Debt Paydown outstanding shares) - Share Buybacks - Gains - Repayment of Lease Principal - Interest paid - - Lease assets + Lease liabilities CFO + CFI + CFF = Net change in cash One big thing that we should be careful with EBITDA is that even if that is high we may not actually be receiving the cash. Because of things like inventory and accounts receivable, EBITDA may be inflated. Thus, looking at cash flow is essential to see if the company is actually receiving this money. An example is channel stuffing, which is when you try to raise accounts payable to inflate income statements. Earnings or net income however is a better metric for future cash flow because you can see if your business fundamentally will be able to focus on products and services for the future rather than just current cash flow of operations. Operating and Financial Leases : Under US GAAP you would find the present value of the lease. ( $147) Then you find the interest expense by doing the discount rate * lease liability to gte interest payment. You then subtract the rental monthly expense by the interest expense to see how much your asset and liability is changing every year. For Finance Leases under both accounting systems and Operating Leases under IFRS, companies record Interest Expense and Depreciation on the Lease, with Interest Expense equal to Discount Rate * Lease Liability, and Depreciation equal to Initial Lease Asset / Lease Term. The Lease Principal Repayment on the CFS equals the Cash Lease Expense – Interest Expense. For Operating Leases under U.S. GAAP, companies record a simple Rental Expense on the Income Statement, but they still “calculate” Interest Expense, Depreciation, and Lease Principal Repayment. Interest Expense = Discount Rate * Lease Liability. Depreciation = Cash Lease Expense – Interest Expense. And Lease Principal Repayment = Straight-Line Rental Expense on IS – Interest Expense. Deferred Tax Assets / Deferred Tax Liabilities If these three things occur: Companies may use accelerated Depreciation in earlier years to reduce their tax burden (and better reflect reality, in some cases). Some expenses may not be deductible for tax purposes, even though they’re listed on the Income Statement. The company might get tax credits from certain activities, such as research & development. NOL If I have deferred tax asset. Income statement Cash flow statement A L SE (50) (50) (25)DTA (75) =(75) 25(DTA) (50) If I have a deferred tax liability Income statement Cash flow statement A L SE  (50) (50) 25 DTL (25) 25 DTL =(25) (50) NOL( net operating loss) When a company has operated in a loss the previous year it can accumulate NOL. Then they can use that NOL money as a DTA to help reduce taxes when they start operating at a profit. Key Metrics &Ratios 1) “Cash Flow Proxy” Metrics – EBIT and EBITDA (and variations, such as EBITDAR). 2) Credit Metrics The Leverage Ratio (Total Debt / EBITDA) : tells you how much Debt a company has, relative to its ability to repay that Debt. Interest Coverage Ratio (EBITDA / Interest Expense) : how easily the company could pay for its current interest expense on the Debt. 3) Returns-Based Metrics ROE = Net Income (to Common) / Average (Common) Shareholders' Equity ROA = Net Income (to Common) / Average Total Assets ROIC = NOPAT / Average Invested Capital where NOPAT (Net Operating Profit After Taxes) = EBIT * (1 – Tax Rate), and Invested Capital = Equity + Debt + Preferred Stock + Other Long-Term Funding Sources. 4) Cash Conversion Metrics – Days Sales Outstanding, Days Inventory Outstanding, Days Payable Outstanding, and the Cash Conversion Cycle These metrics all measure how quickly it takes a company to collect receivables, sell inventory, or pay the amounts it owes to suppliers.Lower numbers is better Days Sales Outstanding (DSO) = Accounts Receivable / Revenue * Days in Year Days Inventory Outstanding (DIO) = Inventory / COGS * Days in Year Days Payable Outstanding (DPO) = Accounts Payable / COGS * Days in Year Together, these metrics create the “Cash Conversion Cycle” (CCC): DIO + DSO – DPO - Compare same firm across time : time-series analysis - Compare firm to other firms or to industry : cross-sectional analysis Return on Equity: Net Income/ Average Shareholder’s Equity -Measures ROI, which should increase with the risk of the company Depends on the level of investment needed to get the net income. Since net income happens over a period of time, and equity is one point in time we have to take the average of beginning and ending balance of equity in order to calculate ROE. Two Drivers of ROE = Operating Performance and Financial Leverage Operating performance is how effectively managers use assets to generate profits Return on Assets ( ROA) = De- Levered Net income/Average assets De-Levered Net Income = Net Income + (1-tax rate) x Interest Expense  Think about it for ROA, we want to take away the aspect of financial leverage. And in net income we have interest expenses which is affecting it, so we have to get rid of that variable ROA also has two drivers : profitability and efficiency Profitability : Return on Sales = Net Income/Sales Efficiency : Asset Turnover = Sales/Average Assets Financial leverage is how managers are using debt to increase available assets for a given level of shareholders equity Financial Leverage= Average assets/ Average Shareholders Equity Assets is always higher than equity, by making them a ratio we can see what portion of the assets are attributed to debt Profitability Margin Ratios Asset Turnover Ratios Liquidity Ratios Short Term Liquidity Ratios ( shows short term cash position) Does it have enough cash coming in to cover liabilities of next period : - Ideally ratios are over 1 - Current ratio = Current assets/ Current liabilities : But not all current assets are cash and can payout liabilities, thus.. - Quick Ratio= (cash + receivables)/Current liabilities - CFO/ Current Liabilities Does the company have enough cash from operations to cover interest obligations - Interest Coverage = ( Operating income before depreciation/interest coverage) - Cash Interest Coverage = ( Cash from operations + cash interest paid + cash taxes)/ Cash interest paid Long Term Liquidity Ratios( shows risk through their leverage) - Debt to Equity = Liabilities/ Shareholders’ Equity  - For every dollar of equity how much liabilities do i have - Long term-debt to equity = total long-term debt/ total stockholders equity ( how its financing its long term growth - For every dollar of equity how much long term debt am I financing - Long term debt/ ( total assets - intangible assets), trying to get a measure of for every dollar of asset that can have collateral ( tangible) how much debt am including ROA or financial leverage can both drive ROE up. To calculate ROE, we dont de lever net income to calculate ROA. Essentially Du pont allows us to see what is affecting our ROE : leverage, Profitability , or Efficiency Discount Retailers have low profitability but high asset turnover or good efficiency. Premium Retailers are the opposite, which as high profit and low efficiency. Multiples TEV / Revenue – Enterprise Value / Revenue TEV / EBIT – Enterprise Value / EBIT TEV / EBITDA – Enterprise Value / EBITDA TEV/EBIDTAR - includes operating leases P / E – Equity Value / Net Income or Price per Share / Earnings per Share Revenue is most useful when the company has negative numbers for EBIT and EBITDA, as wellas negative cash flow figures. Zendesk falls into this category: there’s no other way to value thecompany, so we have to use TEV / Revenue multiples. EBIT is sometimes closer to Free Cash Flow (Cash Flow from Operations – CapEx) because bothmetrics reflect the partial impact, or “after-effect,” of CapEx. So, if CapEx is more important for the company, or you want to reflect its partial impact because CapEx drives value in the sector, then EBIT may be more useful. EBITDA is sometimes closer to Cash Flow from Operations because both metrics completely exclude CapEx. So, you might use EBITDA when CapEx is less significant, or when you want to normalize otherwise similar companies that happen to have different CapEx and D&A policies. EBITDAR is used primarily to normalize companies with different types of leases (Operating vs. Capital) and to normalize companies following U.S. GAAP vs. IFRS. Net Income is not great for comparing companies, and it’s also not great for approximating their cash flows, so it’s useful mostly as a very quick metric that requires no calculations. Here’s a summary of the key points in this section (see the accompanying Excel file as well): A company can look significantly undervalued here because its Revenue Growth is higher than those of its peer companies, but both its Revenue multiples are significantly lower. Valuation VALUE OF ANY ASSET IS THE PRESENT VALUE OF ITS FUTURE CASH FLOWS Value Investing : Buying or investing when something is undervalued Stocks derive value based on the idea that they will get paid dividends. Some companies don't often pay dividends because they believe that they can return higher return if they reinvest money into their company, and eventually pay back higher dividends in the future. A lot of stocks wont pay dividends unless they believe that reinvesting wont provide a greater profit. Enterprise Value : market value of a company’s core operations. “The value of a company’s core business operations to ALL the investors in the company.” MV EV= MV Equity + MV Debt - Cash We are looking at the value of a company based solely on what it takes to operate.You want of think of it as if I were buy the enterprise how much I would pay I would need to pay for the equity and debt of that company, but I get the non-operating cash that comes with so that would be subtracted. Equity Value or Market Cap : Market value of company  The value of EVERYTHING a company has (Net Assets, or Total Assets – Total Liabilities), but only to EQUITY INVESTORS (common shareholders). Enterprise Value: The value of the company’s CORE BUSINESS OPERATIONS (Net MV Equity : Assets + Cash - MV Debt MV Equity = EV + cash - MV debt Essentially the expectations of a company's future cash flows. Think about it , if people think its future cash flow is going to be good, then share prices will go up. If share prices go up then the market cap will go up. That is why the expectations of a company's future cash flows are reflected by the Market Cap. Debt is normally stable. When a company is growing in cash it will result in an increase in equity. The only reason the market value of debt would go down is when equity shareholders are wiped out. Think about it in the pay back pyramid debt is paid first. But lets say equity is wiped out theoretically( or nearly 0 value because stocks will never trade at 0) because the company is unable to pay them. That is an indicator that the company may not be able to pay debt holders either. So then they would possibly trade at a discount. Since the starting point for Current Enterprise Value is Current Equity Value, you subtract NonOperating Assets and add Liability & Equity Items That Represent Other Investor Groups to make this move Equity Value = Market Value of Assets – Market Value of Liabilities Enterprise Value = Equity Value – Non-Operating Assets + Liability and Equity Items That Represent Other Investor Groups In levered DCF you already arrived at equity value.In a Levered DCF, the free cash flows to equity (FCFE) already account for the company's cash position1. The interest income generated from cash is factored into the FCFE projections. Non-operating assets: Financial Investments, such as stocks and bonds. Owned Properties from which the company earns rental income (rather than using the properties internally and generating no income from them).  Side Businesses that earn income for the company (e.g., an ice cream or Japanesewhiskey business owned by a software company). Assets Held for Sale and Assets Associated with Discontinued Operations. Equity Investments or Associate Companies, which represent minority stakes in other companies (the Parent Company owns < 50% of these other companies). Net Operating Losses (NOLs), which are a component of the Deferred Tax Asset. Liability and Equity: Debt and Preferred Stock mostly Capital leases Unfunded pensions Operation leases EV and Equity value implications Implication #1: Current Equity Value Cannot Be Negative, But Current Enterprise Value Can Be Negative Implication #2: Both the IMPLIED Equity Value and IMPLIED Enterprise Value Can Be Negative Company Value = ($100) / (3% – 2%) = ($10,000) Assuming that this is the cash flow to ALL investors (Unlevered Free Cash Flow) and that the Discount Rate is WACC, then the company’s Implied Enterprise Value is negative $10,000. If the company has $500 in Cash and no Debt, then its Implied Equity Value will also be Negative. You back into Implied Equity Value in this case, so there’s no reason why it can’t be negative. While this scenario is THEORETICALLY possible, it’s extremely unlikely in real life unless you’re analyzing distressed or highly speculative companies (e.g., tech or biotech startups). Implication #3: IN THEORY, Financing Events Do Not Affect Enterprise Value; Only Changes to the Company’s Core Business (i.e., Net Operating Assets) Affect Enterprise Value According to the theory behind it (the Modigliani–Miller theorem), financing events do NOT affect Enterprise Value. Here are a few examples (“TEV” = Enterprise Value): Issuing Debt: Won’t impact TEV; Cash and Debt both increase and offset each other. Repaying Debt: Won’t impact TEV; Cash and Debt both decrease and offset each other.  Issuing Stock: Won’t impact TEV; Cash and Equity Value both increase and offset each Other. Repurchasing Shares: Won’t impact TEV; Cash and Equity Value both decrease and offset each other. Issuing Dividends: Won’t impact TEV; Cash and Equity Value both decrease and offset each other Enterprise Value changes only if a company’s Net Operating Assets (i.e., its core business operations) changes. PP&E Increases: PP&E is an Operating Asset. No Operating Liabilities change, so Net Operating Assets (NOA) increases, and Enterprise Value increases. Inventory Increases: Inventory is an Operating Asset. No Operating Liabilities change, so Net Operating Assets (NOA) increases, and Enterprise Value increases. Accounts Receivable Decreases (due to cash collection): AR is also an Operating Asset,and no Operating Liabilities change. NOA decreases, so Enterprise Value decreases. Deferred Revenue Increases: This is an Operating Liability. No Operating Assets change, so when Deferred Revenue goes up, NOA goes down. Therefore, Enterprise Value decreases. 1. Equity Value changes only if Common Shareholders’ Equity changes; if it does, both CSE and Equity Value change by the same amount (at least in a simplified “interview question” setting). 2. Enterprise Value changes only if Net Operating Assets changes; if it does, both NOA and TEV change by the same amount (at least in a simplified “interview question” setting). a. This is true theoretically but if things like debt or equity change that can have an affect on our WACC which will cause a change in the implied enterprise value, but the fact that financing doesnt effect current enterprise value still stands. b. Thus : “Enterprise Value is less affected by capital structure than Equity Value.” Noncontrolling Interests are line items within Equity that represent what a company does not own when it owns a majority, but less than 100%, of another company. In the Equity Value to Enterprise Value bridge, you subtract Equity Investments and add Noncontrolling Interests. This is because equity investments are not a part of core operations, and enterprise value is only core so it is subtracted. You add non-controlling interests because minority stakeholders arent a part of equity value because equity value is only attributable to common shareholders. Therefore, you should always add Capital Leases in the Enterprise Value bridge and count them as Debt-like items; this also ensures consistency in the valuation multiples. We normally do not count Operating Leases in the TEV bridge so that EBIT and EBITDA remain valid metrics in the TEV / EBIT and TEV / EBITDA multiples. If you do count Operating Leases, then you must use EBITDAR and TEV Including Operating Leases / EBITDAR instead xIn the Enterprise Value bridge calculation, you subtract the on-Balance Sheet NOLs within the DTA, counting them as Non-Operating Assets. DTA: Subtracted because it is a non-operating asset that benefits shareholders outside of core operations. DTL: Not subtracted because it is an operational liability already accounted for in the company’s operating structure. Goodwill & Other Intangible Assets: Remember that these get created when a company acquires other companies. So, if the acquired companies are still part of this company’s operations, then these items count as Operating Assets! Therefore, you should not adjust for these in the TEV bridge. MYTH #3: Debt “Adds” to Enterprise Value, and Cash “Subtracts” from Enterprise Value Changes in debt doesnt change enterprise value because it is offessted by cash. Instead the debt is just added to get from equity value to enterprise value MYTH #4: You Subtract Cash When Calculating Enterprise Value Because It’s “The Opposite” of Debt No, no, no, and no. You subtract Cash when moving from Equity Value to Enterprise Value because it is a NonOperating or Non-Core Asset. Relative Valuation : Comparable assets and pricing it in relation Comparable company analysis. You compare the multiples of different assets. 1) Select the appropriate set of comparable companies. 2) Determine the metrics and multiples you want to use. 3) Calculate the metrics and multiples for all the companies. 4) Apply the median multiples (or the 25th or 75th or other percentile multiples) to your company to estimate its Implied Enterprise Value and Implied Equity Value. Precedent transactions : look at past M&A deals ans see what multiples they were bought or sold for 1) Select the appropriate set of comparable companies. 2) Determine the metrics and multiples you want to use. 3) Calculate the metrics and multiples for all the companies. 4) Apply the median multiples (or the 25th or 75th or other percentile multiples) to your company to estimate its Implied Enterprise Value and Implied Equity Value. Often, Precedent Transactions produce higher multiples than the Public Comps because of the control premium built into M&A deals. Such as EV/EBITDA or EV/Revenue Precedent Transactions: Since the average multiple is 14x. We can say based on relative valuation that that CRTR company is actually worth 14m instead of 13m. You are just multiplying 1 million by the 14x multiple. Intrinsic Valuation : Calculating present value based on future cash flows into perpetuity. Risk is also a key factor. The more risk there is there will be discounting at a higher rate, so the present value will be less. Present value of perpetuity : PV = Cash flow /Discount Rate PV = Cash flow / Discount rate - company growth rate = It would be around $100 Present value of a constant growth perpetuity = C/(r-g) R =interest rate g= growth C= cash flow you will get every year Discounted Cash Flow (DCF) - projects out future cash flows to perpetuity and discounts to present value How do you define Cash Flow? Free cash Flow : Cash flow from operations - Capex Levered Free cash flow: Net income + D&A - cap ex - working capital= FCF ( since you arent unlevering you can use net income as it calculates after interest and tax) Think about it, it is how much money i have coming from operations minus what I am using for other investments I need for the business such as machinery, property and construction. Then the difference will give me the cash available to reinvest or give to shareholders. They use free cash flow and discount to present value, to try to value how much a company is worth. If a company has a more heavy investing (CFI) that means a lot is being reinvested, where as if they aren't investing as much in CAPEX that means they are probably paying off debt and dividends maybe. The latter is for a company that is on the down. If a company has more depreciation of current assets in comparison to CAPEX, we can also infer that they don't have that many growth opportunities. If a company is decreasing accounts payable or prepaid expenses it could also indicate that they are reducing in size or not investing. Generally, you want to see a positive and growing FCF. Unlevered free cash flow ( discretionary cash flow , which means attributable to all investors): Unlevered means removing the effects of debt. Free means cash that we can use to pay investors ( debt or equity holders) that won't disrupt business operations. We are unlevereing because we don't want the amount of debt or equity a company has to define the companies core operations.  You are doing EBIT because this is before interest is subtracted, and thus you want to not account for debt but still apply the tax shield. You add back D&A because they are non-cash. You dont subtract interest because you want to ignore debt. You subtract capex and NWC because they are necessary for operations Change in Net working Capital = old NWC - new NWC If FCF is negative, that means the company is not running a sustainable business by itself – it's relying on outside financing to stay afloat! If net income is negative and FCF positive we can assume that they are largely dependent on stock based compensation or that they have large amounts of assets that are depreciating. Discount Rate The discount rate is the expected annualized retuern and also the opportunity cost of a similar risk investment. Think about it. By using the annualized return of another similar company I am saying that I expect atleast this annualized return from this company. It also the opportunity cost because that same rate is how much I can earn per year if I invested in that company. Discount projection period ( 5 -10 years) + Discount terminal value back to present value (less than 70% of the value of company) = Present value Discount projection Period : Unlevered free cash flow for projection period and discount it using WACC A higher Discount Rate means higher risk and potential returns; a lower Discount Rate means lower risk and 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. Terminal Value : Multiples method or Gordon Growth Method Exit Multiples Method - Multiplying final year of projection period metric by a multiple  - If year 10 EBIDTA is $1m and EV/EBIDTA is 10x fo similar companies, than terminal value of year 11 to infinity is $10m. Essentially a person in year 10 should be willing to pay 10m for the company for all the cash flows into perpetuity. You then discount this value back to PV If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense because it implies a growth rate that’s too high. Gordon Growth Method Perpetuity = cash flow/ discount rate Gordon Growth uses perpetuity formula but also accounts for growth. Formula : free cash flow * (1 + growth rate )/(discount rate - growth rate ) Average growth rate is 2%, shouldnt be more than the countries GDP WACC ( weighted average cost of capital) : It is the cost of capital for a business because it is essentially just how much they have to pay out to investors. Lower WACC means higher present value and lower risk. But if it is higher risk I will demand a higher WACC because I would want the present cost.Discount rate that I will use for a company. If IRR is greater than WACC it is a viable buy. Think about it IRR is how much it should be discounted to bring my NPV to 0. WACC is the cost of capital which is how much investors are requiring they should get from their investments. It is the same discount rate used to calculate NPV. So you would want the amount needed to bring my NPV to 0, to be higher than the current discount rate ( WACC). IRR> WACC + cost of preferred stock * % of preferred stock You are doing 1-tax rate(tax shield) because when you are doing the cost of debt. And since interest is tax deductible you are multiplying ( 1-tax rate) to essentially account for what you saved from subtracting interest. Cost of Debt : Expected rate of return for debt holders. - Total interest expense/average book value of debt( debt over the last two years) - Average YTM of companies debt ( best ) - YTM is IRR of a company debt ( the bond's annualized rate of return based on its current market price, interest payments, and face value. ) - Factors risk. - - Credit Spreads : baseline interest rate ( SOFR) Add the credit spread to baseline interest rate to get how much interest I should demand from the company Spreads are in relation to bond ratings Investment grade debt is when they have BB or above High yield bonds. Junk bonds have super high interest rate (usually cheap) Cost of Equity : rate equity investors require CAPM ( Capital Asset Pricing Model) : way to calculate equity Cost of Equity = Risk free Rate (RFR) +Levered Beta*( Market Return - RFR) Equity Risk Premium or Maarket Risk Premum = ( Market Return - RFR) Market return is normally S&P 500 or around 10. Beta shows a stock's volatility in relation to the S&P 500 and allows us to measure the risk of a particular stock in comparison to market Beta of 1: Moves with market Beta of -1: Moves opposite to market Beta of 2: A multiple of market movement (double)  So if S&P goes up 5%, then a stock with Beta 2 will go 10% Beta of 0: No correlation to market Levered Beta = Unlevered Beta * [1+ (D/E *( 1-tax rate))] Gold will have a negative beta because it moves opposite to S&P. When stock market is volatile gold is safer because it doesnt lose value based on the economy. Limited Supply of Gold Gold has a finite supply and cannot be printed or manufactured at will like money. This scarcity makes it less prone to devaluation from inflationary pressures 1. Take a bunch of comps levered betas and unlever them 2. Average it 3. Then relever to the company specific cap structure Co-variance of the stock against the S&P Covariance(Security, Market)/ Var(Market) Bloomberg or Factset This makes sense because if it moves with the market my equity risk premium shouldnt be higher. If it moves opposite my equity risk premium should be lower an make cost of equity lower. And if it moves a multiple of it than it should make my equity premium higher and thus my cost of equity. Levered Beta : risk if a stock by comparing into entire stock market Levered beta means you account for debt. Overall Impact and Key Drivers The Discount Rate and Terminal Value make the biggest impact on the DCF output. That’s because the Discount Rate affects everything and because the PV of the Terminal Value often represents over 50% of the company’s Implied Enterprise Value. Company Size and Geography Smaller companies tend to be riskier – they have higher growth potential but also a higher chance of failing. As a result, they tend to have a higher Cost of Equity, Cost of Debt, and WACC than larger companies. Similarly, companies in emerging markets also tend to be riskier, with higher growth potentialbut also a higher risk of failure because of geopolitical factors. So, the Cost of Equity, Cost of Debt, and WACC will be higher, and the DCF will tend to produce lower values. Debt and Equity As a company uses more Debt, its Cost of Debt and Cost of Equity always increase. More Debt makes the company riskier for everyone and increases the chance of bankruptcy, which is bad for all investors. The tricky part is that WACC initially decreases when a company goes from no Debt or minimal Debt to some Debt, but then it starts increasing. Debt is cheaper than Equity, but past a certain point, the additional risk of Debt starts to outweigh its cost benefits: Risk-Free Rate  A higher Risk-Free Rate (i.e., if government bonds in the country start offering higher yields) increases the Cost of Equity and Cost of Debt, and, therefore, WACC. Equity Risk Premium A higher Equity Risk Premium increases the Cost of Equity and WACC because the stock market is expected to return a higher percentage above the Risk-Free Rate. Beta This one works the same way as the ERP above: a higher Beta increases the Cost of Equity and WACC and reduces a company’s Implied Value, and a lower Beta does the opposite. Tax Rate Assuming that the company has Debt, a higher tax rate reduces the Cost of Debt because it increases the tax benefits. However, the company’s Implied Value from a DCF usually decreases because a higher tax rate also reduces the company’s Free Cash Flow. That FCF reduction tends to make a bigger impact than these changes to the Discount Rate, especially since lower FCF also means a lower Terminal Value. Signs of Trouble 1. Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of the company’s total Implied Value, but it shouldn’t represent 95% of its value. 2. Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country’s long-term GDP growth rate is 3%, something is wrong. LBO( Leveraged Buyout) 1. After raising capital from outside investors, the private equity business model works like this: 2. PE firms search for companies that might be undervalued or misunderstood and that could produce high returns if managed properly. a. After size and price, an ideal LBO candidate must also be able to service its Debt, so stable cash flows are extremely important. b. A pre-revenue biotech or tech startup is the worst possible leveraged buyout candidate because it’s extremely risky and does not yet have positive cash flows. 3. Then, just like a real estate investor might buy a house using a down payment and a mortgage, the PE firm uses Cash (called “Investor Equity”) and Debt to buy a company. a. When a PE firm acquires a company, it does not “own” the company directly. b. Instead, the PE firm typically forms a “holding company,” which it owns, and this “holding company” acquires the real company. 4. The private equity firm runs the company for several years and makes “improvements,” ike the renovations that a real estate investor might make. 5. Eventually, the PE firm sells the company and uses the proceeds to repay the remaining Debt it borrowed to buy the company. If all goes well, it will earn back a multiple of its 6. Investor Equity and earn a high internal rate of return (IRR). Since money today is worth more than money tomorrow, this upfront savings of $400K affects the returns far more than the reduced cash flow in Years 1 – 5 and the reduced sale proceeds. It is financed through both secured and unsecured debt. You can build a simple LBO model in 3 steps: 1) Set up the transaction assumptions, including the Purchase Price and Sources & Usesmschedule (this section of the guide focuses on this step). 2) Project the company’s cash flows and Debt repayment (covered in Key Rule #3). 3) Make the exit assumptions, calculate the IRR and money-on-money multiple, and assess the returns drivers (covered in Key Rule #4). For public companies, the Purchase Price is based on a premium to the company’s current share price, its “undisturbed” share price, or its average price over a certain period. Leverage Ratio Calculation EBITDA Purchase Multiple: 12.0x Purchase Enterprise Value: $600M Therefore, Company's EBITDA = $600M ÷ 12.0 = $50M Debt Sizing Using Leverage Ratio( DEBT/EBIDTA) Leverage Ratio: 5.0x EBITDA Maximum Debt = EBITDA × Leverage Ratio $50M × 5.0 = $250M of debt capacity Impact on Capital Structure Total Purchase Price: $600M Debt Used: $250M (based on 5.0x leverage) Equity Needed: $350M Debt Service Analysis Annual Interest Payment = Debt × Interest Rate $250M × 5.0% = $12.5M annual interest expense Once you have the transaction assumptions and the post-deal capital structure, you can project the company’s cash flows and Debt repayment - The Interest payment slowly goes down as debt is being paid back For a private equity firm to realize an acceptable IRR, it must exit its investment in the company. The three main exit strategies in leveraged buyouts are: 1) M&A – Sell the company to another company or a different private equity firm within the next 3 – 7 years. ( PREFERRED) 2) IPO – Take the company public and sell the stake gradually over time. 3) Ongoing Dividend Recap AKA “Hotel California” – The PE firm never “sells” the company but instead has the company issue Dividends continually. Eventually, if these Dividends get big enough, quickly enough, the firm might realize acceptable returns. Most private equity firms target specific ranges for the IRR and MoM multiple, and these tables help you assess the outcomes in different scenarios. For example, a middle-market private equity firm might plan to hold companies for an average of 5 years and aim for the following financial results: Downside Case: Minimum of a 1.5x MoM multiple, with no specific minimum IRR. Base Case: A 2.0x MoM multiple and a 15% IRR. Upside Case: A 3.0x MoM multiple and a 25% IRR. There are other ways to approximate the IRR as well; for example, you could use the “Rule of 72” to determine the years required to 2x your money at different IRRs (e.g., 72 / 8 = 9, so it takes 9 years to 2x your money at an 8% IRR). Sources Side (Where Money Comes From) New Debt Financing Investor Equity Rollover Equity (if any) Existing Cash (in some cases) Uses Side (Where Money Goes) Purchase Price (Enterprise Value) Transaction Fees Advisory fees Debt issuance fees Legal fees Minimum Cash Requirements Debt Payoff (if applicable) The fundamental rule is that Sources must equal Uses - meaning all the money coming in (Sources) must be accounted for in how it's spent (Uses). In a cash free debt free buyout, all the targets company debt is paid off. And the cash is subtracted when purchased. 2. What IRR and MoM multiple do PE firms typically target? Most private equity firms aim for an IRR of at least 20%, about twice what public equity markets in developed countries have returned historically. The targeted multiple depends on the time frame of each investment, but a 20% IRR over 5 years equates to a 2.5x multiple, so many firms target multiples in that range. I f the firm holds companies for longer periods – say, 7 years on average – it may need to target a higher multiple, such as 3.5x (a ~20% IRR over 7 years). Most firms also target different numbers for the Base, Upside, and Downside cases and aim to avoid losing money no matter what happens. - LFCF (Levered free cash flow - legered/leverage = debt - Cash flow left only left to only equity holders LBO is a similar valuation method of using multiples. But with this method it accounts for buying the company with majority debt. It uses the same EV/EBIDTA and multiplies EBIDTA by the last year. Assume the company will be sold at the end of the holding period: ○ Exit Enterprise Value Use comparable multiples or adjust based on market trends. ○ Equity Value at Exit: Two ways they make money: MOIC (Multiple on Invested Capital): IRR (Internal Rate of Return): The cash flow from the company pays off the debt. So they continue to increase the equity they have of the company.So the new cap structure they will make assumptions for which they will use to calculate the exit multiple. Adjusted Present Value (APV) 1. In adjusted present value its similar to DCF but you calculate the unlevered value of the company through unlevered free cash flow and cost of equity for discount rate. 2. Then you find the interest tax shield and find the present value of that using cost of debt. 3. Then you sum up those to values to get the total projected value of the company Sum of the Parts Valuing each segment of the business Dividend Discount Model Modeling valuation based on projected dividends Net Asset Vaue Take all the assets Pros v Cons Valuation 3 determinants: Equity Risk Premium ( ERP) : amount I am expecting from a company on top of S&P( market value of S&P- RFR) Higher WACC means more risk Why leveraged beta? Why do you unlevered cash flow ? Why do you do 1-tax rate in WACC? What is MV of debt and MV of equity vs just debt and equity? $10 WSFM questions Can coe be lower than cost of debt Find YTM initially down because of tax shield, but the incremental risk of bankruptcy will outweigh incremental tax savings. The decrease is because of the 1-tax or the tax shield. Can a company ever have a negative equity value? No, the equity value will never be 0 or less because there will be option values. Multiples will give you comparables to companies, gordon growth assumes constant growth. What will create more value in DCF : cap ex, revenue or Dand A. It would be Cap ex because it directly affects the free cash flow. D& A is just added back when it was already subtracted. Equity over debt, if your cash flow you may not be able to pay back investors. You can pay employees through stock distributions Stock is good when undervalued. Business is good when they have high ROIC..com bubble slow down in 2001, financial crisis , covid. EV/EBIDTA growing and then bankrupt Debt becomes too high All debt matures on one day Too much capex  Embezzlement Rfr 4 Lev beta 1.5 ERP 6 Interest 10% Year 1 8% 30% debt 70 % equity 70% (4% + 1.5 (6) )+ 30% (9%) 0.7* 13% + 9.1% + 2.7% 11.8% 1.2 * ( 1+3 *(.8) 100 135 140 200 270 3& 8%