Accounting & Financial Statements1. If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?如果一家公司有了一个10刀的折旧费用（税前），这会怎么影响3个财务报表？
This is the most common version of this type of question. Note that the amount of depreciation may be a number other than $10. To answer this question, take the three statements one at a time.
First, the income statement: depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash+4) and shareholder’s equity decreased $6.
You may get the follow-up question: If depreciation is non-cash, explain how this transaction caused cash to increase $4. The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.
Valuation1. What are the three main valuation methodologies?
The three main valuation methodologies are (1) comparable company analysis, (2) precedent transaction analysis and (3) discounted cash flow (“DCF”) analysis.
2. Of the three main valuation methodologies, which ones are likely to result in higher/lower value?
Firstly, the Precedent Transactions methodology is likely to give a higher valuation than the Comparable Company methodology. This is because when companies are purchased, the target’s shareholders are typically paid a price that is higher than the target’s current stock price. Technically speaking, the purchase price includes a “control premium.” Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium and therefore likely result in a higher valuation than a public market valuation (minority interest based valuation methodology).
The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation than the Comparable Company analysis because DCF is also a control based methodology and because most projections tend to be pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or assumptions.
3. How do you use the three main valuation methodologies to conclude value?
The best way to answer this question is to say that you calculate a valuation range for each of the three methodologies and then “triangulate” the three ranges to conclude a valuation range for the company or asset being valued. You may also put more weight on one or two of the methodologies if you think that they give you a more accurate valuation. For example, if you have good comps and good precedent transactions but have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent Transaction analyses than on your DCF.
Discounted Cash Flow1. Walk me through a Discounted Cash Flow (“DCF”) analysis.请叙述一下贴现现金流分析。
In order to do a DCF analysis, first we need to project free cash flow for a period of time (say, five years). Free cash flow equals EBIT less taxes plus D&A less capital expenditures less the change in working capital. Note that this measure of free cash flow is unlevered or debt-free. This is because it does not include interest and so is independent of debt and capital structure.
Next we need a way to predict the value of the company/assets for the years beyond the projection period (5years). This is known as the Terminal Value. We can use one of two methods for calculating terminal value, either the Gordon Growth (also called Perpetuity Growth) method or the Terminal Multiple method. To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow forever. This growth rate should be modest, for example, average long-term expected GDP growth or inflation. To calculate terminal value we multiply the last year’s free cash flow (year 5) by 1 plus the chosen growth rate, and then divide by the discount rate less growth rate.
The second method, the Terminal Multiple method, is the one that is more often used in banking. Here we take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple. This most common metric to use is EBITDA. We typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months (LTM) basis.
Now that we have our projections of free cash flows and terminal value, we need to “present value” these at the appropriate discount rate, also known as weighted average cost of capital (WACC). For discussion of calculating the WACC, please read the next topic. Finally, summing up the present value of the projected cash flows and the present value of the terminal value gives us the DCF value. Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of Enterprise Value, not Equity Value.
2. What is WACC and how do you calculate it?什么是WACC？怎么计算？
The WACC (Weighted Average Cost of Capital) is the discount rate used in a Discounted Cash Flow (DCF) analysis to present value projected free cash flows and terminal value. Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile. The WACC reflects the cost of each type of capital (debt (“D”), equity (“E”) and preferred stock(“P”)) weighted by the respective percentage of each type of capital assumed for the company’s optimal capital structure. Specifically the formula for WACC is: Cost of Equity (Ke) times % of Equity (E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) + Cost of Preferred (Kp) times % of Preferred (P/E+D+P).
To estimate the cost of equity, we will typically use the Capital Asset Pricing Model (“CAPM”) (see the following topic).
To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies. Similar to the cost of debt, estimating the cost of preferred requires us to analyze the dividend yields on preferred stock issued by similar companies.
3. How do you calculate the cost of equity?
To calculate a company’s cost of equity, we typically use the Capital Asset Pricing Model (CAPM). The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium. The risk free rate (for a U.S. company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond. Beta (See the following question on Beta) should be levered and represents the riskiness (equivalently, expected return) of the company’s equity relative to the overall equity markets. The equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term. Prior to the credit crises, most banks tend to use an equity risk premium of between 4% and 5%. However, today is assumed that the equity risk premium is higher.
4. What is Beta?Beta是什么？
Beta is a measure of the riskiness of a stock relative to the broader market (for broader market, think S&P500, Wilshire 5000, etc.) By definition the “market” has a Beta of one (1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky. For example, if the market is expected to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will be expected to outperform by 11% while a stock with a Beta of 0.9 will be expected to outperform by 9%. A stock with a Beta of -1.0 would be expected to underperform the risk-free rate by 10%. Beta is used in the capital asset pricing model (CAPM) for the purpose of calculating a company’s cost of equity. For those few of you that remember your statistics and like precision, Beta is calculated as the covariance between a stock’s return and the market return divided by the variance of the market return.
Enterprise Value & Equity Value1. What is the difference between enterprise value and equity value?
Enterprise Value represents the value of the operations of a company attributable to all providers of capital. Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders.
2. How do you calculate the market value of equity?
A company’s market value of equity (MVE) equals its share price multiplied by the number of fully diluted shares outstanding.
3. What is the formula for Enterprise Value?
The formula for enterprise value is: market value of equity (MVE) + debt+ preferred stock + minority interest – cash.