IB 400 Question Guide

What do bankers really do?

bankers advise companies on transactions - buying and selling other companies, and raising capital. They are "agents" that connect a company with the appropriate buyer, seller, or investor. The day-to-day work involves creating presentations, financial analysis and marketing materials such as Executive Summaries.

Let's say I'm working on an IPO for a client. Can you describe briefly what I would do?

1. Meet with the client and gather basic information - such as their financial details, an industry overview, and who their customers are.

2. Meet with other bankers and the lawyers to draft the S-1 registration statement - which describes the company's business and markets it to investors.

3. you spend a few weeks going on a "road show" where you present the company to institutional investors and convince them to invest.

4. the company begins trading on an exchange once you've raised the capital from investors.

What's in a pitch book?

1. Bank "credentials" (similar deals they have done)

2. Summary of a company's strategic alternatives (options)

3. Valuation and financial models

4. Potential acquisition targets or potential buyers (This is not applicable for equity/debt deals)

5. Summary and key recommendations.

How do companies select the bankers they work with?

This is usually based on relationships - banks develop relationships with companies over the years before they need anything, and then when it comes time to do a deal, the

company calls different banks it has spoken with and asks them to "pitch" for the business. This is called a "bake-off" and the company selects the "winner" afterward.

Walk me through the process of a typical sell-side M&A deal.

1. Meet with company, create initial marketing materials (pitchbooks, CIMs, teasers) and decide on potential buyers

2. Send out Executive Summary to potential buyers to gauge interest.

3. Send NDAs (Non-Disclosure Agreements) to interested buyers along with more detailed information like the Offering Memorandum, and respond to any follow-up due diligence requests from the buyers.

4. Set a "bid deadline" and solicit written Indications of Interest (IOIs) from buyers.

5. Select which buyers advance to the next round.

6. Continue responding to information requests and setting up due diligence meetings between the company and potential buyers.

7. Set another bid deadline and pick the "winner."

8. Negotiate terms of the Purchase Agreement with the winner and announce the deal.

Walk me through the process of a typical buy-side M&A deal.

1. Spend a lot of time upfront doing research on dozens or hundreds of potential acquisition targets, and go through multiple cycles of selection and filtering with the company you're representing.

2. Narrow down the list based on their feedback and decide which ones to approach.

3. Conduct meetings and gauge the receptivity of each potential seller.

4. As discussions with the most likely seller become more serious, conduct more in-depth due diligence and figure out your offer price.

5. Negotiate the price and key terms of the Purchase Agreement and then announce the transaction.

How are Equity Capital Markets (ECM) and Debt Capital Markets (DCM) different from M&A or industry groups?

ECM and DCM are both more "markets-based" than M&A.

In M&A your job is to execute sell-side and buy-side transactions,

Whereas in ECM/DCM most of your tasks are related to staying on top of the market, following current trends, and making recommendations to industry and product groups for clients and pitch books.

What's the difference between DCM and Leveraged Finance?

DCM is more related to following market trends while LevFin is more modeling intensive and consists of more deal execution

Explain what a divestiture is.

It's when a company (public or private) decides to sell off a specific division rather than sell the entire company.

The process is very similar to the sell-side M&A process above, but it tends to be "messier" because you're dealing with a part of one company rather than the whole thing. Valuations for only part of a company is trickier than the entire company

Imagine you want to draft a 1-slide company profile for an investor. What would you put there?

Name of the company in the header and then divide into 4 parts.

1. business description, key execs, headquarters

2. a stock chart and the key historical and projected financial metrics and multiples

3. description of products or services

4. key geographies

Why Banking?

1. I really enjoy understanding how big companies work, and IB is one of the few places where you can get that exposure early in your career

2. when a business owner acquires a company or sells their company it is one of the biggest decisions they will ever make and I feel it would be a great experience to help someone through that process.

3. there are so many great people to learn from and make long term relationships with in the industry.

What's your greatest fear about investment banking?

I would probably say putting a lot of work into a certain deal over many months and then having it fall through.

Walk me through the 3 financial statements.

IS - The Income Statement gives the company's revenue and expenses, and goes down to

Net Income, the final line on the statement.

BS - The Balance Sheet shows the company's Assets - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and

Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity.

CF - The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash."

Can you give examples of major line items on each of the financial statements?

IS - Revenue, COGS, SG&A, Operating Income, Pretax Income, Net Income

BS - Assets (Cash, AR, Inventory) Liabilities (AP, Debt) Equity (RE, Common Stock)

CF - Net Income, D&A, Cash Flows from Operating Financing and Investing, Beginning and Ending Cash

How do the 3 statements link together?

Net Income from the Income Statement is the first line of the cash flows statement and is also a part of shareholders equity on the balance sheet.

Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders' Equity.

The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash flowing in from the final line on the Cash Flow Statement

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that's the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?

Income Statement and Balance Sheet because you create the cash flows statement using them

Walk me through how Depreciation going up by $10 would affect the statements.

- First Operating Income would go down by $10 and then assuming a 40% tax rate NI would go down by $6.

- because net income is the first line of the cash flows statement, net income would go down by $6, but the $10 depreciation would get added back as its a non cash expense

- Net change in cash would go up by $4 because of this

- PP&E would go down by $10 bc of depreciation and cash would go up by $4 so total assets is down by $6

- Since NI went down by $6, Retained earnings under SE would go down by $6 too which would balance the BS

If Depreciation is a non-cash expense, why does it affect the cash balance?

because depreciation is tax deductible, which reduces cash outflow from income taxes

Where does Depreciation usually show up on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

What happens when Accrued Compensation goes up by $10?

- accrued compensation is an expense

- Pretax income goes down by $10 and assuming a 40% tax rate Net Income is down by $6

- NI on cash flows statement is down by $6 but $10 accrued compensation is added back to cash from operations so overall net change is cash is up $4

- On BS, cash is up by $4 and on the other side Liabilities is up by $10 and Retained Earnings under SE is down by $6 due todecrease in NI

What happens when Inventory goes up by $10, assuming you pay for it with cash?

- nothing happens to IS

- Cash flows are down by $10 (from operations)

- on BS, cash goes down by $10 but inventory is up by $10 so it cancels out

Why is the Income Statement not affected by changes in Inventory?

the expense is only recorded on the IS when it is sold and becomes part of COGS or operating expense

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common to see this in 2 scenarios:

1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative.

2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders' Equity.

What is working capital? How is it used?

Working Capital = Current Assets - Current Liabilities.

If it's positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound."

What does negative Working Capital mean? Is that a bad sign?

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.

2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.

3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don't pay quickly and upfront and the company is carrying a high debt balance).

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write-down of $100.

First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income

line. With a 40% tax rate, Net Income declines by $60.

On the Cash Flow Statement, Net Income is down by $60 but the write-down is a non-

cash expense, so we add it back - and therefore Cash Flow from Operations increases by

$40. Overall, the Net Change in Cash rises by $40.

On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it's not clear

which asset since the question never stated the specific asset to write-down). Overall, the

Assets side is down by $60.

On the other side, since Net Income was down by $60, Shareholders' Equity is also

down by $60 - and both sides balance.

Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most

common scenario here is an equity investment from the government, so here's what

happens:

No changes to the Income Statement.

On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100.

On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side,

Shareholders' Equity would go up by $100 to make it balance.

Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a

company's balance sheet and how it affects the 3 statements.

This is counter-intuitive. When a liability is written down you record it as a gain on the

Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by

$100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60.

On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt

write-down - so Cash Flow from Operations is down by $40, and Net Change in Cash is

down by $40.

On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side,

Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was

up by $60 - so Liabilities & Shareholders' Equity is down by $40 and it balances.

When would a company collect cash from a customer and not record it as revenue?

Companies that agree to services in the future often collect cash upfront to ensure stable revenue - this makes investors happy as well since they can better predict a company's performance.

Per the rules of GAAP (Generally Accepted Accounting Principles), you only record revenue when you actually perform the services - so the company would not record everything as revenue right away.

If cash collected is not recorded as revenue, what happens to it?

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.

Over time, as the services are performed, the Deferred Revenue balance "turns into" real revenue on the Income Statement.

What's the difference between accounts receivable and deferred revenue?

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

28. Let's say a customer pays for a TV with a credit card. What would this look like

under cash-based vs. accrual accounting?

In cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet.

In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would "turn into" Cash.

How do you decide when to capitalize rather than expense a purchase?

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

30. Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative.

2. The company has high interest expense and is no longer able to afford its debt.

3. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash completely when paying back the debt.

4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement (see: eBay/Skype). It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios:

1. The company gets acquired or bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price in an acquisition.

2. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number.

Why do we look at both Enterprise Value and Equity Value?

Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors).

You look at both because Equity Value is the number the public-at-large sees, while

Enterprise Value represents its true value.

When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value, because that's how much an acquirer really "pays" and includes the often mandatory debt repayment.

What's the formula for Enterprise Value?

EV = Equity Value + Debt + Preferred Stock + Minority Interest - Cash

Why do you need to add Minority Interest to Enterprise Value?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial performance. In keeping with the "apples-to-apples" theme, you must add Minority Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

How do you calculate fully diluted shares?

Take the basic share count and add in the dilutive effect of stock options and warrants, convertible debt or convertible preferred stock.

To calculate the dilutive effect of options, you use the Treasury Stock Method (detail on this below).

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also

has 10 options outstanding at an exercise price of $5 each - what is its fully diluted

equity value?

Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all "in-the-money" - their exercise price is less than the current share price. When these options are exercised, there will be 10 new shares created - so the share count is now 110 rather than 100.

However, that doesn't tell the whole story. In order to exercise the options, we had to "pay" the company $5 for each option (the exercise price). As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created. So the fully diluted share count is 105, and the fully diluted equity value is $1,050.

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also

has 10 options outstanding at an exercise price of $15 each - what is its fully diluted

equity value?

$1,000. In this case the options' exercise price is above the current share price, so they

have no dilutive effect.

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

Cash is subtracted because it's considered a non-operating asset and because Equity Value implicitly accounts for it. It's not always accurate because technically you should be subtracting only excess cash - the amount of cash a company has above the minimum cash it requires to operate.

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price. However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I've personally never seen it, but once again "never say never" applies.

Could a company have a negative Enterprise Value? What would that mean?

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with:

1. Companies on the brink of bankruptcy.

2. Financial institutions, such as banks, that have large cash balances.

Could a company have a negative Equity Value? What would that mean?

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

Why do we add Preferred Stock to get to Enterprise Value?

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company's assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

How do you account for convertible bonds in the Enterprise Value formula?

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they're out-of-the-money then you count the face value of the convertibles as part of the company's Debt.

A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?

First, note that these convertible bonds are in-the-money because the company's share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt.

Next, we need to divide the value of the convertible bonds ($10 million) by the par value ($1,000) to figure out how many individual bonds we get: $10 million / $1,000 = 10,000 convertible bonds.

Next, we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: $1,000 / $50 = 20 shares per bond. So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding.

What's the difference between Equity Value and Shareholders' Equity?

Equity Value is the market value and Shareholders' Equity is the book value.

What are the 3 major valuation methodologies?

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Rank the 3 valuation methodologies from highest to lowest expected value.

there is no ranking that always holds. In general, Precedent

Transactions will be higher than Comparable Companies due to the Control Premium

built into acquisitions.

Beyond that, a DCF could go either way and it's best to say that it's more variable than

other methodologies. Often it produces the highest value, but it can produce the lowest

value as well depending on your assumptions.

When would you not use a DCF in a Valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies.

What other Valuation methodologies are there?

Other methodologies include:

- Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive

- Replacement Value - Valuing a company based on the cost of replacing its assets

- LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range

- Sum of the Parts - Valuing each division of a company separately and adding them together at the end

- M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth

- Future Share Price Analysis - Projecting a company's share price based on the P/E multiples of the public company comparables, then discounting it back to its present value

When would you use a Liquidation Valuation?

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company's debts have been paid off. It is often used to advise struggling businesses on whether it's better to sell off assets separately or to try and sell the entire company.

When would you use Sum of the Parts?

This is most often used when a company has completely different, unrelated divisions -

a conglomerate like General Electric, for example.

When do you use an LBO Analysis as part of your Valuation?

Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also

used to establish how much a private equity firm could pay, which is usually lower than

what companies will pay.

It is often used to set a "floor" on a possible Valuation for the company you're looking at.

What are the most common multiples used in Valuation?

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price /

Earnings per Share), and P/BV (Share Price / Book Value).

What are some examples of industry-specific multiples?

Technology (Internet): EV / Unique Visitors, EV / Pageviews

Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation,

Amortization & Rent)

Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D =

MCFE per Day), P / NAV (Share Price / Net Asset Value)

Real Estate Investment Trusts (REITs): Price / FFO, Price / AFFO (Funds From

Operations, Adjusted Funds From Operations)

Technology and Energy should be straightforward - you're looking at traffic and energy

reserves as value drivers rather than revenue or profit.

For Retail / Airlines, you often remove Rent because it is a major expense and one that

varies significantly between different types of companies.

When you're looking at an industry-specific multiple like EV / Scientists or EV /

Subscribers, why do you use Enterprise Value rather than Equity Value?

You use Enterprise Value because those scientists or subscribers are "available" to all the

investors (both debt and equity) in a company. The same logic doesn't apply to

everything, though - you need to think through the multiple and see which investors

the particular metric is "available" to.

Would an LBO or DCF give a higher valuation?

Technically it could go either way, but in most cases the LBO will give you a lower valuation.

Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you're only valuing it based on its terminal value.

With a DCF, by contrast, you're taking into account both the company's cash flows in between and its terminal value, so values tend to be higher.

Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

How would you present these Valuation methodologies to a company or its

investors?

Usually you use a "football field" chart where you show the valuation range implied by

each methodology. You always show a range rather than one specific number.

Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise

Value / EBITDA?

because Equity Value

does not reflect the company's entire capital structure - only the part available to equity

investors.

When would a Liquidation Valuation produce the highest value?

This is highly unusual, but it could happen if a company had substantial hard assets but

the market was severely undervaluing it for a specific reason (such as an earnings miss

or cyclicality).

As a result, the company's Comparable Companies and Precedent Transactions would

likely produce lower values as well - and if its assets were valued highly enough,

Liquidation Valuation might give a higher value than other methodologies.

Let's go back to 2004 and look at Facebook back when it had no profit and no

revenue. How would you value it?

You would use Comparable Companies and Precedent Transactions and look at more

"creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than

EV/Revenue or EV/EBITDA.

You would not use a "far in the future DCF" because you can't reasonably predict cash

flows for a company that is not even making money yet.

This is a very common wrong answer given by interviewees. When you can't predict

cash flow, use other metrics - don't try to predict cash flow anyway!

What would you use in conjunction with Free Cash Flow multiples - Equity Value

or Enterprise Value?

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for

Levered Free Cash Flow you would use Equity Value.

Remember, Unlevered Free Cash Flow excludes Interest and thus represents money

available to all investors, whereas Levered already includes Interest and the money is

therefore only available to equity investors.

Debt investors have already "been paid" with the interest payments they received.

You never use Equity Value / EBITDA, but are there any cases where you might

use Equity Value / Revenue?

Never say never. It's very rare to see this, but sometimes large financial institutions

with big cash balances have negative Enterprise Values - so you might use Equity Value

/ Revenue instead.

You might see Equity Value / Revenue if you've listed a set of financial and non-

financial companies on a slide, you're showing Revenue multiples for the non-financial

companies, and you want to show something similar for the financials.

Note, however, that in most cases you would be using other multiples such as P/E and

P/BV with banks anyway.

How do you select Comparable Companies / Precedent Transactions?

1. Industry classification

2. Financial criteria (Revenue, EBITDA, etc.)

3. Geography

For Precedent Transactions, you often limit the set based on date and only look at

transactions within the past 1-2 years.

The most important factor is industry - that is always used to screen for

companies/transactions, and the rest may or may not be used depending on how specific

you want to be.

How do you apply the 3 valuation methodologies to actually get a value for the

company you're looking at?

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take

the median multiple of a set of companies or transactions, and then multiply it by the

relevant metric from the company you're valuing.

Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x

and your company's EBITDA is $500 million, the implied Enterprise Value would be $4

billion.

To get the "football field" valuation graph you often see, you look at the minimum,

maximum, 25th percentile and 75th percentile in each set as well and create a range of

values based on each methodology.

What do you actually use a valuation for?

Usually you use it in pitch books and in client presentations when you're providing

updates and telling them what they should expect for their own valuation.

It's also used right before a deal closes in a Fairness Opinion, a document a bank creates

that "proves" the value their client is paying or receiving is "fair" from a financial point

of view.

Valuations can also be used in defense analyses, merger models, LBO models, DCFs

(because terminal multiples are based off of comps), and pretty much anything else in

finance.

Why would a company with similar growth and profitability to its Comparable

Companies be valued at a premium?

This could happen for a number of reasons:

• The company has just reported earnings well-above expectations and its stock price

has risen recently.

• It has some type of competitive advantage not reflected in its financials, such as a

key patent or other intellectual property.

• It has just won a favorable ruling in a major lawsuit.

• It is the market leader in an industry and has greater market share than its

competitors.

What are the flaws with public company comparables?

• No company is 100% comparable to another company.

• The stock market is "emotional" - your multiples might be dramatically higher

or lower on certain dates depending on the market's movements.

• Share prices for small companies with thinly-traded stocks may not reflect their

full value.

How do you take into account a company's competitive advantage in a valuation?

1. Look at the 75th percentile or higher for the multiples rather than the Medians.

2. Add in a premium to some of the multiples.

3. Use more aggressive projections for the company.

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

There's no "rule" that you have to do this, but in most cases you do because you want to

use values from the middle range of the set. But if the company you're valuing is

distressed, is not performing well, or is at a competitive disadvantage, you might use the

25th percentile or something in the lower range instead - and vice versa if it's doing well.

You mentioned that Precedent Transactions usually produce a higher value than

Comparable Companies - can you think of a situation where this is not the case?

Sometimes this happens when there is a substantial mismatch between the M&A market

and the public market. For example, no public companies have been acquired recently

but there have been a lot of small private companies acquired at extremely low

valuations.

For the most part this generalization is true but keep in mind that there are exceptions to

almost every "rule" in finance.

What are some flaws with precedent transactions?

• Past transactions are rarely 100% comparable - the transaction structure, size of

the company, and market sentiment all have huge effects.

• Data on precedent transactions is generally more difficult to find than it is for

public company comparables, especially for acquisitions of small private

companies.

28. Two companies have the exact same financial profile and are bought by the same

acquirer, but the EBITDA multiple for one transaction is twice the multiple of the

other transaction - how could this happen?

1. One process was more competitive and had a lot more companies bidding on the

target.

2. One company had recent bad news or a depressed stock price so it was acquired at a

discount.

3. They were in industries with different median multiples.

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Warren Buffett once famously said, "Does management think the tooth fairy pays for

capital expenditures?"

He dislikes EBITDA because it excludes the often sizable Capital Expenditures

companies make and hides how much cash they are actually using to finance their

operations.

In some industries there is also a large gap between EBIT and EBITDA - anything that is

very capital-intensive, for example, will show a big disparity.

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's

profitability. What's the difference between them, and when do you use each one?

P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA

are capital structure-neutral. Therefore, you use P / E for banks, financial institutions,

and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it -

you're more likely to use EV / EBIT in industries where D&A is large and where capital

expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in

industries where fixed assets are less important and where D&A is comparatively

smaller (e.g. Internet companies).

If you were buying a vending machine business, would you pay a higher multiple

for a business where you owned the machines and they depreciated normally, or one

in which you leased the machines? The cost of depreciation and lease are the same

dollar amounts and everything else is held constant.

You would pay more for the one where you lease the machines. Enterprise Value would

be the same for both companies, but with the depreciated situation the charge is not

reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a

result. For the leased situation, the lease would show up in SG&A so it would be

reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

How do you value a private company?

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:

• You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you're valuing is not as "liquid" as the public comps.

• You can't use a premiums analysis or future share price analysis because a private company doesn't have a share price.

• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.

• A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would probably just estimate WACC based on the public comps' WACC rather than trying to calculate it.

Let's say we're valuing a private company. Why might we discount the public

company comparable multiples but not the precedent transaction multiples?

There's no discount because with precedent transactions, you're acquiring the entire

company - and once it's acquired, the shares immediately become illiquid. But shares - the ability to buy individual "pieces" of a company rather than the whole

thing - can be either liquid (if it's public) or illiquid (if it's private).

Since shares of public companies are always more liquid, you would discount public

company comparable multiples to account for this.

Can you use private companies as part of your valuation?

Only in the context of precedent transactions - it would make no sense to include them

for public company comparables or as part of the Cost of Equity / WACC calculation in

a DCF because they are not public and therefore have no values for market cap or Beta.

Walk me through a DCF.

"A DCF values a company based on the Present Value of its Cash Flows and the Present

Value of its Terminal Value.

First, you project out a company's financials using assumptions for revenue growth,

expenses and Working Capital; then you get down to Free Cash Flow for each year,

which you then sum up and discount to a Net Present Value, based on your discount

rate - usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company's

Terminal Value, using either the Multiples Method or the Gordon Growth Method, and

then also discount that back to its Net Present Value using WACC.

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then,

multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and

subtract Capital Expenditures and the change in Working Capital.

What's an alternate way to calculate Free Cash Flow aside from taking Net Income,

adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities

and CapEx?

Take Cash Flow From Operations and subtract CapEx - that gets you to Levered Cash

Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted

Interest Expense and subtract the tax-adjusted Interest Income.

Why do you use 5 or 10 years for DCF projections?

That's usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

What do you usually use for the discount rate?

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you've set up the DCF.

How do you calculate WACC?

The formula is: Cost of Equity (% Equity) + Cost of Debt (% Debt) * (1 - Tax Rate) +

Cost of Preferred * (% Preferred).

How do you calculate the Cost of Equity?

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield;

Beta is calculated based on the "riskiness" of Comparable Companies and the Equity

Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets.

How do you get to Beta in the Cost of Equity calculation?

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever

each one, take the median of the set and then lever it based on your company's capital

structure. Then you use this Levered Beta in the Cost of Equity calculation.

Why do you have to un-lever and re-lever Beta?

Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from whatever source you're using) they will be levered to reflect the debt already assumed by each company.

But each company's capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has.

To get that, we need to un-lever Beta each time.

But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Would you expect a manufacturing company or a technology company to have a

higher Beta?

A technology company, because technology is viewed as a "riskier" industry than

manufacturing.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash

Flow in your DCF - what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the

cash flow is only available to equity investors (debt investors have already been "paid"

with the interest payments).

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with

Debt or Preferred Stock in this case - we're calculating Equity Value, not Enterprise

Value.