Understanding Financial Statements and Valuation Methods

What are the three major financial statements?

The Income Statement, Balance Sheet, and Cash Flow Statement.

What does the Income Statement show?

It provides the company's revenue and expenses, culminating in Net Income.

What key equation is represented in the Balance Sheet?

Assets must equal Liabilities plus Shareholders' Equity.

What does the Cash Flow Statement begin with?

It begins with Net Income and adjusts for non-cash expenses and working capital changes.

List some major line items found on the Income Statement.

Revenue, Cost of Goods Sold, SG&A, Operating Income, Pretax Income, Net Income.

What are some key line items on the Balance Sheet?

Cash, Accounts Receivable, Inventory, PP&E, Accounts Payable, Accrued Expenses, Debt, Shareholders' Equity.

What are some major line items on the Cash Flow Statement?

Net Income, Depreciation & Amortization, Stock-Based Compensation, Cash Flow From Operations, Capital Expenditures.

How does Net Income from the Income Statement link to the other financial statements?

Net Income flows into Shareholders' Equity on the Balance Sheet and into the top line of the Cash Flow Statement.

What is the effect of a $10 increase in Depreciation on the Income Statement?

Operating Income would decline by $10, and Net Income would decrease by $6 assuming a 40% tax rate.

How does an increase in Depreciation affect the Cash Flow Statement?

Net Income at the top goes down by $6, but the $10 Depreciation is added back, resulting in a $4 increase in Cash Flow from Operations.

What happens to the Balance Sheet when Depreciation increases by $10?

PP&E decreases by $10, Cash increases by $4, resulting in a net decrease in Assets of $6.

Why does Depreciation, a non-cash expense, affect cash balance?

It is tax-deductible, reducing the amount of taxes paid, which affects cash.

Where does Depreciation usually appear on the Income Statement?

It can be a separate line item or embedded in Cost of Goods Sold or Operating Expenses.

What happens when Accrued Compensation increases by $10?

Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6.

How does an increase in Accrued Compensation affect the Cash Flow Statement?

Net Income decreases by $6, but Accrued Compensation increases Cash Flow by $10, resulting in a $4 increase in Cash Flow from Operations.

What is the recommended order to analyze the impact of changes on financial statements?

1. Income Statement 2. Cash Flow Statement 3. Balance Sheet.

What is the relationship between an Asset increase and Cash Flow?

An Asset increase decreases your Cash Flow.

What is the relationship between a Liability increase and Cash Flow?

A Liability increase increases your Cash Flow.

What is the final effect on the Balance Sheet when Net Income falls by $6 due to Depreciation?

Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6, keeping the Balance Sheet balanced.

What is the significance of the Cash and Shareholders' Equity items on the Balance Sheet?

They act as 'plugs' with Cash flowing in from the final line on the Cash Flow Statement.

What does the term 'non-cash expense' refer to in financial statements?

Expenses that do not involve an actual cash outflow, such as Depreciation.

How does the tax rate affect the impact of Depreciation on Net Income?

A higher tax rate means a larger reduction in Net Income due to Depreciation.

What is the overall impact on cash flow when accrued expenses are recognized?

It typically increases cash flow as it reflects an increase in liabilities without an immediate cash outflow.

What is the overall change in Cash Flow from Operations when Net Income is down by $6 and Accrued Compensation increases Cash Flow by $10?

The overall Cash Flow from Operations is up by $4.

How does an increase in Inventory by $10 affect the Income Statement?

There are no changes to the Income Statement.

What happens to Cash Flow from Operations when Inventory increases by $10 and is paid for with cash?

Cash Flow from Operations decreases by $10.

What is the effect on the Balance Sheet when Inventory increases by $10 and is paid for with cash?

Inventory is up by $10 and Cash is down by $10, so the changes cancel out and Assets still equal Liabilities & Shareholders' Equity.

Why does the Income Statement not reflect changes in Inventory until the goods are sold?

The expense is recorded only when the goods are sold; until then, it does not count as Cost of Goods Sold or Operating Expense.

What is the initial effect on the Income Statement when Apple buys $100 worth of new iPad factories with debt?

There are no changes on Apple's Income Statement at the start of Year 1.

How does the Cash Flow Statement reflect the purchase of $100 worth of factories and the associated debt?

Cash Flow from Investing shows a net reduction in Cash Flow by $100 for the factory purchase, but Cash Flow increases by $100 due to the debt raised, resulting in no change in cash.

What is the impact on the Balance Sheet from purchasing $100 worth of factories with debt?

PP&E increases by $100 and Assets increase by $100; Liabilities also increase by $100, keeping both sides balanced.

Can shareholders' equity ever be negative, and under what circumstances?

Yes, it can occur in leveraged buyouts with dividend recapitalizations or if a company has been losing money consistently.

What does negative shareholders' equity indicate?

It can be a cause for concern, indicating that the company may be struggling, especially if due to consistent losses.

Why do we analyze both Enterprise Value and Equity Value?

Enterprise Value represents the total value attributable to all investors, while Equity Value represents the portion available to shareholders.

Which value is more important when considering an acquisition: Enterprise Value or Equity Value?

Enterprise Value is more important because it reflects the total cost to acquire the company, including debt repayment.

What is the formula for calculating Enterprise Value?

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest - Cash.

Why is Noncontrolling Interest added to Enterprise Value?

It is added because a company that owns over 50% of another must report the financial performance of that company as part of its own.

What happens to shareholders' equity immediately after a leveraged buyout (LBO)?

Shareholders' equity does not turn negative immediately after an LBO; it may only become negative after a dividend recap or continued net losses.

What is the impact on Cash Flow from Operations when Inventory is an asset that increases?

Cash Flow from Operations decreases.

How does an increase in Accrued Compensation affect Cash Flow?

Accrued Compensation increases Cash Flow by $10.

What is the effect of a $6 decrease in Net Income on the Balance Sheet?

Retained Earnings decrease by $6.

What balances the increase in Accrued Compensation on the Liabilities side of the Balance Sheet?

The decrease in Retained Earnings by $6 balances the increase in Liabilities.

What is the significance of the Cash Flow Statement in relation to operational changes?

It reflects how operational changes, like inventory increases, affect cash flow.

What does it mean if a company has declining Retained Earnings?

It indicates that the company has been losing money consistently.

What is the relationship between Assets and Liabilities & Shareholders' Equity when Inventory is purchased?

Assets remain equal to Liabilities & Shareholders' Equity despite changes in Inventory and Cash.

What does a company report regarding its majority-owned subsidiary?

It reports 100% of the subsidiary's financial performance, even if it doesn't own 100%.

Why must Noncontrolling Interest be added to calculate Enterprise Value?

To ensure both the numerator and denominator reflect 100% of the majority-owned subsidiary.

How do you calculate fully diluted shares?

Add the basic share count to the dilutive effect of stock options and other dilutive securities.

What method is used to calculate the dilutive effect of options?

The Treasury Stock Method.

If a company has 100 shares at $10 each and 10 options at $5 each, what is its fully diluted equity value?

$1,050, with a fully diluted share count of 105.

What happens to fully diluted equity value if options are out-of-the-money?

The options have no dilutive effect, and the equity value remains at $1,000.

Why is cash subtracted in the formula for Enterprise Value?

Cash is a non-operating asset and is implicitly accounted for in Equity Value.

What does Enterprise Value represent in an acquisition context?

It indicates how much a buyer would effectively pay to acquire a company.

Is it always accurate to subtract cash when calculating Enterprise Value?

Not always; only excess cash above the minimum required for operations should be subtracted.

Is adding Debt to Equity Value always accurate for calculating Enterprise Value?

In most cases, yes, as debt is typically refinanced in an acquisition.

What does a negative Enterprise Value indicate?

It indicates a company has a large cash balance or a low market capitalization.

Can a company have a negative Equity Value?

No, because share count and share price cannot be negative.

Why do we add Preferred Stock to calculate Enterprise Value?

Preferred Stock has a fixed dividend and a higher claim on assets, making it similar to debt.

How are convertible bonds accounted for in the Enterprise Value formula?

If in-the-money, they count as dilution; if out-of-the-money, their face value is counted as Debt.

What is the basic equity value of a company with 100 shares at $10 each?

$1,000.

What is the impact of exercising options on share count?

Exercising options increases the share count by the number of options exercised.

What cash amount is generated when options are exercised at a lower price than the share price?

The company receives cash equal to the exercise price multiplied by the number of options.

What is the significance of the exercise price being below the current share price?

It indicates that the options are 'in-the-money' and will have a dilutive effect.

What does it mean if a company has a large cash balance and low market capitalization?

It may result in a negative Enterprise Value.

What is the relationship between preferred stockholders and equity investors?

Preferred stockholders have a higher claim to a company's assets than equity investors.

What is the Treasury Stock Method used for?

To calculate the dilutive effect of stock options.

What happens to the share count when options are exercised and cash is used to buy back shares?

The share count is adjusted down by the number of shares bought back with the cash from the exercise.

How do you calculate diluted shares outstanding when a company has convertible bonds?

First, determine the number of convertible bonds by dividing the total value of the bonds by the par value. Then, calculate the number of shares per bond using the par value divided by the conversion price. Multiply the number of bonds by the shares per bond to find the total new shares, and add this to the existing shares outstanding.

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

Equity Value is the market value of a company and can never be negative, while Shareholders' Equity is the book value and can be any value, including negative. Typically, for healthy companies, Equity Value exceeds Shareholders' Equity.

What are the three major valuation methodologies?

Comparable Companies, Precedent Transactions, and Discounted Cash Flow Analysis.

How do you rank the three valuation methodologies from highest to lowest expected value?

There is no consistent ranking. Generally, Precedent Transactions may be higher than Comparable Companies due to the Control Premium, while a DCF can vary widely depending on assumptions.

When should you not use a DCF in a valuation?

Do not use a DCF if the company has unstable or unpredictable cash flows, such as tech or biotech startups, or when debt and working capital play fundamentally different roles, as in banks.

What is Liquidation Valuation?

Liquidation Valuation assesses a company's assets assuming they are sold off, subtracting liabilities to determine the capital available for equity investors.

When is Liquidation Valuation most commonly used?

It is most commonly used in bankruptcy scenarios to evaluate whether equity shareholders will receive any capital after debts are settled.

What is Replacement Value in valuation?

Replacement Value is the valuation of a company based on the cost of replacing its assets.

What is LBO Analysis?

LBO Analysis determines how much a private equity firm could pay for a company to achieve a target Internal Rate of Return (IRR), typically in the 20-25% range.

What is the Sum of the Parts valuation method?

Sum of the Parts involves valuing each division of a company separately and then adding those values together to get the total value of the company.

When would you use a Sum of the Parts valuation?

It is used when a company has unrelated divisions, such as a conglomerate, requiring different sets of Comparable Companies and Precedent Transactions for each division.

What is M&A Premiums Analysis?

M&A Premiums Analysis examines mergers and acquisitions to determine the premium paid by buyers, which can help establish the value of a company.

What is Future Share Price Analysis?

Future Share Price Analysis projects a company's share price based on the P/E multiples of comparable public companies, then discounts it back to present value.

How do you determine the number of convertible bonds from the total value?

Divide the total value of the convertible bonds by the par value of each bond.

How many shares does one convertible bond represent if the par value is $1,000 and the conversion price is $50?

One convertible bond represents 20 shares, calculated as $1,000 divided by $50.

What is the total number of diluted shares outstanding if a company has 1 million shares and 200,000 new shares from convertible bonds?

The total diluted shares outstanding would be 1.2 million shares.

Why is the Treasury Stock Method not used with convertible bonds?

The Treasury Stock Method is not applicable because the company does not receive cash from the conversion of bonds.

What is the Control Premium in valuation?

The Control Premium is the additional amount paid over the market value of a company to acquire a controlling interest.

What factors can affect the variability of a DCF valuation?

The variability of a DCF valuation can be influenced by assumptions regarding future cash flows, growth rates, and discount rates.

Why might a DCF produce the highest or lowest valuation?

A DCF can produce varying valuations based on the assumptions made regarding cash flows and growth, leading to either high or low outcomes.

What is the significance of a company's share price being above the conversion price of convertible bonds?

If the share price is above the conversion price, the convertible bonds are considered in-the-money, making it beneficial to convert them into shares.

What is the par value of the convertible bonds mentioned in the notes?

The par value of the convertible bonds is $1,000.

What is the purpose of using multiples in Valuation?

To establish how much a private equity firm could pay and to set a 'floor' on a possible Valuation for the company.

What are the most common multiples used in Valuation?

EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

What are some industry-specific multiples for Technology?

EV / Unique Visitors and EV / Pageviews.

What is the industry-specific multiple used in Retail and Airlines?

EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense).

What multiples are used in the Energy sector?

EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities.

How is value derived in the Energy sector?

Value is derived from companies' reserves of oil & gas.

What is the significance of Funds From Operations (FFO) in Real Estate Investment Trusts (REITs)?

FFO adds back Depreciation and subtracts gains on the sale of property, providing a normalized picture of cash flow.

Why is Enterprise Value used instead of Equity Value for industry-specific multiples like EV / Scientists?

Enterprise Value represents the value available to all investors (debt and equity), while Equity Value only reflects the portion available to equity investors.

Which valuation method typically yields a higher valuation, LBO or DCF?

In most cases, a DCF will yield a higher valuation because it accounts for cash flows in between and terminal value, while an LBO primarily values based on terminal value.

What is the primary focus of an LBO model?

It determines how much could be paid for a company based on a desired IRR, rather than providing a specific valuation.

How should Valuation methodologies be presented to a company or its investors?

Using a 'football field' chart to show the valuation range implied by each methodology.