Bricking 4

What are the 2 ways you can measure a company’s value?

Market value - what is the company worth right now according to the stock market, its owners, or current investors?

Implied or Intrinsic value - what should the company be worth according to your analysis or views?

What is the main reason market value and intrinsic value are different?

Most valuation differences boil down to differing expectations about future cash flow growth rates. However, differences can also exist about discount rate or cash flows.

What is equity value?

The value of EVERYTHING a company has (i.e., ALL its Assets), but only to EQUITY INVESTORS (i.e., common shareholders).

If publicly traded, Current Equity Value = market cap

What is enterprise value?

The value of the company’s CORE BUSINESS OPERATIONS (i.e., ONLY the Assets related to its core business), but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

How do you move from equity value to enterprise value?

Subtract non-core business assets (e.g., Cash and investments) and add items representing debt, preferred, and other investor groups.

Theoretically, only operational changes affect enterprise value, whereas financing and operational changes affect equity value.

What does a negative current enterprise value tell you?

Current enterpise value = current equity value + (debt and preferred) - cash

Say company has $100M in current equity value and $200 million in cash. Since the market is valuing the company at $100 million, even though they have $200 million in cash, it suggests that they have lost confidence in the ability of the company to generate cash and its core business operations have become a liability and are eating up cash on a regular basis. As a result, the current enterprise value is negative, and it can suggest that if you are able to get your hands on the company before it uses up much of its cash, you could theoretically buy the cash at a discount because you would only have to pay the market cap and get all the cash in return.

How can implied equity value and implied enterprise value be negative?

Company value = cash flow/(discount - growth rate)

If we look at cash flow to all sources of funding, and then discount rate is WACC, then implied enterprise value can be < 0, and thus so can implied enterprise value (if cash cannot make up for negative implied enterprise value)

How do financing events affect equity value and enterprise value?

Issuing equity: Equity value goes up because cash comes into business and no corresponding liability; enterprise value unaffected because cash goes up and so does equity value (cash is a non-operating asset)

Repurchasing shares: Equity value goes down because cash flows out of business; enterprise value unaffected because equity value down and cash down

Issuing dividends: Same outcome as repurchasing shares

Raising debt: Cash up and debt up, so equity value unchanged; enterprise value unchanged

Repaying debt: Cash down and debt down, so equity value unchanged; enterprise value unchanged

Why can enterprise value actually be changed by financing events in the real world?

Taxes, risk of bankruptcy, agency costs, and inefficient markets.

E.g., raising debt provides a future tax shield through interest payments being tax-deductible, which increases cash flows (common dividends and preferred dividends do not provide such tax shield). So, enterprise value can actually change. Higher debt can also lead to higher expected risk of bankruptcy, which works in the opposite direction and increases concern about fees related to bankruptcy, which decreases future cash flow expectations (higher WACC due to both debt and equity investors getting more concerned). Agency costs: debt investors want company to be conservative, equity investors want company to take risk; so, raising debt vs equity can affect company operations and thus affect cash flows. Efficient markets: market may not actually view debt, equity, and preferred stock as all equivalent. For example, issuing debt to buy back equity can be seen as confidence from management and thus equity value and EV go up

How do you determine whether to pair a metric with enterprise value or equity value?

Enterprise value: before both interest and preferred dividends have been paid.

Equity value: after both interest and preferred dividends have been paid.

Why is enterprise value a good approximation but not exact value of cost to acquire a company?

Enterprise value = equity value - cash + (debt and preferred)

When we buy a company, minimum we have to pay is 100% of the shares, which is equity value. Then, we need to pay off the debt and can use the existing cash to do that. However, adjustments have to be made: debt is often refinanced, the seller needs to keep certain cash for operational purposes, there may be additional fees associated, etc. Additionally, debt may not allow for early repayment, so cash cannot just be used to pay off the debt.

What are the two equivalent formulas for P/E?

Price per share/earnings per share and equity value/net income

What do multiples tell us?

How much we are willing to pay for/value company. It’s based on income statement metrics, such as revenue, and can thus be inaccurate because these metrics may not match cash flow, which is what we actually use to value company. Additionally, discount rate can be different for different companies due to different risk profiles. Finally, one-time events like lawsuits or hiring executive from a major competitor could disproportionately impact multiples.

What is the fundamental balance sheet equation behind equity value and enterprise value formula?

Market value of debt + market value of equity = market value of cash & other non-operating assets + market value of core business/operating assets

Firm value = market value of all assets: market value of debt + market value of equity

Equity value = market value of equity

Enterprise value = market value of core business/operating assets: market value of debt (& preferred technically) + Equity Value - market value of cash & other non-operating assets

What are the 3 ways for factoring in securities dilution?

1) Treasury stock method: assume that all options are exercised and the company uses the money they get from that to buy back some shares (can’t buy back all shares since exercise price < current share price) to reduce dilution

2) “If Converted” method: applies for convertible bonds; if company’s current share price exceeds conversion price, assume that all bonds convert into shares; otherwise, treat bonds as debt; you get the # of convertible bonds by doing convertible dollar amount/par value, then multiply the # of bonds by the conversion ratio (which is par value/conversion price) to get the # of shares, and then that many shares are what is issued if the conversion price < current share price

3) Straight-Up Addition: Just add shares from different sources such as Restriced Stocks and RSUs

The 3 methods are used together and the result is the Diluted Share Count.

What are the 3 rules of thumb when moving from equity value to enterprise value?

1) Add in long-term funding sources: debt, preferred are clear, but also add in unfunded pension obligations (employees are the investment source), environmental liabilities, non-controlling interests, etc.

2) Add items that will cost potential acquirer extra when moving from equity value to EV: debt, preferred stock are again the best examples of this because they typically must immediately be repaid fully/refinanced when an acquisition happens (don’t add something like A/P because that is naturally paid by the company’s cash flows); basically anything that costs extra due to a change of control clause in the contract

3) Subtract items that are not operating assets: cash, investments, NOLs, Assets Held for Sale, Assets of Discontinued Businesses, investments in affiliates, etc. (these can be thought of as saving money for the acquirer, but that may not necessarily be true for all of these assets)

Why are goodwill and other intangible assets not subtracted from equity value when moving to EV?

They are created when another company is acquired, so they are now core parts of the business if that acquired company is still part of the parent.

Why do you subtract Equity Investments when moving from Equity Value to Enterprise Value?

1. They are considered non-core-business Assets. In other words, this Parent Company could easily run its business without this 30% stake in the Associate Company.

2. For comparability purposes. The Parent Company’s Revenue and Operating Income will not reflect any contributions from Associate Companies that it owns less than 50% of, so you need to remove these stakes from Enterprise Value as well.

Why do you add Noncontrolling Interests when moving from Equity Value to Enterprise Value?

1. Noncontrolling interests represent a funding source since the company could get funding from them

2. For compatability purposes. Parent’s revenue, operating income reflect 100% of contribution from associate companies, so should EV.

What are the three cash flow formulas and their significance?

1) Free cash flows = CF from Ops - CapEx

Represents how much cash company’s core business is generating on a regular basis; only available to equity investors

2) Unlevered free cash flow (FCF to firm) = NOPAT (which is EBIT x [1 - tax rate]) + Non-Cash Adjustments and Changes in Working Capital from CFS - CapEx

Alternative formula is CFO + (Interest expense + other items between EBIT and pre-tax income, i.e., non-operating income) x (1 - tax rate) - CapEx

Represents how much cash company’s core business is generating on a regular basis; available to all investors

3) Levered free cash flow (FCF to equity) = Net income + Non-Cash Adjustments and Changes in Working Capital from CFS - CapEx - (Mandatory?) Debt Repayments (or, CF from Ops - CapEx - (Mandatory?) Debt Repayments)

Similar to free cash flow but subtracts out mandatory debt repayments as well; gives a better estimate of how much cash flow is available to just the equity investors; some people use mandatory debt repayments only, while others include all debt repayments

How and why does unlevered free cash flow not include non-core business activities, whereas levered FCF and FCF do?

Unlevered starts with NOPAT whereas levered FCF and FCF start with CF from Ops and thus basically Net Income. Examples of non-core business activities included are interest expenses, tax costs/shieldings from gains/losses, etc.

What type of industries is EV/IC useful for?

Asset-heavy; not useful for software, biotech, services, etc. because they are more dependent on employees rather than assets.

What does the PEG ratio tell you?

Tells you how expensive or cheap a company is relative to its net income growth. P/E tells how much you are paying for each unit of earnings, then PEG = P/E/(net income growth % x 100) and tells you how much you are paying per unit of earnings for a company growing at a certain % net income growth rate.

Lower PEG = more growth for money.