Investment Banking 400 Questions

Walk me through the 3 financial statements.

"The 3 major financial statements are the Income Statement, Balance Sheet and Cash

Flow Statement.

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

Net Income, the final line on the statement.

The Balance Sheet shows the company's Assets - its resources - 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.

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?

Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General &

Administrative Expenses); Operating Income; Pretax Income; Net Income.

Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment

(PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity.

Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based

Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations;

Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends

Issued; Cash Flow From Financing.

How do the 3 statements link together?

"To tie the statements together, Net Income from the Income Statement flows into

Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow

Statement.

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?

You would pick the Income Statement and Balance Sheet, because you can create the

Cash Flow Statement from both of those (assuming, of course that you have "before"

and "after" versions of the Balance Sheet that correspond to the same period the Income

Statement is tracking).

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

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate,

Net Income would go down by $6.

Cash Flow Statement: The Net Income at the top goes down by $6, but the $10

Depreciation is a non-cash expense that gets added back, so overall Cash Flow from

Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in

Cash goes up by $4.

Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side

because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow

Statement.

Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity

on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the

Balance Sheet balance.

Note: With this type of question I always recommend going in the order:

1. Income Statement

2. Cash Flow Statement

3. Balance Sheet

This is so you can check yourself at the end and make sure the Balance Sheet balances.

Remember that an Asset goin

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

Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash

expense, Depreciation affects cash by reducing the amount of taxes you pay.

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?

For this question, confirm that the accrued compensation is now being recognized as an

expense (as opposed to just changing non-accrued to accrued compensation).

Assuming that's the case, Operating Expenses on the Income Statement go up by $10,

Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).

On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation

will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the

Net Change in Cash at the bottom is up by $4.

On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the

Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10

and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

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

No changes to the Income Statement.

On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from

Operations - it goes down by $10, as does the Net Change in Cash at the bottom.

On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so

the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

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

This is a common interview mistake - incorrectly stating that Working Capital changes

show up on the Income Statement.

In the case of Inventory, the expense is only recorded when the goods associated with it

are sold - so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or

Operating Expense until the company manufactures it into a product and sells it.

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all

3 statements affected at the start of "Year 1," before anything else happens?

At the start of "Year 1," before anything else has happened, there would be no changes

on Apple's Income Statement (yet).

On the Cash Flow Statement, the additional investment in factories would show up

under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down

by $100 so far). And the additional $100 worth of debt raised would show up as an

addition to Cash Flow, canceling out the investment activity. So the cash number stays

the same.

On the Balance Sheet, there is now an additional $100 worth of factories in the Plants,

Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100.

On the other side, debt is up by $100 as well and so both sides balance.

Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no

principal is paid off, and assume an interest rate of 10%. Also assume the factories

depreciate at a rate of 10% per year. What happens?

After a year has passed, Apple must pay interest expense and must record the

depreciation.

Operating Income would decrease by $10 due to the 10% depreciation charge each year,

and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20

altogether ($10 from the depreciation and $10 from Interest Expense).

Assuming a tax rate of 40%, Net Income would fall by $12.

On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a

non-cash expense, so you add it back and the end result is that Cash Flow from

Operations is down by $2.

That's the only change on the Cash Flow Statement, so overall Cash is down by $2.

On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due

to the depreciation, so overall Assets are down by $12.

On the other side, since Net Income was down by $12, Shareholders' Equity is also

down by $12 and both sides balance.

Remember, the debt number under Liabilities does not change since we've assumed

none

At the start of Year 3, the factories all break down and the value of the equipment

is written down to $0. The loan must also be paid back now. Walk me through the 3

statements.

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per

year assumption. It is this $80 that we will write down in the 3 statements.

First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line.

With a 40% tax rate, Net Income declines by $48.

On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash

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

$32.

There are no changes under Cash Flow from Investing, but under Cash Flow from

Financing there is a $100 charge for the loan payback - so Cash Flow from Investing falls

by $100.

Overall, the Net Change in Cash falls by $68.

On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets

have decreased by $148 altogether.

On the other side, Debt is down $100 since it was paid off, and since Net Income was

down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilities &

Shareholders'

Now let's look at a different scenario and assume Apple is ordering $10 of

additional iPod inventory, using cash on hand. They order the inventory, but they

have not manufactured or sold anything yet - what happens to the 3 statements?

No changes to the Income Statement.

Cash Flow Statement - Inventory is up by $10, so Cash Flow from Operations decreases

by $10. There are no further changes, so overall Cash is down by $10.

On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets

number stays the same and the Balance Sheet remains in balance.

Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me

through the 3 statements under this scenario.

Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by

$10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is

up by $6.

Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by

$10 (since we just manufactured the inventory into real iPods), which is a net addition to

cash flow - so Cash Flow from Operations is up by $16 overall.

These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by

$16.

On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up

by $6 overall.

On the other side, Net Income was up by $6 so Shareholders' Equity is up by $6 and

both sides balance.

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.

It doesn't "mean" anything in particular, but it can be a cause for concern and possibly

demonstrate that the company is struggling (in the second scenario).

Note: Shareholders' equity never turns negative immediately after an LBO - it would only

happen following a dividend recap or continued net losses.

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 shortterm

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."

Bankers look at Operating Working Capital more commonly in models, and that is

defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt).

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 writedown

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 noncash

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?

Three examples come to mind:

1. Web-based subscription software

2. Cell phone carriers that cell annual contracts

3. Magazine publishers that sell subscriptions

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 transactionvalue

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.

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.

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?

Several possibilities:

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.

Remember, EBITDA excludes investment in (and depreciation of) long-term assets,

interest and one-time charges - and all of these could end up bankrupting 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.

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based.

2. GAAP uses straight-line depreciation or a few other methods whereas tax

accounting is different (accelerated depreciation).

3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax

accounting is only concerned with revenue/expenses in the current period and

what income tax you owe.

What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for

cash tax purposes vs. what they can deduct for book tax purposes.

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but

haven't actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you

pay taxes in cash but haven't expensed them on the Income Statement yet.

The most common way they occur is with asset write-ups and write-downs in M&A

deals - an asset write-up will produce a deferred tax liability while a write-down will

produce a deferred tax asset (see the Merger Model section for more on this).

Walk me through how you create a revenue model for a company.

There are 2 ways you could do this: a bottoms-up build and a tops-down build.

• Bottoms-Up: Start with individual products / customers, estimate the average

sale value or customer value, and then the growth rate in sales and sale values to

tie everything together.

• Tops-Down: Start with "big-picture" metrics like overall market size, then

estimate the company's market share and how that will change in coming years,

and multiply to get to their revenue.

Of these two methods, bottoms-up is more common and is taken more seriously

because estimating "big-picture" numbers is almost impossible.

Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company,

the # of employees in each, the average salary, bonuses, and benefits, and then make

assumptions on those going forward.

Usually you assume that the number of employees is tied to revenue, and then you

assume growth rates for salary, bonuses, benefits, and other metrics.

Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should

incur an expense.

Other items such as rent, Capital Expenditures, and miscellaneous expenses are either

linked to the company's internal plans for building expansion plans (if they have them),

or to Revenue for a more simple model.

Let's say we're trying to create these models but don't have enough information or

the company doesn't tell us enough in its filings - what do we do?

Use estimates. For the revenue if you don't have enough information to look at separate

product lines or divisions of the company, you can just assume a simple growth rate into

future years.

For the expenses, if you don't have employee-level information then you can just

assume that major expenses like SG&A are a percent of revenue and carry that

assumption forward.

Walk me through the major items in Shareholders' Equity.

• Common Stock - Simply the par value of however much stock the company has

issued.

• Retained Earnings - How much of the company's Net Income it has "saved up"

over time.

• Additional Paid in Capital - This keeps track of how much stock-based

compensation has been issued and how much new stock employees exercising

options have created. It also includes how much over par value a company raises

in an IPO or other equity offering.

• Treasury Stock - The dollar amount of shares that the company has bought back.

• Accumulated Other Comprehensive Income - This is a "catch-all" that includes

other items that don't fit anywhere else, like the effect of foreign currency

exchange rates changing.

Walk me through what flows into Retained Earnings.

Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued

If you're calculating Retained Earnings for the current year, take last year's Retained

Earnings number, add this year's Net Income, and subtract however much the company

paid out in dividends.

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises

If you're calculating it, take the balance from last year, add this year's stock-based

compensation number, and then add in however much new stock was created by

employees exercising options this year.

What is the Statement of Shareholders' Equity and why do we use it?

This statement shows everything we went through above - the major items that

comprise Shareholders' Equity, and how we arrive at each of them using the numbers

elsewhere in the statement.

You don't use it too much, but it can be helpful for analyzing companies with unusual

stock-based compensation and stock option situations.

What are examples of non-recurring charges we need to add back to a company's

EBIT / EBITDA when looking at its financial statements?

• Restructuring Charges

• Goodwill Impairment

• Asset Write-Downs

• Bad Debt Expenses

• Legal Expenses

• Disaster Expenses

• Change in Accounting Procedures

Note that to be an "add-back" or "non-recurring" charge for EBITDA / EBIT purposes, it

needs to affect Operating Income on the Income Statement. So if you have one of these

charges "below the line" then you do not add it back for the EBITDA / EBIT calculation.

Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based

Compensation for EBITDA / EBIT, but that these are not "non-recurring charges"

because all companies have them every year - these are just non-cash charges.

How do you project Balance Sheet items like Accounts Receivable and Accrued

Expenses in a 3-statement model?

Normally you make very simple assumptions here and assume these are percentages of

revenue, operating expenses, or cost of goods sold. Examples:

• Accounts Receivable: % of revenue.

• Deferred Revenue: % of revenue.

• Accounts Payable: % of COGS.

• Accrued Expenses: % of operating expenses or SG&A.

Then you either carry the same percentages across in future years or assume slight

changes depending on the company.

How should you project Depreciation & Capital Expenditures?

The simple way: project each one as a % of revenue or previous PP&E balance.

The more complex way: create a PP&E schedule that splits out different assets by their

useful lives, assumes straight-line depreciation over each asset's useful life, and then

assumes capital expenditures based on what the company has invested historically.

How do Net Operating Losses (NOLs) affect a company's 3 statements?

The "quick and dirty" way to do this: reduce the Taxable Income by the portion of the

NOLs that you can use each year, apply the same tax rate, and then subtract that new

Tax number from your old Pretax Income number (which should stay the same).

The way you should do this: create a book vs. cash tax schedule where you calculate the

Taxable Income based on NOLs, and then look at what you would pay in taxes without

the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on

the Balance Sheet.

This method reflects the fact that you're saving on cash flow - since the DTL, a liability,

is rising - but correctly separates the NOL impact into book vs. cash taxes.

What's the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property, and do not

involve ownership of anything. Operating lease expenses show up as operating

expenses on the Income Statement.

Capital leases are used for longer-term items and give the lessee ownership rights; they

depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

1. If there's a transfer of ownership at the end of the term.

2. If there's an option to purchase the asset at a bargain price at the end of the term.

3. If the term of the lease is greater than 75% of the useful life of the asset.

4. If the present value of the lease payments is greater than 90% of the asset's fair

market value.

Why would the Depreciation & Amortization number on the Income Statement be

different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this

happens, you need to use the Cash Flow Statement number to arrive at EBITDA because

otherwise you're undercounting D&A.

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

(This formula does not tell the whole story and can get more complex - see the

Advanced Questions. Most of the time you can get away with stating this formula in an

interview, though).

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 any other

dilutive securities, such as 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?

The "official" reason: Cash is subtracted because it's considered a non-operating asset

and because Equity Value implicitly accounts for it.

The way I think about it: In an acquisition, the buyer would "get" the cash of the seller,

so it effectively pays less for the company based on how large its cash balance is.

Remember, Enterprise Value tells us how much you'd really have to "pay" to acquire

another company.

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.

10. 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.

These days, there's a lot of overlap in these 2 categories...

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?

This gets confusing because of the different units involved. 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.

We do not use the Treasury Stock Method with convertibles because the company is

not "receiving" any cash from us.

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

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

Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders' Equity could be any value. For healthy companies,

Equity Value usually far exceeds Shareholders' Equity.

Are there any problems with the Enterprise Value formula you just gave me?

Yes - it's too simple. There are lots of other things you need to add into the formula with

real companies:

• Net Operating Losses - Should be valued and arguably added in, similar to cash.

• Long-Term Investments - These should be counted, similar to cash.

• Equity Investments - Any investments in other companies should also be added

in, similar to cash (though they might be discounted).

• Capital Leases - Like debt, these have interest payments - so they should be

added in like debt.

• (Some) Operating Leases - Sometimes you need to convert operating leases to

capital leases and add them as well.

• Pension Obligations - Sometimes these are counted as debt as well.

So a more "correct" formula would be Enterprise Value = Equity Value - Cash + Debt +

Preferred Stock + Minority Interest - NOLs - Investments + Capital Leases + Pension

Obligations...

In interviews, usually you can get away with saying "Enterprise Value = Equity Value -

Cash + Debt + Preferred Stock + Minority I

Should you use the book value or market value of each item when calculating

Enterprise Value?

Technically, you should use market value for everything. In practice, however, you

usually use market value only for the Equity Value portion, because it's almost impossible to establish market values for the rest of the items in the formula - so you

just take the numbers from the company's Balance Sheet.

What percentage dilution in Equity Value is "too high?"

There's no strict "rule" here but most bankers would say that anything over 10% is odd.

If your basic Equity Value is $100 million and the diluted Equity Value is $115 million,

you might want to check your calculations - it's not necessarily wrong, but over 10%

dilution is unusual for most companies.

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.

Trick question - 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?

• 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.

If you have a plastics division, a TV and entertainment division, an energy division, a

consumer financing division and a technology division, you should not use the same set

of Comparable Companies and Precedent Transactions for the entire company.

Instead, you should use different sets for each division, value each one separately, and

then add them together to get the Combined Value.

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.

For REITs, Funds From Operations is a common metric that adds back Depreciation and

subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large

expense in real estate, and gains on sales of properties are assumed to be non-recurring,

so FFO is viewed as a "normal

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.

How would you value an apple tree?

The same way you would value a company: by looking at what comparable apple trees

are worth (relative valuation) and the value of the apple tree's cash flows (intrinsic

valuation).

Yes, you could do a DCF for anything - even an apple tree.

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

Value / EBITDA?

EBITDA is available to all investors in the company - rather than just equity holders.

Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair

them together.

Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value

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

investors.

**Certain profit metrics (Net Income, EPS) ARE influenced by non-core activities or capital structure; these cannot be compared to EV (since EV calculates only core operating assets)

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 nonfinancial

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?

The 3 main ways to select companies and 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.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in

revenue

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving

sellers with over $1 billion in revenue

Precedent Transaction Screen: Retail M&A transactions over the past year

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.

In practice you rarely do all of the above - these are just possibilities.

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.

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?

Possible reasons:

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.