Valuation You should know the three main valuation methodologies and be able to explain them to your interviewers.

First is comparable company analysis - looking at publicly traded companies and the multiples they trade at, then applying those to the company in question. This depends very much on "market data" to value companies, and the main downside is that sometimes there are no true comparable companies to use. Second is precedent transaction analysis - looking at what buyers paid for sellers in similar industries and with similar financial profiles and applying the multiples to your own company. Again, there are often no true comparable transactions. Precedent transaction analysis also tends to produce the the highest valuations because of the control premium required to acquire companies. Finally, there is the Discounted Cash Flow Analysis - using a company's projected cash flows, discounting them for the time-value of money and cost of capital and summing those to find the company's present value. This is the "purest" way of valuing a company since it depends solely on its financial performance, but the drawback is that it depends heavily on future projections, which tend to be unreliable. Know these methodologies and the various advantages and disadvantages of each. Modeling Questions The most likely financial modeling questions you'll get will concern merger models (when a company acquires another company) and Leveraged Buyout, or LBO models - when a private equity firm buys a company using equity and debt. The most important part of a merger model is the accretion/dilution - will a company have a higher or lower earnings per share (EPS) after acquiring another company? A merger model is an analysis of the trade-offs between using cash, stock, or debt to finance an acquisition. Any of these methods, or any combinations, will result in a different EPS. Beyond just the EPS impact, you also have to consider how much debt the buyer can afford, how much cash they have, and how much stock they can issue. In an LBO model, you're trying to solve for the private equity firm's return on investment - the IRR. It's very similar to buying a house with a mortgage - there is a down payment (the equity part of an LBO) and the mortgage (the debt used to finance an LBO). The model measures how much the company's value grows and how much debt is paid off over 3 to 5 years. The most important drivers are purchase price, exit price, amount of debt used, and the company's

growth rate and profitability. Accounting Questions Make sure you know the three financial statements - the income statement, balance sheet and cash flow statement - link together and be able to walk through how changes to one of them will affect the others. One common question here is how an increase of $10 in depreciation will affect all the statements. On the income statement, depreciation is an expense so operating income would decline by $10. With a tax rate of 40%, net income would drop by $6. On the cash flow statement, net income is down by $6 but depreciation - one of the "addbacks" - increases by $10, so cash flow from operations would increase by $4. On the balance sheet, Net PP&E would decrease by $10 because of the depreciation, while cash would be up by $4 from the tax savings. The $6 decrease in net income would also cause retained earnings to decrease by $6, so that the balance sheet balances - both assets and liabilities / shareholders' equity are now lower by $6.

Accounting and Financial Statements How does ??? impact the three financial statements? Varieties of this question are some of the most common technical question asked in interviews today. This type of question attempts to test your understanding of how the three financial statements (income statement, balance sheet, cash flow statement) fit together. The most common variation of this question is how does $10 of depreciation affect the three financial statements (answered below). I ve posted a few additional examples as well. To answer this question, take the 3 statements one at a time. My advice is to start with the income statement. Remember to tax-affect any change in revenue or costs (usually you will be told to assume a tax rate of 40%). Work your way down to net income. Next, tackle the cash flow statement. The first line of the cash flow statement is net income so start with that and work your way down to net change in cash. Last, take the balance sheet. The first line of the balance sheet is cash so again, start with that. The balance sheet must balance in order for your answer to be correct, which is why I recommend doing the balance sheet last. Remember the basic balance sheet equation: Assets = Liabilities + Shareholders Equity.

Don t get too stressed when asked a question like this. Just take it slowly, one statement at a time. July 24th, 2008 | Category: Accounting and Financial Statements | Comments are closed If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements? The most common version of this type of question. Note that the amount of depreciation may be a number other than $10. To answer this question, take the three statements one at a time. First, the income statement: depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder s equity decreased $6. You may get the follow-up question: If depreciation is non-cash, explain how this transaction caused cash to increase $4. The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense. October 12th, 2007 | Category: Accounting and Financial Statements | Comments are closed A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year? First Year: Let s assume that the company s fiscal year ends Dec. 31. The relevance of the purchase date is that we will assume no depreciation the first year. Income Statement: A purchase of equipment is considered a capital expenditure which does not impact earnings. Further, since we are assuming no depreciation, there is no impact to net income, thus no impact to the income statement. Cash Flow Statement: No change to net income so no change to cash flow from operations. However we ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. No change in cash flow from financing (since this is a cash purchase) so the net effect is a use of cash of $100. Balance Sheet: Cash (asset) down $100 and PP&E (asset) up $100 so no net change to the left side of the balance sheet and no change to the right side. We are balanced. Second Year: Here let s assume straightline depreciation over 5 years and a 40% tax rate. Income Statement: Just like the previous question: $20 of depreciation, which results in a $12 reduction to net income. Cash Flow Statement: Net income down $12 and depreciation up $20. No change to cash flow from investing or financing activities. Net effect is cash up

$8. Balance Sheet: Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet doen $12. Retained earnings (shareholders equity) down $12 and again, we are balanced. July 24th, 2008 | Category: Accounting and Financial Statements | Comments are closed Same question as the previous but the company finances the purchase of equipment by issuing debt rather than paying cash. First Year: Income Statement: No depreciation and no interest expense so no change. Cash Flow Statement: No change to net income so no change to cash flow from operations. Just like the previous question, we ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. Now, however, in our cash flows from financing section, we ve got an increase in debt of $100 (source of cash). Net effect is no change to cash. Balance Sheet: No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 so we balance. Second Year: Same depreciation and tax assumptions as previously. Let s also assume a 10% interest rate on the debt and no debt amortization. Income Statement: Just like the previous question: $20 of depreciation but now we also have $10 of interest expense. Net result is a $18 reduction to net income ($30 x (1 40%)). Cash Flow Statement: Net income down $18 and depreciation up $20. No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities). Net effect is cash up $2. Balance Sheet: Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18. Retained earnings (shareholders equity) down $18 and voila, we are balanced. July 24th, 2008 | Category: Accounting and Financial Statements | Comments are closed Continuing with the last question, on Jan. 1 of Year 3 the equipment breaks and is deemed worthless. The bank calls in the loan. What happens in Year 3? Now the company must writedown the value of the equipment down to $0. At the beginning of Year 3, the equipment is on the books at $80 after one year s depreciation. Further, the company must pay back the entire loan. Income statement: The $80 writedown causes net income to decline $48. There is no further depreciation expense and no interest expense. Cash Flow Statement: Net income down $48 but the writedown is non-cash so add $80. Cash flow from financing decreases $100 when we pay back the loan. Net cash is down $68. Balance Sheet: Cash (asset) down $68, PP&E (asset) down $80, Debt (liability) down $100 and Retained Earnings (shareholders equity) down $48. Left side of the balance sheet is down $148 and right side is down $148 and we re good!

- How long have you been with the bank and how has your experience been? - What do you like best about working here. Worst? - How do you compare working here with other banks at which you have worked? - How is the dealflow? - On what types of deals are you currently working? - What kind of responsibility does the typical Analyst/Associate receive? - Can you tell me about your training program? - How do Analysts/Associates get staffed?

Discounted Cash Flow Analysis Walk me through a Discounted Cash Flow ( DCF ) analysis In order to do a DCF analysis, first we need to project free cash flow for a period of time (say, five years). Free cash flow equals EBIT less taxes plus D&A less capital expenditures less the change in working capital. Note that this measure of free cash flow is unlevered or debtfree. This is because it does not include interest and so is independent of debt and capital structure. Next we need a way to predict the value of the company/assets for the years beyond the projection period (5 years). This is known as the Terminal Value. We can use one of two methods for calculating terminal value, either the Gordon Growth (also called Perpetuity Growth) method or the Terminal Multiple method. To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow forever. This growth rate should be modest, for example, average long-term expected GDP growth or inflation. To calculate terminal value we multiply the last year s free cash flow (year 5) by 1 plus the chosen growth rate, and then divide by the discount rate less growth rate. The second method, the Terminal Multiple method, is the one that is more often used in banking. Here we take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple. This most common metric to use is EBITDA. We typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months (LTM) basis. Now that we have our projections of free cash flows and terminal value, we need to present value these at the appropriate discount rate, also known as weighted average cost of capital (WACC). For discussion of calculating the WACC, please read the next topic. Finally, summing up the present value of the projected cash flows and the present value of the terminal value gives us the DCF value. Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of Enterprise Value, not Equity Value. October 12th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed

What is WACC and how do you calculate it? The WACC (Weighted Average Cost of Capital) is the discount rate used in a Discounted Cash Flow (DCF) analysis to present value projected free cash flows and terminal value. Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile. The WACC reflects the cost of each type of capital (debt ( D ), equity ( E ) and preferred stock ( P )) weighted by the respective percentage of each type of capital assumed for the company s optimal capital structure. Specifically the formula for WACC is: Cost of Equity (Ke) times % of Equity (E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) + Cost of Preferred (Kp) times % of Preferred (P/E+D+P). To estimate the cost of equity, we will typically use the Capital Asset Pricing Model ( CAPM ) (see the following topic). To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies. Similar to the cost of debt, estimating the cost of preferred requires us to analyze the dividend yields on preferred stock issued by similar companies. October 12th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed How do you calculate the cost of equity? To calculate a company s cost of equity, we typically use the Capital Asset Pricing Model (CAPM). The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium. The risk free rate (for a U.S. company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond. Beta (See the following question on Beta) should be levered and represents the riskiness (equivalently, expected return) of the company s equity relative to the overall equity markets. The equity risk premium is the amount that stocks are expected to outperform the risk free rate over the longterm. Prior to the credit crises, most banks tend to use an equity risk premium of between 4% and 5%. However, today is assumed that the equity risk premium is higher. October 12th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed What is Beta? Beta is a measure of the riskiness of a stock relative to the broader market (for broader market, think S&P500, Wilshire 5000, etc). By definition the market has a Beta of one (1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky. For example, if the market is expected to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will be expected to outperform by 11% while a stock with a Beta of 0.9 will be expected to outperform by 9%. A stock with a Beta of -1.0 would be expected to underperform the risk-free rate by 10%. Beta is used in the capital asset pricing model (CAPM) for the purpose of calculating a company s cost of equity. For those few of you

that remember your statistics and like precision, Beta is calculated as the covariance between a stock s return and the market return divided by the variance of the market return. October 12th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta? In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate Beta. We typically get the appropriate Beta from our comparable companies (often the mean or median Beta). However before we can use this industry Beta we must first unlever the Beta of each of our comps. The Beta that we will get (say from Bloomberg or Barra) will be a levered Beta. Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other things being equal, stocks of companies that have debt are somewhat more risky that stocks of companies without debt (or that have less debt). This is because even a small amount of debt increases the risk of bankruptcy and also because any obligation to pay interest represents funds that cannot be used for running and growing the business. In other words, debt reduces the flexibility of management which makes owning equity in the company more risky. Now, in order to use the Betas of the comps to conclude an appropriate Beta for the company we are valuing, we must first strip out the impact of debt from the comps Betas. This is known as unlevering Beta. After unlevering the Betas, we can now use the appropriate industry Beta (e.g. the mean of the comps unlevered Betas) and relever it for the appropriate capital structure of the company being valued. After relevering, we can use the levered Beta in the CAPM formula to calculate cost of equity. October 12th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed What are the formulas for unlevering and levering Beta? Unlevered Beta = Levered Beta / (1 + ((1 Tax Rate) x (Debt/Equity))) Levered Beta = Unlevered Beta x (1 + ((1 Tax Rate) x (Debt/Equity))) October 29th, 2007 | Category: Discounted Cash Flow Analysis | Comments are closed Which is less expensive capital, debt or equity? Debt is less expensive for two main reasons. First, interest on debt is tax deductible (i.e. the tax shield). Second, debt is senior to equity in a firm s capital structure. That is, in a liquidation or bankruptcy, the debt holders get paid first before the equity holders receive anything. Note, debt being less expensive capital is the equivalent to saying the cost of debt is lower than the cost of equity.

Enterprise Value and Equity Value What is the difference between enterprise value and equity value? Enterprise Value represents the value of the operations of a company attributable to all providers of capital. Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders. October 12th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed How do you calculate the market value of equity? A company s market value of equity (MVE) equals its share price multiplied by the number of fully diluted shares outstanding. October 12th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed What is the difference between basic shares and fully diluted shares? Basic shares represent the number of common shares that are outstanding today (or as of the reporting date). Fully diluted shares equals basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt. In calculating a company s market value of equity (MVE) we always want to use diluted shares. Implicitly the market also uses diluted shares to value a company s stock. October 12th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed How do you calculate fully diluted shares? To calculate fully diluted shares, we need to add the basic number of shares (found on the cover of a company s most recent 10Q or 10K) and the dilutive effect of employee stock options. To calculate the dilutive effect of options we typically use the Treasury Stock Method. The options information can be found in the company s latest 10K. Note that if the company has other potentially dilutive securities (e.g. convertible preferred stock or convertible debt) we may need to account for those as well in our fully diluted share count. October 12th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed How do we use the Treasury Stock Method to calculate diluted shares? To use the Treasury Stock Method, we first need a tally of the company s issued stock options and weighted average exercise prices. We get this information from the company s most recent 10K. If our calculation will be used for a control based valuation methodology (i.e. precedent transactions) or M&A analysis, we will use all of the options outstanding. If our calculation is for a minority interest based valuation methodology (i.e. comparable companies) we will use only

options exercisable. Note that options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested. Once we have this option information, we subtract the exercise price of the options from the current share price (or per share purchase price for an M&A analysis), divide by the share price (or purchase price) and multiply by the number of shares outstanding. We repeat this calculation for each subset of options reported in the 10K (usually companies will report several line items of options categorized by exercise price). Aggregating the calculations gives us the amount of diluted shares. If the exercise price of an option is greater than the share price (or purchase price) then the options are out-of-the-money and have no dilutive effect. The concept of the treasury stock method is that when employees exercise options, the company has to issue the appropriate number of new shares but also receives the exercise price of the options in cash. Implicitly, the company can use this cash to offset the cost of issuing new shares. This is why the diluted effect of exercising one option is not one full share of dilution, but a fraction of a share equal to what the company does NOT receive in cash divided by the share price. October 15th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed Why do you subtract cash in the enterprise value formula? Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a nonoperating asset AND (2) cash is already implicitly accounted for within equity value. Note that when we subtract cash, to be precise, we should say excess cash. However, we will typically make the assumption that a company s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash. October 12th, 2007 | Category: Enterprise Value and Equity Value | Comments are closed What is Minority Interest and why do we add it in the Enterprise Value formula? When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books. In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the sub ) on its own financial statements. But since the parent company does not 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting the portion of the sub s net income that the parent is not entitled to (the percentage that it does not own). The parent company s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub s book value of equity that the parent does NOT own. It is the balance sheet minority interest figure that we add in the Enterprise Value formula. Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDA from the parent company s

financial statements, these figures due to the accounting consolidation, will contain 100% of the sub s sales or EBITDA, even though the parent does not own 100%. In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest). By doing this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric. One might ask, instead of adding minority interest to Enterprise Value, why don t we just subtract the portion of sales or EBITDA that the parent does NOT own. In theory, this would indeed work and may in fact be more accurate. However, typically we do not have enough information about the sub to do such an adjustment (minority owned subs are rarely, if ever, public companies). Moreover, even if we had the financial information of the sub, this method is clearly more time consuming.

Leveraged Buyout (LBO) Analysis Walk me through an LBO analysis First, we need to make some transaction assumptions. What is the purchase price and how will the deal be financed? With this information, we can create a table of Sources and Uses (where Sources equals Uses). Uses reflects the amount of money required to effectuate the transaction, including the equity purchase price, any existing debt being refinanced and any transaction fees. The Sources tells us from where the money is coming, including the new debt, any existing cash that will be used, as well as the equity contributed by the private equity firm. Typically, the amount of debt is assumed based on the state of the capital markets and other factors, and the amount of equity is the difference between the Uses (total funding required) and all of the other sources of funding. The next step is to change the existing balance sheet of the company to reflect the transaction and the new capital structure. This is known as constructing the proforma balance sheet. In addition to the changes to debt and equity, intangible assets such as goodwill and capitalized financing fees will likely be created. The third, and typically most substantial step is to create an integrated cash flow model for the company. In other words, to project the company s income statement, balance sheet and cash flow statement for a period of time (say, five years). The balance sheet must be projected based on the newly created proforma balance sheet. Debt and interest must be projected based on the post-transaction debt. Once the functioning model is created, we can make assumptions about the private equity firm s exit from its investment. For example, a typical assumption is that the company is sold after five years at the same implied EBITDA multiple at which the company was

purchased. Projecting a sale value for the company allows us to also calculate the value of the private equity firm s equity stake which we can then use to analyze its internal rate of return (IRR). Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm s original equity investment grows (to its value at the exit). While the private equity firm s IRR is usually the most important piece of information that comes out of an LBO analysis, the analysis also has other uses. By assuming the PE firm s required IRR (amongst other things), we can back into a purchase price for the company, thus using the analysis for valuation purposes. In addition, we can utilize the LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest coverage ratio) which is especially important from a lender s perspective. November 7th, 2007 | Category: Leveraged Buyout (LBO) Analysis | Comments are closed Why do private equity firms use leverage when buying a company? By using significant amounts of leverage (debt) to help finance the purchase price, the private equity firm reduces the amount of money (the equity) that it must contribute to the deal. Reducing the amount of equity contributed will result in a substantial increase to the private equity firm s rate of return upon exiting the investment (e.g. selling the company five years later). November 7th, 2007 | Category: Leveraged Buyout (LBO) Analysis | Comments are closed Let s say you run an LBO analysis and the private equity firm s return is too low. What drivers to the model will increase the return? Some of the key ways to increase the PE firm s return (in theory, at least) include:
y y y

- reduce the purchase price that the PE firm has to pay for the company - increase the amount of leverage (debt) in the deal - increase the price for which the company sells when the PE firm exits its investment (i.e. increase the assumed exit multiple) - increase the company s growth rate in order to raise operating income/cash flow/EBITDA in the projections decrease the company s costs in order to raise operating income/cash flow/EBITDA in the projections

November 7th, 2007 | Category: Leveraged Buyout (LBO) Analysis | Comments are closed What are some characteristics of a company that is a good LBO candidate?

Notwithstanding the recent LBO boom where nearly all companies were considered to be possible LBO candidates, characteristics of a good LBO target include steady cash flows, limited business risk, limited need for ongoing investment (e.g. capital expenditures or working capital), strong management, opportunity for cost reductions and a high asset base (to use as debt collateral). The most important trait is steady cash flows, as the company must have the ability to generate the cash flow required to support relatively high interest expense. Mergers and Acquisitions Walk me through an accretion/dilution analysis The purpose of an accretion/dilution analysis (sometimes also referred to as a quick-and-dirty merger analysis) is to project the impact of an acquisition to the acquiror s Earnings Per Share (EPS) and compare how the new EPS ( proforma EPS ) compares to what the company s EPS would have been had it not executed the transaction. In order to do the accretion/dilution analysis, we need to project the combined company s net income ( proforma net income ) and the combined company s new share count. The proforma net income will be the sum of the buyer s and target s projected net income plus/minus certain transaction adjustments. Such adjustments to proforma net income (on a post-tax basis) include synergies (positive or negative), increased interest expense (if debt is used to finance the purchase), decreased interest income (if cash is used to finance the purchase) and any new intangible asset amortization resulting from the transaction. The proforma share count reflects the acquiror s share count plus the number of shares to be created and used to finance the purchase (in a stock deal). Dividing proforma net income by proforma shares gives us proforma EPS which we can then compare to the acquiror s original EPS to see if the transaction results in an increase to EPS (accretion) or a decline in EPS (dilution). Note also that we typically will perform this analysis using 1-year and 2-year projected net income and also sometimes last twelve months (LTM) proforma net income. October 15th, 2007 | Category: Mergers and Acquisitions | Comments are closed What factors can lead to the dilution of EPS in an acquisition? A number of factors can cause an acquisition to be dilutive to the acquiror s earnings per share (EPS), including: (1) the target has negative net income, (2) the target s Price/Earnings ratio is greater than the acquiror s, (3) the transaction creates a significant amount of intangible assets that must be amortized going forward, (4) increased interest expense due to new debt used to finance the transaction, (5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction and (6) low or negative synergies. October 15th, 2007 | Category: Mergers and Acquisitions | Comments are closed

If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive? Other things being equal, if the Price to Earnings ratio (P/E) of the acquiring company is lower than the P/E of the target, then the deal will be dilutive to the acquiror s Earnings Per Share (EPS). This is because the acquiror has to pay more for each dollar of earnings than the market values its own earnings. Hence, the acquiror will have to issue proportionally more shares in the transaction. Mechanically, proforma earnings, which equals the acquiror s earnings plus the target s earnings (the numerator in EPS) will increase less than the proforma share count (the denominator), causing EPS to decline. October 15th, 2007 | Category: Mergers and Acquisitions | Comments are closed What is goodwill and how is it calculated? Goodwill, a type of intangible asset, is created in an acquisition and reflects the value (from an accounting standpoint) of a company that is not attributed to its other assets and liabilities. Goodwill is calculated by subtracting the target s book value (written up to fair market value) from the equity purchase price paid for the company. This equation is sometimes referred to as the excess purchase price. Accounting rules state that goodwill no longer should be amortized each period, but must be tested once per year for impairment. Absent impairment, goodwill can remain on a company s balance sheet indefinitely. October 15th, 2007 | Category: Mergers and Acquisitions | Comments are closed Why might one company want to acquire another company? There are a variety of reasons why companies do acquisitions. Some common reasons include:
y y

- The Buyer views the Target as undervalued. - The Buyer s own organic growth has slowed or stalled and needs to grow in other ways (via acquiring other companies) in order to satisfy the growth expectations of Wall Street. - The Buyer expects the deal to result in significant synergies (see the next post for a discussion of synergies). - The CEO of the Buyer wants to be CEO of a larger company, either because of ego, legacy or because he/she will get paid more.

October 29th, 2007 | Category: Mergers and Acquisitions | Comments are closed Explain the concept of synergies and provide some examples. In simple terms, synergy occurs when 2 + 2 = 5. That is, when the sum of the value of the Buyer and the Target as a combined company is greater than the two companies valued

apart. Most mergers and large acquisitions are justified by the amount of projected synergies. There are two categories of synergies: cost synergies and revenue synergies. Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations. For example, closing one corporate headquarters, laying off one set of management, shutting redundant stores, etc. Revenue synergies refer to the ability to sell more products/services or raise prices due to the merger. For example, increasing sales due to crossmarketing, co-branding, etc. The concept of economies of scale can apply to both cost and revenue synergies. In practice, synergies are easier said than done. While cost synergies are difficult to achieve, revenue synergies are even harder. The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it. Of course, this last fact never finds its way into a banker s M&A pitch.

Valuation What are the three main valuation methodologies? The three main valuation methodologies are (1) comparable company analysis, (2) precedent transaction analysis and (3) discounted cash flow ( DCF ) analysis. October 12th, 2007 | Category: Valuation | Comments are closed Of the three main valuation methodologies, which ones are likely to result in higher/lower value? Firstly, the Precedent Transactions methodology is likely to give a higher valuation than the Comparable Company methodology. This is because when companies are purchased, the target s shareholders are typically paid a price that is higher than the target s current stock price. Technically speaking, the purchase price includes a control premium. Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium and therefore likely result in a higher valuation than a public market valuation (minority interest based valuation methodology). The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation than the Comparable Company analysis because DCF is also a control based methodology and because most projections tend to be pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or assumptions. October 12th, 2007 | Category: Valuation | Comments are closed How do you use the three main valuation methodologies to conclude value?

The best way to answer this question is to say that you calculate a valuation range for each of the three methodologies and then triangulate the three ranges to conclude a valuation range for the company or asset being valued. You may also put more weight on one or two of the methodologies if you think that they give you a more accurate valuation. For example, if you have good comps and good precedent transactions but have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent Transaction analyses than on your DCF. October 12th, 2007 | Category: Valuation | Comments are closed What are some other possible valuation methodologies in addition to the main three? Other valuation methodologies include leverage buyout (LBO) analysis, replacement value and liquidation value. October 12th, 2007 | Category: Valuation | Comments are closed What are some common valuation metrics? Probably the most common valuation metric used in banking is Enterprise Value (EV)/EBITDA. Some others include EV/Sales, EV/EBIT, Price to Earnings (P/E) and Price to Book Value (P/BV). October 12th, 2007 | Category: Valuation | Comments are closed Why can t you use EV/Earnings or Price/EBITDA as valuation metrics? Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital. That is to say, because EV incorporates all of both debt and equity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debt and equity). If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA. These such metrics are also not dependant on capital structure because they do not include interest expense. Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependant metrics. Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered. Again, apples to oranges. Price/Earnings is fine (apples to apples) because they are both levered. October 12th, 2007 | Category: Valuation | Comments are closed What is the formula for Enterprise Value? The formula for enterprise value is: market value of equity (MVE) + debt + preferred stock + minority interest cash.

October 12th, 2007 | Category: Valuation | Comments are closed

Markets and Investing Are markets efficient? Let s start with an easy one, albeit important one, albeit one that most people, academics included, don t really understand. And the answer is: it depends on the market but in most cases, for all practical purposes the answer is yes. But before we can really answer this question, we need to define market efficiency very clearly (and very simply). Forget what you ve learned about weak forms and strong forms and the other stuff coming out of academia. An efficient market is a market where all publicly available information is priced in. What is public information? Basically, any information that affects the price of that asset, such as information reported by the company, by its competitors, suppliers and vendors, macroeconomic data, etc. So which markets are efficient and which less so? For the most part, the larger and more liquid the market, the more efficient. Large cap U.S. stocks, U.S. treasuries, currency markets? All extremely efficient. Small to mid-cap U.S. stocks? Still pretty efficient but certainly less so than large caps. Microcap stocks and emerging market stocks less efficient still. August 18th, 2009 | Category: Markets and Investing | Leave a comment What does it mean for a market to be efficient? Essentially it means you can t make money, without one of the following (1) luck or (2) nonpublic information. Now, to be precise, the phrase you can t make any money really means, you will not consistently achieve risk-adjusted above market returns. And by you I do mean YOU, whether you re a Harvard undergrad day-trading in your dorm, a retiree with a 401K, or you re running a $10 billion mutual fund or hedge fund. August 18th, 2009 | Category: Markets and Investing | Leave a comment So how do you make money in the markets? Since luck is pretty hard to control, let s talk about the second factor: having non-public information. Now, of course there are two types of non-public information. The legal type and the illegal type. Here at IBankingFAQ, we recommend the legal type, at least in the United States (we give no such recommendation for those investing outside the U.S. ) Most of you probably know what the illegal type is usually called insider information. An example of this would be investing in an airline of which your Dad has influence over union decisions.

The legal type would be any information not known by the broader investing community that has not been obtained illegally (i.e. in violation of SEC or other regulatory body regulations). For example, hedge funds that cover retailers might send consultants to a retail store to count cars in the parking lot or peak into stock rooms to count inventory levels, given them non-public insight into the financial results of the retailer. Or perhaps a doctor, due to his or her own specialty has indirect insight into the likely success or failure of a new drug in clinical trials. Or maybe a mutual fund manager has the ability to meet directly with a management team. Even if no non-public information is disclosed by the CEO during that meeting, the fund manager might have insight into the quality of the CEO that other market participants, who do not have the ability to meet management, cannot have. Keep in mind that often there is a very fine line between legally obtained non-public information and illegal insider information. So how does one go about legally obtaining non-public information? Well, aside from the examples I ve given above, the answer is that it is usually extraordinarily difficult as an individual investor and still extremely difficult as an institutional investor. The short answer is if you re going to try to make money in financial markets, concentrate on less efficient markets such as small cap stocks or emerging markets but ONLY if you have the ability to uncover non-public information. The even shorter answer is, its nearly impossible for an individual investor (or institutional investor such as a hedge fund) to outperform the market so don t even try. August 18th, 2009 | Category: Markets and Investing | Leave a comment If you say markets are efficient, then explain the dot-com bubble or the real estate bubble. Ah ha! You think you ve got me, don t you? Recall the definition of an efficient market: that all public information is priced in. I never said that prices were fundamentally correct (more on this in the next question). I merely said to be efficient prices must reflect all publicly available information. If the consensus amongst the public (i.e. market participants) is that we re in a new era of phenomenal growth to which the world has never seen before, then that public sentiment (or more precisely, that economic outlook or forecast) will be priced into stocks (or other financial assets). That overly optimistic sentiment may be ultimately shown to be foolish or short-sighted, but it does not mean that markets are inefficient, or even wrong. August 18th, 2009 | Category: Markets and Investing | Leave a comment Aren t you saying that there is no such thing as a bubble? No. Prices of financial assets can certainly rise to unsustainable levels due to overly optimistic forecasts. And this is actually pretty easy to spot, at least near its peak. You may recall that plenty of market commentators and academics spoke of an Internet bubble in the late 90s and a real estate bubble in the last few years. What I am saying is that just because asset prices may

vary greatly over time (say NASDAQ at over 5000 in March 2000 and at about 1100 two and a half years later) doesn t mean that markets are inefficient. It just means that public information (i.e. market sentiment and forecasts) changed. August 18th, 2009 | Category: Markets and Investing | Leave a comment I still don t get it. How can fundamental value change in such a short period of time? Now you re thinking. Fundamental value doesn t change because there is no such thing as fundamental value. Let me repeat that again: there is no such thing as fundamental value. This is perhaps the most important myth of finance (and economics). There is only relative value. Those of you that are on this site doing investment banking interview prep know that the way you value a company is by comparing its value to other similar companies (even our so called intrinsic value DCF analysis uses comparisons to come up with forecasts, terminal values and WACC). So, if Amazon in 1999 trades at a 100x P/E ratio than why shouldn t Ebay or Pets.com? Similarly, if my neighbor s ocean front Miami beach condo sells for $1 million shouldn t my identical one also be valued at $1 million? That there is no such thing as fundamental value is true for not only financial assets but applies to all assets. August 18th, 2009 | Category: Markets and Investing | Leave a comment Even if markets are efficient then surely a boom or subsequent bust proves that market participants are irrational, right? Wrong. Not just wrong, but WRONG. This is one question that everyone and I mean everyone gets wrong. People are rational. Period. Full Stop. (No, I m not Milton Friedman writing from the grave). August 18th, 2009 | Category: Markets and Investing | Leave a comment How can you say that people are rational given all of the research that seems to show otherwise in addition to all of the booms and busts throughout history? Okay, this is really important. To really understand this point, let s first understand how economists usually define rationality. An economic actor (that is to say, a person) is rational if he or she always makes decisions which will maximize his or her economic well being. Now, there is an enormous body of research in psychology and behavioral economics (the same field by the way just that the economics know how to use statistics) that shows otherwise. This we do not dispute in the least. What we dispute is the above definition of rationality. It is wrong in three ways. The most obvious way it is wrong is that we don t maximize our current economic well being but the present value of our well being. Now, I would guess that almost all economists would probably agree with this modified definition. But it is a very important distinction because people have very different discount rates. That is to say, some people place much more value on well being

today versus well being in the future. To place more value on well being today is not irrational if one s discount rate at the time is higher. The second error in the definition of rationality is that people don t seek to maximize their economic being (that is to say, their wealth or income) but their overall well being or their utility . (I have a lot more to say about the definition utility but for now leave it as one s overall well-being). Now again, most economics would agree with this modification to the definition but alas, fail to internalize the distinction. Understanding that many decisions (even investing ones) are affected by things are than income or wealth goes far to explain many of the experiments that claim to prove that people are irrational. For example, many studies have shown that individual investors trade too much even though they know that trading costs hurt their overall investment performance. Therefore, they are irrational, right? Not necessarily. Most individuals who trade in and out of stocks get other utility out of their actions. That is to say, trading is fun, not unlike, say, going to Las Vegas. In other words, the entertainment value of trading adds more to their utility than the lost money due to trading costs subtracts. There is nothing irrational about that. The third and final error is probably the most important one and also the least understood. Many experiments have shown that when faced with a probability based decision many people make the wrong choice (that is one that results in lower expected value) or given two sets of decisions, make inconsistent choices. These types of experiments are used to demonstrate the irrationality of human beings. But this is wrong. What they demonstrate mostly is that humans are bad at probabilities (they demonstrate other things as well for example that most of us would rather not lose money than gain money). Perhaps we re all dumb, perhaps we all slept through statistics class in college or perhaps our incentives are messed up. That we don t fully understand the question or that we didn t bother (or don t know how) to do the expected value arithmetic does not demonstrate irrationality. So the third distinction that we need to make to our definition of rationality is that we make decisions to maximize the present value of our utility based on the decision maker s understanding of the decision and NOT the experimenter s understanding of the decision. Assuming you re still reading this and haven t fallen asleep, you might be wondering so what? Who cares if people are rational or not? Let s talk about that next. August 18th, 2009 | Category: Markets and Investing | Leave a comment Who cares if investors are rational or irrational? To some extent this is really an academic argument. Why does it matter if investors make rational and stupid decisions (as I say) or irrational ones (as everyone else says). I do think knowledge for knowledge sake is cool and to better understand how people make decisions is cool too. However I also think there is something very important about the distinction as it relates to policy.

Given today s economic situation, the irrationality of investors and economic actors is being used to justify hugely significant policy decisions. Instead we should be focusing on, for example, the horribly wrong incentive structures throughout the finance system that led to (rational) decision making which in turn led to the our current economic woes (much more to come about this under Current Economic Situation category). We also should be focusing on how to educate people to make smarter decisions (i.e. to understand economic and finance decisions). It is also important to understand the fallacy of irrationality because it is being used as key evidence of the inherent failure or instability of a free market system. This couldn t be further from the truth, as we will also discuss in other posts. August 18th, 2009 | Category: Markets and Investing | Leave a comment If people are indeed rational, as you say, then how can bubbles arise and persist for so long? August 18th, 2009 | Category: Markets and Investing | Leave a comment Is investing in stocks really investing? No. Buying stocks is speculating. Even if you re buying value stocks. Even if you re planning to hold stocks for the long-term (whatever that means). I wish more people understood this. Anytime you spend money on the hope and prayer that the thing you bought appreciates in value, you are speculating, not investing. Here s another way to think about it. If you have significant control over your spent money (say, starting a business or building a new factory) then you re investing. If you don t then you re speculating. Oh, and one last thing: speculating is just a more acceptable synonym for gambling. August 18th, 2009 | Category: Markets and Investing | Leave a comment Does fundamental analysis work? As we alluded to when we were discussing the efficiency of markets, fundamental analysis works if and only if you can discover important enough non-public information AND that nonpublic information will become public within a reasonable time frame. It is not enough to discover the information because if other market participants don t learn about it (there s no catalyst ), prices won t reflect it and you can t make money on it. Now, one type of non-public information would be to have a different (better) view on the company s prospects or on say, macroeconomic prospects. Three things make this very difficult in practice. Firstly, it is very difficult to be smarter than the market. Second, even if you are correct, it often takes much longer to be proven right, hurting your returns (or worse). This is analogous to Keyne s famous statement that the market can remain irrational far longer than you can be solvent. I would, of course, modify this to say that the market can remain stupid far longer than you can be solvent. Third, since the market tends to lean towards optimism most of

the time, having a contrarian view usually means being short the market. Shorting the market brings its own set of risks and is a strategy that is extraordinarily difficult with which to make money. You may have noted that numbers 2 and 3 help illustrate why bubbles can persist for a long time. August 18th, 2009 | Category: Markets and Investing | Leave a comment Does technical analysis work? Yes. No. Maybe. I think all three are correct depending on how we define technical analysis. Academics have known for about 15 years that stocks with positive momentum tend to outperform stocks with negative momentum. Traders and speculators have probably known this for centuries longer. If we define technical analysis as using information contained in historical prices (and other information such as trading volume) to predict future prices than there is no question the answer is yes, technical analysis does work. Most quantitative trading methods (including high frequency trading) is based on this sort of analysis. In fact, I would go as far as to say that much of what people view as fundamental analysis is actually technical analysis. I would argue that much of value investing (e.g. buying stocks with low Price/Book Value ratios or Price/Earnings ratios is actually a reflection of technical factors (the stock has gone down in the past) than it is of fundamental factors such as its book value or earnings. If, however, we define technical analysis as humans looking at charts looking for patterns which they then give cool names, I am more than a little skeptical. Not because the charts don t contain good information (they contain the same information used by the computers discussed above) but because I am skeptical that humans can consistently and correctly interpret this information. I do leave open the possible that certain exceptional individuals can indeed profit from interpreting such charts. I ve stated that technical analysis is essentially just momentum investing (I use the word investing loosely). I think its worth mentioning that virtually all trading is based on momentum investing. Of course the downside of momentum (from the trader s perspective) as a strategy is that it works until it doesn t. Which is to say you ve got to get out in time (no easy task), making it a risky strategy. From the market s prospective, it is not difficult to see the relationship between momentum and frothy markets.