Advanced Tech Questions

8/6/2019 Advanced Tech Questions

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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


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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 finan

cial 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). Ive 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 andwork 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.


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Dont 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 balancesheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholders 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

Acompany makes a $100 cash purchase of equipment on Dec. 31. How does this impact thethree statements this year and next year?

First Year: Lets assume that the companys 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 weve 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 lets 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


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$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, weve 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, weve

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. Lets 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 |C

omments arec

losed

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 years 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 RetainedEarnings (shareholders equity) down $48. Left side of the balance sheet is down $148 and right

side is down $148 and were good!


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- 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 thechange in working capital. Note that this measure of free cash flow is unlevered or debt-

free. 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 orinflation. To calculate terminal value we multiply the last years 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


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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 companys 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.


How do you calculate the cost of equity?

To calculate a companys 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 companys equity relative to the overall equity markets. The equity riskpremium is the amount that stocks are expected to outperform the risk free rate over the long-

term. 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.


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 lessthan 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 companys cost of equity. For those few of you


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that remember your statistics and like precision, Beta is calculated as the covariance

between a stocks return and the market return divided by the variance of the market return.


When using the CAPM for purposes ofcalculating 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 debtincreases 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.


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)))


Whic

h is less expensivec

apital, 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 firms 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.


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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 companys market value of equity (MVE) equals its share price multiplied by the number of

fully diluted shares outstanding.


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 companys market value of equity (MVE) we always want to use diluted

shares. Implicitly the market also uses diluted shares to value a companys stock.


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 companys 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 companys 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.


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 companys issued stock options

and weighted average exercise prices. We get this information from the companys 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


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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 thiscalculation 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.


Why do you subtract cash in the enterprise value formula?

Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a non-

operating 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 companys cash balance (including cash equivalents such as

marketable securities or short-term investments) equals excess cash.


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 subs net income that the parent isnot entitled to (the percentage that it does not own). The parent companys balance sheet will

also contain a line item called minority interest which reflects the percentage of the subs 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 companys


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financial statements, these figures due to the accounting consolidation, will contain 100% of the

subs 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 dont 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 companys income statement, balance sheet and cashflow 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

firms 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


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purchased. Projecting a sale value for the company allows us to also calculate the value of the

private equity firms 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 firms original equity investment grows (to its value at the

exit).

While the private equity firms 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

firms 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 lenders 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 firms rate of return upon exiting the investment (e.g. selling the company five

years later).


Lets say you run an LBO analysis and the private equity firms return is too low. What drivers

to the model will increase the return?

Some of the key ways to increase the PE firms return (in theory, at least) include:

y - reduce the purchase price that the PE firm has to pay for the companyy - increase the amount of leverage (debt) in the dealy - increase the price for which the company sells when the PE firm exits its investment

(i.e. increase the assumed exit multiple)

y - increase the companys growth rate in order to raise operating income/cashflow/EBITDA in the projectionsdecrease the companys costs in order to raise operating income/cash flow/EBITDA in

the projections


What are some characteristics of a company that is a good LBO candidate?


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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 acquirors Earnings Per Share

(EPS) and compare how the new EPS (proforma EPS) compares to what the companys EPS

would have been had it not executed the transaction.

In order to do the accretion/dilution analysis, we need to project the combined companys netincome (proforma net income) and the combined companys new share count. The proforma

net income will be the sum of the buyers and targets 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 acquirors 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 acquirors originalEPS 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 ofEPS in an acquisition?

A number of factors can cause an acquisition to be dilutive to the acquirors earnings per share

(EPS), including: (1) the target has negative net income, (2) the targets Price/Earnings ratio is

greater than the acquirors, (3) the transaction creates a significant amount of intangible assetsthat 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.



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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 acquirors Earnings Per Share

(EPS). This is because the acquiror has to pay more for each dollar of earnings than the marketvalues its own earnings. Hence, the acquiror will have to issue proportionally more shares in the

transaction. Mechanically, proforma earnings, which equals the acquirors earnings plus the

targets earnings (the numerator in EPS) will increase less than the proforma share count (the

denominator), causing EPS to decline.


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 andliabilities. Goodwill is calculated by subtracting the targets 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 companys balance sheet indefinitely.


Why might one company want to acquire another company?

There are a variety of reasons why companies do acquisitions. Some common reasons include:

y - The Buyer views the Target as undervalued.y - The Buyers 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.

y - The Buyer expects the deal to result in significant synergies (see the next post fora discussion of synergies).

y- 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.


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


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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 cross-

marketing, 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 bankers 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

targets shareholders are typically paid a price that is higher than the targets 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.


How do you use the three main valuation methodologies to conclude value?


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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.


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.


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).


Why cant 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.


What is the formula for Enterprise Value?

The formula for enterprise value is: market value of equity (MVE) + debt + preferred stock +

minority interest cash.


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Markets and Investing

Are markets efficient?

Lets start with an easy one, albeit important one, albeit one that most people, academics

included, dont 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 youve 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 cant make money, without one of the following (1) luck or (2) non-

public information. Now, to be precise, the phrase you cant make any money really means,

you will not consistently achieve risk-adjusted above market returns. And by you I do mean

YOU, whether youre a Harvard undergrad day-trading in your dorm, a retiree with a 401K,

or youre running a $10 billion mutual fund or hedge fund.


So how do you make money in the markets?

Since luck is pretty hard to control, lets 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.


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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 Ive 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 youre

going to try to make money in financial markets, concentrate on less efficient markets such assmall 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 dont even try.


If you say markets are efficient, then explain the dot-com bubble or the real estate bubble.

Ah ha! You think youve got me, dont 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 were 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.


Arent 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


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vary greatly over time (say NASDAQ at over 5000 in March 2000 and at about 1100 two and a

half years later) doesnt mean that markets are inefficient. It just means that public information

(i.e. market sentiment and forecasts) changed.


I still dont get it. How can fundamental value change in such a short period of time?

Now youre thinking. Fundamental value doesnt 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 shouldnt Ebay or

Pets.com? Similarly, if my neighbors ocean front Miami beach condo sells for $1 million

shouldnt 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.


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, Im not Milton Friedman writing from

the grave).


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, lets 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 dont 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


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today versus well being in the future. To place more value on well being today is not irrational if

ones discount rate at the time is higher.

The second error in the definition of rationality is that people dont 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 onesoverall 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 were all

dumb, perhaps we all slept through statistics class in college or perhaps our incentives are

messed up. That we dont fully understand the question or that we didnt bother (or dont knowhow) 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 makers understanding of the

decision and NOT the experimenters understanding of the decision.

Assuming youre still reading this and havent fallen asleep, you might be wondering so

what? Who cares if people are rational or not? Lets talk about that next.


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.


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Given todays 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 couldnt be further

from the truth, as we will also discuss in other posts.


If people are indeed rational, as you say, then how can bubbles arise and persist for so long?


Is investing in stocks really investing?

No. Buying stocks is speculating. Even if youre buying value stocks. Even if youre 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. Heres 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 youre investing. If you dont then youre speculating.

Oh, and one last thing: speculating is just a more acceptable synonym for gambling.


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 non-

public information will become public within a reasonable time frame. It is not enough to

discover the information because if other market participants dont learn about it (theres no

catalyst), prices wont reflect it and you cant make money on it.

Now, one type of non-public information would be to have a different (better) view on thecompanys 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 Keynes 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


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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.


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 highfrequency 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 dont

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 thisinformation. I do leave open the possible that certain exceptional individuals can indeed profit

from interpreting such charts.

Ive 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 traders perspective) as a strategy is

that it works until it doesnt. Which is to say youve got to get out in time (no easy task),

making it a risky strategy. From the markets prospective, it is not difficult to see the

relationship between momentum and frothy markets.

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