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Do companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, companies generally prefer straight-line depreciation. That's because a company will record lower depreciation in the early years of the asset's life than if they had used accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income than under accelerated depreciation.
Do companies depreciate land?
No, land is considered to have an indefinite life and is not depreciated.
Can companies amortize goodwill?
Under GAAP, public companies are not allowed to amortize goodwill. Instead, it must be tested annually for impairment.
The longer answer is that under GAAP, public companies are not allowed to amortize goodwill and must instead test it annually for impairment. However, private companies may elect to amortize goodwill. In
addition, for tax reporting purposes, goodwill may be amortized over 15 years under some circumstances.
What is the impact of share issuance on EPS?
The major impact to EPS is that the actual share count increases, thereby decreasing EPS. However, there is sometimes an impact on net income. That's because assuming share issuances generate cash for the company, there will be higher interest income, which increases net income and EPS slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the negative impact to EPS from a higher share count.
What is the impact of share repurchases on EPS?
The major impact to EPS is that the actual share count is reduced, thereby increasing EPS. However, there is sometimes an impact on net income. That's because assuming share repurchases are funded with the company's excess cash, any interest income that would have otherwise been generated on that cash is no longer available, thereby reducing net income - and EPS - slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the positive impact to EPS from a lower share count.
How do you calculate earnings per share?
Earnings per share (EPS) is calculated as net income divided by the company's weighted average shares outstanding during the period.
There are two ways to measure EPS - Basic and Diluted. Basic
Under US GAAP, companies can choose to account for leases as operating or capital leases.
Operating leases primarily only impact the income statement. When leases are accounted for as operating leases, lease (rent) payments are treated as operating expenses like wages and utilities: Regardless of whether you sign a 1-year lease or a 30-year lease, every time you pay the rent, cash is credited and an operating expense is debited.
The only significant balance sheet impacts have to do with timing differences between payments (prepaid and accrued rent) and the matching of rent payments to when the tenant benefits from that rent (leading to balance sheet accruals for smoothing of rent escalations and upfront rent incentives like a free month). Starting in 2019, operating leases will no longer be allowed under US GAAP.
How can a profitable firm go bankrupt?
To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it is unable to get favorable terms from suppliers and must pay cash for all inventories and supplies, what can occur is that despite a profitable income statement, the company suffers from liquidity problems due to the timing mismatch of cash inflows and outflows.
While reliably profitable companies who simply have these working capital issues can usually secure financing to deal with it, theoretically, if financing becomes unavailable for some reason (the 2008 credit crisis is an example where even profitable companies couldn't secure financing), even a profitable company could be forced to declare bankruptcy.
Is it bad if a company has negative retained earnings?
Not necessarily. Retained earnings will be negative if the company has generated more accounting losses than profits. This is often the case for early-stage companies that are investing heavily to support future growth. The other component of retained earnings is common or preferred dividends, which could contribute to a lower or even negative retained earnings.
What's more important: the income statement or the cash flow statement?
hey are both important and any serious analysis requires using both. However, I would think that the cash flow is slightly more important because it reconciles net income, the accrual-based bottom line on the income statement to what's happening to cash, while also showing you the critical movement of cash during the period. Without the cash flow statement, I can only see what's happening from an accrual profitability standpoint. The cash flow statement on the other hand can alert me to any liquidity issues, as well as any other major investments or financial activities that do not hit the income statement.
The one situation in which I would prefer the income statement is if I also have the beginning and end- of-year balance sheet. That's because I could reconcile the cash flow statement simply by looking at the balance sheet year over changes along with the income statement.
Why are increases in accounts receivable a cash reduction on the cash flow statement?
Since cash flow statements start with net income, and net income captures all of a company's revenue - not just cash revenue - an increase in accounts receivable suggests that more customers paid with credit during the period and so an adjustment down needs to be made to net income when arriving at cash since the company never actually received those funds - they're still sitting on the balance sheet as receivables.
Cash goes down by the purchase price and is reflected in the cash from investing section. On the balance sheet, the offsetting entry to the cash reduction is an increase in PP&E. There is no immediate impact on the income statement.
Over the life of the asset, depreciation expense from the building is recognized on the income statement and reduces net income by the amount of depreciation expense net of tax expense saved due to the depreciation expense. That's because depreciation is generally tax deductible.
On the cash flow statement, depreciation is added back since it is non-cash. On the balance sheet, PPE is reduced by the depreciation and is offset by a reduction to retained earnings for the depreciation expense.
How does selling a building impact the 3 statements?
If I sell a building for $10 million that has a book value of $6 million on my balance sheet, I will recognize a $4 million gain on sale on the income statement which will – ignoring taxes for a moment – increase my net income by $4 million.
On the cash flow statement, since the $4 million gain is non-cash, it will be subtracted out from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. On the balance sheet, the $6 million book value of the building is removed, while retained earnings increases by $4 million. The net credit of $10 million is offset by a $10 million debit to cash that came from the cash flow statement.
Stop here for non-finance students. Business students should expand as follows:
The gain on sale will also however result in higher taxes. Assuming a 25% tax rate, I will pay $1 million in additional tax – 25% of $4 million – which will be recognized on the income statement. This lowers retained earnings by $1 million and is offset by a $1 million credit to cash.
Is EBITDA a good proxy for cash flow?
Not really. That's because even though EBITDA does add back D&A - typically the largest non-cash expense - it does not capture any working capital changes during the period. It also doesn't capture cash outflows from taxes or interest payments. Those adjustments would need to be made to get to operating cash flows. EBITDA also doesn't capture stock-based compensation (SBC) expenses required to get to operating cash flows (although an increasingly used "adjusted EBITDA" calculation does add back SBC)
How are the 3 financial statements connected?
The financial statements are very interconnected, both directly and indirectly.
The income statement is directly connected to the balance sheet through retained earnings. Specifically, net income (the bottom line in the income statement) flows through retained earnings as an increase each period less dividends issued during the period.
The offsetting balance sheet adjustments to the increase in retained earnings impacts a variety of line items on the balance sheet, including cash, working capital and fixed assets.
The cash flow statement is connected to the income statement through net income as well, which is the starting line of the cash flow statement.
Lastly, the cash flow statement is connected to the balance sheet because the cash impact of changes in balance sheet line items like working capital, PP&E (through capex), debt, equity and treasury stock are all reflected in the cash flow statement. In addition, the final calculation in the cash flow statement - net change in cash - is directly connected to balance sheet, as it grows the beginning of the period cash balance to arrive at the end of period cash balance on the balance sheet.
Yes. Negative debt simply means that a company has more cash than debt. For example, Apple and Microsoft have massive negative net debt because they hoard so much cash. In these cases, companies will have enterprise values lower than their equity value.
Note: If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value just represents the value of a company’s operations – which excludes any non-operating assets. When you think of it this way, it should come as no surprise that companies with a lot of cash (which is treated as a non-operating asset in the prevailing definition of enterprise value) will have higher equity than enterprise values.
Why would a company issue equity vs. debt (and vice versa)?
Perhaps the greatest advantage of equity is that it has no required payments, thus giving management more flexibility around the repayment of capital (equity eventually gets it back in the form of dividends, but timing and magnitude are entirely at the board and management's discretion).
Another advantage in the case of public equity is that it gives companies access to a very large investor base. On the other hand, equity dilutes ownership, and is generally more expensive (i.e. higher cost of capital). In addition, public equity comes with more regulation and scrutiny.
An advantage of debt is that unlike equity, debt is tax-deductible (although recent tax reform rules limit the deduction for highly-levered companies). In addition, debt results in no ownership dilution and generally has a lower cost of capital. Of course, the disadvantages are that debt means the company faces required interest and principal payments, and it introduces the risk of default. In addition, debt covenants can restrict management from undertaking a variety of activities.
How many years would it take to double a $100,000 investment at a 9% annual return (no calculator)?
The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72 by the investment's annual return. In this case, the rule of 72 suggests that it would take approximately 72/9 = 8 years.
Why would a company buy back (aka repurchase) shares? What would be the impact on share price and the financial statements?
A company buys back shares primarily as a way to move cash from the company's balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash (in the case of dividends), a share repurchase removes shareholders, leaving a smaller shareholder base.
The impact on share price is theoretically neutral - as long as shares are priced correctly, a share buyback should not lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can impact share price movement positively or negatively if they are perceived as a new signal about the company's future behavior or growth prospects.
For example, cash-rich but otherwise risky companies could see artificially low share prices if investors are discounting that cash. In this case, a buyback should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator.
Conversely, if shareholders view the buyback as a signal that the company's investment prospects aren't great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash AND lower perceived growth and investment prospects).
On the financial statements, a $100 million share buyback would be treated as follows:
Cash is credited by $100 million
Treasury stock is debited by $100 million
Assume a company has ROA of 10% and a 50/50 debt-to-equity capital structure. What is the ROE?
Growth and cost of capital are not the only drivers of value. Another critical component is return on invested capital. All else equal, if one of the companies has a higher return on equity, you would expect its PE ratio to be higher.
Other reasons may include relative mispricing or inconsistent calculations of EPS due to things like nonrecurring items and different accounting assumptions.
Should two identical companies but with different rates of leverage trade at different EV/EBITDA multiples?
You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company's value and profits independent of its capital structure. Technically, they will not be exactly equal because EV does depend on cost of capital so there will be some variation
Should two identical companies but with different rates of leverage trade at different P/E multiples?
P/E multiples can vary significantly due to leverage difference for otherwise identical companies. All else equal, as a company borrows money (debt), the EPS (denominator) will decline due to higher interest expense.
The impact on the share price, on the other hand, is harder to predict and depends on how the debt will be used. At the two most extreme cases, imagine the debt proceeds will go unused, generating no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment.
In this scenario, the share price can be expected to decline to such a level that the PE ratio declines. On the other hand, if the debt is used to efficiently invest and grow the business, the P/E ratio will increase.
You are evaluating a company that has net income of $100 million and a PE multiple of 15x. The company is considering raising $200 million in debt in order to pay a one-time special cash dividend to shareholders. Do you think this is a good idea?
The answer depends on several factors. If we make an assumption that the PE multiple stays the same after the dividend and a cost of debt of 5% (note: there’s also tax impact since interest is mostly deductible but in the interview you can probably ignore taxes for simplicity), the impact to shareholders is as follows:
Net income will drop from $100 to $90 [($200 new borrowing x 5%) = $10 million]
Equity value will drop from $1,500 million (15.0 x $100 million) to $1,350 million (15.0 x $90 million).
That’s a $150 million drop in equity value. However, shareholders are immediately getting $200 million. So ignoring any tax impact, there’s a net benefit of $200 – $150 million to shareholders from this move.
Obviously, the assumptions we made about taxes, cost of debt and the multiple staying the same inform the result. If any of those variables are different – for example, if the cost of debt is higher, equity value might be destroyed in light of this move.
A key assumption in getting the answer here was that PE ratios will stay the same at 15x. A company’s PE multiple is a function of its growth prospects, returns on equity and cost of equity. Borrowing more without any compensatory increase in investment or growth will raise the cost of equity (via a higher beta) which will pressure the PE multiple down.
So while it appears based on our assumptions that this is an ok idea, it could easily be a bad idea given a different set of assumptions. Moreover, it is possible to broadly say that borrowing for the sake of issuing dividends is unsustainable indefinitely, because eventually debt levels will rise to a point where cost of capital and PE ratios are adversely impacted. Debt should generally be used to support investments and activities that will increase firm and shareholder value rather than to extract cash from the business.
The most notable exceptions to this are companies like Apple with low cost of debt and large excess cash that can’t be distributed due to repatriation reasons and thus borrow to issue dividends.
working capital adjustments, subtract capital expenditures and add cash inflows or outflows for cash from new borrowing, net of dept paydowns.
Contrast the DCF approach to comps.
The DCF values a company based on the company's forecasted cash flows. This is viewed as the most direct and academically rigorous way to measure value, but it suffers from several drawbacks, most notably that it is very sensitive to assumptions which makes it easily to manipulate.
Comps, on the other hand, values a company by looking at how the market values similar businesses. Comps relies much more heavily on market pricing to determine value than the DCF. While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced in an acquisition, it is vulnerable to two criticisms - 1) The market isn't always right and therefore a comps analysis is simply pricing, as opposed to valuing a business and 2) There are very few truly comparable companies so you're in effect always comparing apples and oranges.
Because both approaches have drawbacks, both approaches are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa). For example, an analyst valuing an acquisition target will look the premiums and values paid on comparable transactions to determine what the acquirer must realistically expect to pay. But in addition, the analyst may value the company using the DCF to help show how far off the "intrinsic" value the market prices are. Another example of how these two valuation approaches are used together is when an investor considers investing in a business - the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuation derived using a DCF (although it bears repeating that the DCF's sensitivity to assumptions is a frequent criticism of its usefulness).
How do you calculate the terminal value?
There are two common approaches for calculating the terminal value:
Growth in perpetuity
Exit multiple approach.
The growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the stage 1 forecast period, and inserting this assumption into the perpetuity formula:
Terminal value = Unlevered Free cash flow / (WACC – long term growth rate)
When doing a levered DCF, the perpetuity formula would be:
Terminal value = Levered Free cash flow / (Cost of equity – long term growth rate)
The exit multiple approach calculates the terminal value by applying a multiple assumption on a financial metric in the terminal year (usually EBITDA). The multiple should reflect the multiple a comparable company in a mature state would expect to trade at to reflect the fact that the company should theoretically be in a normalized mature state at the terminal year. Under both approaches, the terminal value represents a present value in the terminal year and thus both approaches need to discount the terminal value back to the valuation date.
How would you handle stock options when calculating a company's share count?
Companies often issue stock options. The common convention is to include in the dilutive share count any vested (exercisable) options whose strike price is below the current share price (“in the money”).
In addition, any option proceeds that the company would receive from the exercise of these options are assumed to be used by the company to repurchase shares at the current share price (called the treasury stock method).
How would you handle convertible bonds in the share count?
Convertible bonds are assumed to be converted into common stock if the conversion price of the bond (book value of bond / shares bond is convertible into) is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing a bond convertible into 10 million shares of common stock. Because the current share price is > the conversion price, we would assume that the bond is converted for the purposes of calculating the diluted share count.
When you do assume conversion into common stock for the purposes of calculating the share count in the context of a valuation, you should eliminate the convertible bond from the balance sheet when calculating net debt to be consistent and to avoid double counting.
How should operating leases be treated in a DCF valuation?
They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar in nature to debt obligations than to a simple expense (i.e. tenants should present the lease obligation as a liability on their balance sheet as they do long term debt).
In fact, the option to account for leases as operating lease is set to be eliminated starting in 2019 for that reason. In the meantime, when operating leases are significant for a business (retailers and capital- intensive businesses), the rent expense should be ignored from the free cash flow buildup, and instead, the present value of the lease obligation should be reflected as part of net debt.
What's the difference between WACC and IRR?
The IRR is the discount rate on a stream of cash flows that leads to a net present value of 0. The WACC (or cost of capital) is the minimum required internal rate of return for both debt and equity providers of capital. Thus an IRR that exceeds the WACC is often used as criteria for deciding whether a project should be pursued.
When valuing a company using multiples, what are the tradeoffs of using LTM vs. forward multiples?
Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT and EPS forecasts are subjective. This is particularly problematic for smaller public firms, whose guidance tends to be less reliable and generally harder to come.
That said, LTM suffers from the problem that historical results are often distorted by nonrecurring expenses and income that were recognized during the period and distort the picture of recurring operating performance. That's why when using LTM results it is important to exclude nonrecurring items to get a clean multiple.
That's why both LTM and forward multiples are often presented side by side, rather than picking just one.
What can a transaction comps analysis tell you that a trading comps analysis cannot?
Transaction comps can provide insight into purchase premiums that buyers and sellers should expect when negotiating a transaction.
How would you value a private company?
The main difference between valuing a private and public company is availability of data - private companies are usually not required to make their financial statements and details public. Historical data is critical for performing a DCF. If you're provided private company financials, the process is similar to public companies except that private company financial disclosures are often less complete, standardized and reliable. In addition, private companies are less liquid and should thus be valued lower all else equal to reflect the liquidity premium.
