Accounting - "Talking"
68 cardsby @nagong1
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68
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Walk me through the 3 financial statements & how they generally work
Not measured yet- The three financial statements are the income statement, balance sheet, and cash flow statement, and each answers a different question about the business●●○○○
- The income statement measures profitability over a period, flowing from revenue down through costs to net income●●○○○
- Net income tells you whether the company made or lost money●●●○○
- The balance sheet is a snapshot at a point in time showing assets — resources like cash, inventory, and PP&E●○○○○
- Assets are funded either by liabilities like debt and payables or by shareholder equity, and assets always equal liabilities plus equity●●●○○
- The cash flow statement measures liquidity — actual cash generated and used over a period●●●○○
- The cash flow statement starts with net income, adds back non-cash charges like D&A, and adjusts for working capital to get operating cash flow●●○○○
- Investing activities capture cash spent on long-term assets like CapEx, and financing activities capture debt, equity, and dividend flows●●○○○
- Net income from the income statement feeds the cash flow statement and flows into retained earnings on the balance sheet, and the cash flow statement's net change in cash explains why the balance sheet's cash balance changed●●●●○
How do the three statements link together?
Not measured yet- Net income from the income statement flows into retained earnings within shareholder equity on the balance sheet●○○○○
- Net income is also the starting line of the cash flow statement●●○○○
- Changes in short-term assets and liabilities on the balance sheet appear as working capital changes in the operating section of the cash flow statement●●○○○
- A growing short-term asset like receivables is a use of cash, which is why working capital changes adjust operating cash flow●●●●○
- Investing activity like CapEx reduces cash but increases PP&E on the balance sheet●●○○○
- Financing activity changes debt and equity balances — issuing or repaying debt, issuing stock, or paying dividends●●○○○
- Ending cash on the balance sheet equals beginning cash plus the net change in cash from the cash flow statement, closing the loop and keeping the balance sheet balanced●●●○○
Walk me through the income statement
Not measured yet- The income statement shows profitability over a period, flowing top to bottom from revenue to net income●○○○○
- Revenue minus COGS — the direct cost of what was sold — gives gross profit●●●○○
- Gross profit shows how profitable the core product is before any overhead●●●○○
- Gross profit minus operating expenses — SG&A and D&A — gives EBIT, or operating profit●●●○○
- EBIT measures the profitability of the business's operations independent of how it is financed, so it lets you compare operating performance across companies with different debt loads●●●●○
- Adding D&A back to EBIT gives EBITDA, which strips out the non-cash charge●●●○○
- EBITDA is a rough proxy for operating cash generation●●●○○
- Below the operating line, subtract interest expense and then tax the pre-tax income to arrive at net income●●○○○
- Everything above EBIT is operational, while everything below — interest and taxes — reflects capital structure and the tax regime●●●○○
Give me more details on assets, liabilities, and equity
Not measured yet- Assets, liabilities, and equity are the three balance sheet categories, tied by the identity assets equal liabilities plus equity●●○○○
- Assets are resources the company controls that are expected to bring positive monetary benefits — future inflows of cash or value●●○○○
- Examples of assets include cash, inventory, receivables, and PP&E used to generate revenue●●○○○
- Liabilities are unsettled obligations to outside parties that represent future outflows of cash, like payables and debt●○○○○
- Liabilities are an external source of capital — lenders and suppliers effectively help fund the company's assets●●○○○
- Equity is the owners' claim and the internal source of funding: invested capital plus retained earnings kept rather than paid out●○○○○
Walk me through the cash flow statement
Not measured yet- The cash flow statement shows actual cash generated and used over a period, organized into operating, investing, and financing sections●○○○○
- The operating section starts with net income and adds back non-cash charges like D&A because they reduced net income without consuming cash●●●●○
- Operating cash flow also adjusts for working capital changes — growing receivables mean sales were booked but cash not yet collected, so that's subtracted●●●○○
- The investing section captures cash spent on or received from long-term assets, mainly CapEx●●○○○
- The financing section covers cash with capital providers: debt issued or repaid, stock issued or bought back, and dividends paid●○○○○
- Summing the net flows of all three sections gives the change in cash — free cash flow — which plus beginning cash equals ending cash on the balance sheet●●●○○
Which statement is most important?
Not measured yet- The cash flow statement tracks the actual cash moving into and out of a company over a period, and is the most important of the three financial statements because it reveals liquidity.●●●○○
- Accrual accounting books revenue when it is earned, not when cash arrives.●●●●○
- A company can look profitable on paper while its earnings sit in accounts receivable that customers have not yet paid.●●●○○
- Profit on the income statement does not tell you whether the company can pay its suppliers, its employees, or its debt.●●●●○
- The cash flow statement is direct: it cuts through accruals and simply shows whether more cash is flowing into the business than out of it.●●●●○
- A company survives on cash, not paper profit.●●●●○
- Cash is much harder to manipulate than accrual-based figures.●●●●○
- Cash gives the truest read on financial health.●●●○○
Why GAAP is important?
Not measured yet- GAAP stands for Generally Accepted Accounting Principles: the standardized set of accounting rules companies use to prepare their financial statements●●○○○
- Under GAAP, all companies record the same kind of transaction the same way, following the same codified rules rather than each inventing its own accounting treatment●●●●●
- Because every company applies the same codified rules, reported financials are fair and consistent across different companies●●●●○
- The same common basis also makes financials fair and consistent across different periods for the same company●●●○○
- Investors can compare companies directly just by reviewing their reported financial documents●●○○○
- Investors do not need to adjust each company's numbers for its own idiosyncratic accounting choices●●●○○
- The GAAP framework constrains how much management can stretch the presentation of the numbers, limiting opportunistic or misleading reporting●●●○○
- GAAP also helps management gain insight into its own practices and performance●●●○○
Explain the conservatism principle in accrual accounting
Not measured yet- The conservatism principle says that when judgment is involved, choose the treatment least likely to overstate assets and income●●●○○
- Revenue is recognized only once there is firm evidence it actually occurred or was realized●●●●○
- Expenses and liabilities are recognized as soon as they are probable, not deferred until certain●●●●○
- The result is a deliberate downward bias in the financials: revenue may end up understated●●●○○
- The risk of understating expenses and liabilities is minimized because they are booked early●●●○○
Why is fair value accounting used?
Not measured yet- Fair value accounting records assets and liabilities at their current market price rather than their historical cost●●○○○
- It is used because current market prices give a more accurate, timely valuation than an old purchase price●●●○○
- This applies even to illiquid securities, which must still be marked to market rather than carried at cost●●●○○
- When market values deteriorate, losses surface on the books as they happen instead of accumulating unseen●●●●○
- The 2008 crisis showed that carrying deteriorating assets at inflated values let losses build up hidden until they surfaced as sudden write-downs and a market collapse●●●○○
Why know difference between IFRS & US GAAP?
Not measured yet- IFRS and US GAAP are the two dominant accounting frameworks, and they treat certain items differently●●●○○
- Without reconciling the frameworks, you could compare two companies on a false basis and misvalue one●●●○○
- In cross-border M&A, diligence and valuation require translating the target's financials into a framework you understand●●●●○
- Multinational companies may report under one framework or both, across different jurisdictions●●●○○
- Globalization and demand for geographic diversification of investments put more foreign financials in front of investors●●●●○
- Knowing the differences is what makes cross-border analysis comparable●●●○○
Above vs Below the Line
Not measured yet- The 'line' is a divider on the income statement separating core-operations items from non-operating items●○○○○
- The line is drawn on the income statement rather than on the balance sheet or cash flow statement because everything on the income statement ultimately feeds taxable income.●●●○○
- Above the line are operating items — revenue, COGS, SG&A, and D&A — that come from the core business●●●○○
- Above-the-line items are the repeatable activities of the core business●●○○○
- Below the line are non-operating items — interest income and expense, gains and losses on asset sales, other one-off income●●○○○
- Below-the-line items are volatile or non-recurring and get stripped out when assessing core profitability●●●●○
- The distinction matters because above-the-line earnings are the repeatable stream analysts use to judge core profitability●●○○○
How can a profitable firm go bankrupt?
Not measured yet- Profit is an accounting measure — revenue greater than expense over a period — and says nothing about when cash moves●●○○○
- Revenue is often booked before cash is received: credit sales create receivables that raise profit while the cash hasn't arrived●●●○○
- Expenses like payroll, suppliers, and debt service must be paid in cash on fixed schedules regardless of collections●●○○○
- If the firm is ineffective at collecting from customers, cash inflows lag cash outflows — a timing mismatch●●●●○
- That mismatch creates a liquidity problem: the firm can be profitable on paper with no cash in the bank●●●○○
- Bankruptcy is triggered by failing to pay obligations as they come due, so a profitable firm can still be forced into insolvency●●○○○
What is the difference between EBIT and operating profit?
Not measured yet- Operating profit is revenue minus operating expenses — COGS, SG&A, D&A.●●○○○
- Operating profit captures core operations and excludes non-operating items.●●○○○
- EBIT is earnings before interest and taxes: net income with interest and taxes added back.●●●●○
- EBIT is built from the bottom line.●●●●○
- For most companies the two come out the same number, which is why the terms are used interchangeably.●●○○○
- Operating profit and EBIT are computed by different routes, and that is where the difference shows up.●●○○○
- Because EBIT starts from net income, which contains everything the company did during the period, it can pick up non-core items that operating profit excludes.●●●○○
- A loss on the sale of equipment, for example, would push EBIT below operating profit.●●●○○
- Operating profit is the cleaner read on core operations, so EBIT built from the bottom line should be checked for non-operating noise before you treat it as core earnings.●●●○○
What is a DTL?
Not measured yet- A DTL arises from a timing difference between the tax expense in the earnings report and the taxes actually paid in cash●●●○○
- The classic driver is depreciation: straight-line on the income statement, accelerated on the tax return●●○○○
- Early on, accelerated tax depreciation makes taxable income lower than book income, so less cash tax is paid than the book expense implies●●●●○
- The gap is recorded as a liability because the timing difference reverses and future cash taxes will be higher●●●○○
- A DTL is not a debt owed to a creditor — it is a recognized obligation to pay more tax in the future●●●○○
- As the timing differences unwind, the DTL is drawn down and eventually zeroes out if no new differences arise●○○○○
What are some ratios used to perform credit analyses?
Not measured yet- Credit analysis ratios are the metrics a lender uses to judge a borrower's ability to service its debt●●○○○
- Liquidity ratios — current, quick, cash — test whether short-term assets cover near-term obligations●●●○○
- Leverage ratios — debt-to-EBITDA, debt-to-assets, debt-to-equity — measure how heavily the balance sheet is financed with debt●●●○○
- Coverage ratios — times interest earned, EBITDA interest coverage, DSCR, fixed charge coverage — test whether earnings or cash flow covers required payments like interest and principal●●●○○
- Profitability ratios — gross, operating, and net margins plus ROE, ROA, ROIC — show whether the business generates earnings efficiently enough to sustain the debt●●●○○
- A weak reading in any one family flags where the credit risk sits●●●○○
How would share issuance affect EPS?
Not measured yet- EPS is net income divided by shares outstanding●●●○○
- Issuing shares means selling new stock, so shares outstanding increase the moment the deal closes●●○○○
- At the moment of issuance net income is unchanged, because the new capital has not yet earned anything●●●○○
- With a larger denominator and the same numerator, EPS decreases — issuance is dilutive●●●○○
If a company continuously incurs goodwill impairment, what can you take away?
Not measured yet- Because goodwill only moves through impairment, a recurring pattern signals a structural problem rather than a one-off event●●●●●
- One takeaway is that management overpaid and failed to recognize how the acquired company would actually contribute●●●○○
- The other takeaway is unforeseen circumstances — the target's market or performance deteriorated in ways the buyer didn't anticipate●●○○○
- Each impairment hits the income statement, so repeated charges also raise earnings-quality and diligence concerns●●●○○
**How do finance and operating leases work? ****How does it affect equity value/EV?
Not measured yet- At inception a lease creates both a right-of-use asset and a lease liability on the balance sheet●●●○○
- Finance leases depreciate the asset straight-line, while the fixed cash payment splits into interest (discount rate × outstanding liability) plus principal paydown●●●●○
- The interest portion shrinks each period as the liability is paid down, so more of each fixed payment goes to principal●●●○○
- Because straight-line depreciation doesn't track the declining interest split, the finance-lease asset and liability balances diverge over time●●●●○
- Operating leases set the asset's amortization equal to the principal paydown●●●●○
- For an operating lease the right-of-use asset equals the lease liability at each point in time●●●●○
- The principal repayment portion of a lease payment reflects a real cash outflow and cannot be added back when computing cash flow●●●●○
- In the US this is harmless because the operating lease expense equals the paydown; under IFRS the asset/liability mismatch makes sloppy treatment problematic●●●○○
- In a DCF, keep leases out of the capital structure: exclude from WACC and debt, keep on the balance sheet, and treat the payment as a normal operating expense in free cash flow●●●○○
What is restricted cash?
Not measured yet- Restricted cash is cash the company holds but cannot deploy freely because it is set aside for a specific purpose●●○○○
- Common purposes include acquisition escrows or reserves, debt collateral, and regulatory deposits●●●●○
- It is still cash on the balance sheet, but it is disclosed separately from unrestricted cash●●●○○
- Analysts exclude it from liquidity ratios and net debt because it cannot cover near-term obligations●●●●○
- So a reported cash balance including restricted amounts overstates what the company can actually spend●●●○○
Why are some assets exempt from the historical cost principle?
Not measured yet- The historical cost principle records assets at their original purchase price●○○○○
- Some assets are exempt and are instead carried at current market price or the cash they are expected to realize●●●●○
- Historical cost goes stale for these assets, so the old purchase price stops reflecting their economic value●●●○○
- The exemption applies where market values or expected realization are reliably measurable, such as assets with active markets or held for sale●●●○○
Why are intangible assets not in the balance sheet?
Not measured yet- Intangibles are non-physical assets such as patents, brands, and customer relationships●○○○○
- Internally generated intangibles are not on the balance sheet because their value cannot be reliably verified●●○○○
- Without a market transaction, any internal valuation would be a management estimate open to manipulation and not auditable●●●●○
- Acquired intangibles can be recorded because the purchase price is a real transaction verified by a third party●●●●○
- Third-party verification is what lets auditors substantiate acquired intangibles like goodwill on the books●●●○○
Why do we use the historical cost principle?
Not measured yet- The historical cost principle records assets at the price actually paid for them, with no ongoing revaluation●●○○○
- Constantly re-marking assets to market value would push market price swings through reported earnings and equity●●●●○
- Historical cost avoids subjecting the company's reported results to price volatility unrelated to business performance●●●○○
- Historical cost is more conservative because the price paid is a verifiable, objective number●●●○○
- Fair-value estimates require judgment, and management has incentives to mark assets up optimistically●●●●○
- The trade-off is that historical cost can go stale over time, but verifiability and stability outweigh this for reporting●●○○○
What are non-recurring items? What do we generally do with them?
Not measured yet- Non-recurring items are one-off income or expense items that don't reflect the run-rate performance of the business●●○○○
- Typical examples are restructuring charges, inventory write-downs, impairments, and gains or losses on asset sales●●●○○
- Non-recurring items are added back when comparing companies because they are not part of core operations●●○○○
- The add-back gets you to earnings the business can be expected to generate going forward●●●●○
- Caveat: these are still real cash costs, and some companies take 'one-off' charges repeatedly, so don't ignore them entirely●●●●○
- Adjustments should be symmetric — strip out unusually large one-off gains, not just charges●●●○○
What is the difference between organic vs inorganic growth?
Not measured yet- Inorganic growth is growth driven by M&A — acquiring other companies or assets●●●●○
- Organic growth is generated from within by optimizing the company's own business operations●●●○○
- Organic growth sources include internal efficiency boosts, such as getting more output from existing assets●●●○○
- Organic growth also comes from expanding business operations, like new locations or new markets, and improving the product mix●●●○○
- The deciding difference is ownership: organic growth builds on the existing revenue base, inorganic growth arrives as a step-change from consolidating an acquisition●●●●○
- Organic growth signals a genuinely healthy core business, while inorganic growth can be bought with capital and carries integration risk — so analysts strip out acquisitions to isolate organic growth●●●○○
How does CapEx & depreciation shift for mature vs new companies?
Not measured yet- CapEx is spending on new long-term assets; depreciation spreads the cost of past CapEx over their useful lives●●○○○
- Mature companies have lower CapEx because they only need to maintain an already-built asset base, not grow it●●●○○
- Mature companies have higher depreciation because their books carry a large stock of older assets still being written off●●●○○
- New companies have high CapEx because they are building out their asset base with factories, equipment, or stores●●●○○
- New companies have low depreciation because their assets are newly purchased, so accumulated depreciation is still small●●●●○
- For a mature company depreciation can exceed CapEx, so EBITDA overstates its cash generation●●●○○
- For a young company heavy CapEx means earnings understate its cash burn●●●●○
What is working capital?
Not measured yet- Working capital is the difference between current assets and current liabilities●●●●○
- Current assets convert to cash within a year; current liabilities are obligations due within a year●●●○○
- The metric's purpose is to gauge liquidity — whether the company can cover short-term obligations as they come due●●○○○
- Positive working capital gives a cushion because current assets more than cover near-term obligations●●●○○
Why are effective & marginal tax rates often different? Can you give specific examples on why they might differ?
Not measured yet- The effective tax rate is total tax expense divided by pre-tax income — the average rate actually paid●●○○○
- The marginal tax rate is the rate applied to the next dollar of income●●○○○
- Because progressive brackets tax the first dollars of income at lower rates than the last, the marginal rate exceeds the effective rate; the two coincide only under a flat tax.●●●●○
- Deductions and credits reduce the effective rate without changing the statutory marginal rate applicable to the next dollar.●●●○○
- Permanent differences, such as income taxed at a lower rate (e.g. lower-taxed foreign income) or non-deductible expenses, pull the effective rate below or above the marginal rate.●●●●○
- Deferred tax timing differences can make one year's effective rate diverge from the rate that will apply to future income.●●●○○
What are some ways/metrics to compare companies?
Not measured yet- The first lens is location and market, since companies in the same geography and customer base face the same demand and regulatory conditions●●●○○
- Growth metrics compare how fast revenue or earnings are expanding between companies●●●○○
- Size can be measured by equity value — the shareholders' stake — or by enterprise value●●●○○
- Enterprise value is usually the better size lens because it captures the whole business including debt, not just the stock●●●○○
- Profitability metrics like gross, operating, and net margins show how much of each revenue dollar each company keeps●●●○○
- Debt metrics like debt-to-EBITDA or debt-to-equity reveal balance sheet risk●●○○○
- Industry-specific metrics — LTV and CAC for B2C SaaS, load factor for airlines — capture operational differences generic financials hide●●○○○
- In practice you match peers on location and industry, then compare them on size, growth, margins, and leverage●●○○○
Walk me through a DCF
Not measured yet- A DCF is an intrinsic valuation that values the company as the present value of the cash flows it will generate●○○○○
- UFCF is cash available to all capital providers, debt and equity alike, before interest payments●●●●○
- The forecast runs five to ten years so the business reaches a steady state before the terminal value takes over●●●○○
- Terminal value captures all cash flows beyond the forecast period●●●○○
- Terminal value has two methods: perpetual growth applies a modest growth rate forever, exit multiple applies a multiple to the final year's metric●●○○○
- Unlevered cash flows are discounted at WACC because WACC is the blended cost of the debt and equity holders who receive those flows●●●○○
- Both the forecast-period UFCF sum and the terminal value must be discounted, the TV especially since it is a future value●○○○○
- The EV-to-equity bridge subtracts net debt and claims like preferred or minority interest, and adds back non-operating assets like excess cash●○○○○
- You finish by dividing equity value by diluted shares for an intrinsic price per share, then sensitivity-test WACC, terminal growth, and margins to show a range rather than one number●○○○○
Conceptually, what does the discount rate represent?
Not measured yet- The discount rate is the return investors expect to require from an investment given its risk profile.●○○○○
- The discount rate represents the opportunity cost of investing in this asset instead of a similar-risk alternative.●●●●○
- The discount rate is the rate applied to shrink future cash flows back to today's terms in a present value calculation.●●○○○
- Higher risk means investors demand higher compensation, so the discount rate rises with risk.●●●●○
- Because a higher discount rate shrinks future cash flows more, riskier investments get lower valuations for the same cash flows.●●●○○
- In a DCF, the discount rate is typically WACC.●●●○○
- The WACC discount rate is matched to unlevered cash flows.●●●○○
- The discount rate is the market's price of risk for that asset, converting a risk judgment into a concrete number that directly moves the valuation.●●●○○
What is the difference between Unlevered & Levered DCF? What are the discount rates used for?
Not measured yet- (definition) Unlevered DCF discounts cash flow available to all capital providers and lands on enterprise value; levered DCF discounts cash flow after interest, available to equity holders only.●●●●○
- (mechanism) Unlevered DCF uses WACC because the cash flows belong to debt and equity holders, and WACC is their blended required return.●●●●●
- (mechanism) Levered DCF uses the cost of equity because once interest is paid, the residual cash flows belong solely to shareholders.●●●○○
- (contrast) From unlevered enterprise value you subtract net debt to reach equity value; the levered DCF gets there directly with no bridge.●●●●○
- (causal) Unlevered DCF is the standard choice because it's capital-structure neutral, letting you compare companies with different debt loads.●●●○○
How do you determine the risk-free rate?
Not measured yet- The risk-free rate is the yield on default-free government bonds — the return an investor can earn with zero default risk.●○○○○
- In theory, each cash flow gets the yield of a government bond matching its timing — a 1-year Treasury note for the year-one cash flow.●●●○○
- In practice, one rate — usually the 10-year Treasury yield — is applied to every cash flow and the terminal value.●●●○○
- Company free cash flows are assumed to be reinvested in the business, so the effective horizon is longer than a matched short-term bond.●●●●○
- The liquidity of company cash flows does not resemble short-term Treasuries.●●●●○
- The risk-free rate embedded in the discount rate is also applied to the long-term terminal value, so discounting that decades-long stream at a 1-year rate would be inconsistent.●●●○○
- Short-term Treasury yields swing with Fed policy, so maturity-matching would make valuations jump whenever policy shifts.●●●●○
- The 10-year yield is less variable than short-term rates, so valuations built on it are more stable and comparable across periods.●●●●○
What effect does a low interest-rate environment have on DCF valuations?
Not measured yet- A DCF's value is the sum of future free cash flows divided by a discount rate built from the risk-free rate plus risk premiums.●●●○○
- In a low interest-rate environment the risk-free rate falls.●●●●●
- Since the risk-free rate is the base of WACC and of the cost of equity, a lower risk-free rate lowers the whole discount rate used in a DCF.●●●●●
- Each cash flow is divided by (1+r) raised to its period, so a smaller r leaves a larger present value for the same cash flows.●●●●●
- The effect compounds with time, so distant cash flows — and especially the terminal value — gain the most present value.●●●●○
- Because the terminal value is typically the majority of a DCF's value, the rate drop moves the total valuation disproportionately.●●●●○
- So holding cash flows constant, lower interest rates mean higher DCF valuations.●●○○○
Define the equity risk premium used in the CAPM formula.
Not measured yet- The equity risk premium is the excess return investors require for holding equities over risk-free securities — compensation for bearing incremental risk.●●○○○
- It's the market-risk premium term in CAPM: cost of equity equals the risk-free rate plus beta times the ERP.●●○○○
- Beta scales the market-wide premium up or down to a specific stock's sensitivity, producing that stock's cost of equity.●○○○○
- Historically it has run around 4 to 6 percent.●●○○○
Explain the concept of beta.
Not measured yet- Beta measures a stock's systematic — non-diversifiable — risk relative to the broader market.●●○○○
- A stock's beta is estimated as the slope of a linear regression of that stock's returns against the market's returns.●●●●○
- Because diversification wipes out company-specific risk, beta — not total volatility — is the risk measure in CAPM.●●●●○
- A beta of 1.0 means returns in line with the market: if the market rises 10%, the stock is expected to return about 10%.●●○○○
- A beta above 1 means more sensitive than the market — a beta of 1.5 implies roughly a 15% move when the market moves 10%.●●○○○
- A beta between 0 and 1 means the stock is less sensitive than the market, so it dampens market swings.●●●○○
- A negative beta means the stock moves inversely to the market — rare, with gold the classic example.●●●○○
- In CAPM, beta scales the equity risk premium: cost of equity equals the risk-free rate plus beta times the ERP.●●○○○
What is the difference between systematic risk and unsystematic risk?
Not measured yet- Systematic risk is market-wide risk inherent to the equity market — rates, recessions, macro shocks — that no amount of diversification can eliminate●●●○○
- Unsystematic risk is company- or industry-specific risk — a lawsuit, a product failure — that diversification can reduce or eliminate●●●○○
- With a sufficiently diversified portfolio the idiosyncratic swings cancel out, leaving only systematic risk in the portfolio●●●●○
- The market pays no extra expected return for unsystematic risk, because investors could diversify it away themselves for free●●●○○
- Systematic risk cannot be avoided by any equity investor, so it is built into securities' prices●●●●○
- Because systematic risk must be borne, investors are compensated for bearing it●●●○○
** (THINK) Does a higher beta lead to a lower or higher valuation?
Not measured yet- Beta measures a stock's volatility relative to the market — how much it amplifies or dampens market moves●●○○○
- Beta feeds directly into the cost of equity via CAPM: risk-free rate plus beta times the equity risk premium●●●●○
- A higher beta signals more risk to investors, which translates into a higher discount rate●●○○○
- Discounting the same future cash flows at a higher rate shrinks each one more heavily, so present value falls●●●●○
- A higher beta therefore leads to a lower valuation●●●○○
** (THINK ON SPOT) What types of sectors have higher/lower beta?
Not measured yet- Beta measures a stock's sensitivity to market moves, so a sector's beta reflects how demand for its products behaves through the economic cycle●●●○○
- Lower-beta sectors are defensive: their products are still wanted in a recession, so demand and earnings stay stable●●○○○
- Consumer staples and hospitals/healthcare are the classic low-beta examples — people buy groceries and seek medical care regardless of the economy●●○○○
- Higher-beta sectors are cyclical, with autos and restaurants as typical examples●●●●○
- In a downturn consumers postpone discretionary purchases like cars and eating out, so cyclical earnings swing more than the market and beta rises above 1●●●●○
** (CONCEPT) What is industry beta? What is the benefit of using an industry beta?
Not measured yet- Industry beta is estimated from comparable companies rather than the target's own stock history●●○○○
- Peer betas are unlevered first, to strip out the effect of each company's different capital structure●●●●○
- The median unlevered beta of the peer group is applied to the target, then re-levered for the target's own debt-to-equity mix●●○○○
- The key benefit is reducing company-specific noise — one firm's regression beta is noisy, while a median across many peers is more stable and reflects the business's risk●●○○○
- A second benefit is coverage: private companies have no traded share price, so an industry-derived beta is often the only practical way to get one●●●○○
** (HARD) What are the flaws of regression beta?
Not measured yet- Regression beta comes from a linear regression of a company's historical stock returns against a market index, with the slope as the beta.●●●●○
- Flaw one: it is backward-looking — it reflects how the stock moved in the past, which may not match the company's future risk profile.●○○○○
- Flaw two: the regression slope has a large standard error, so the beta estimate is statistically imprecise.●●○○○
- The beta is sensitive to the index regressed against and the length of the regression period.●●○○○
- Company-specific events over the estimation window — a merger, lawsuit, or earnings shock — can produce inexplicable deviations in the regression slope.●●●○○
- Because of these sensitivities, two analysts can get materially different betas for the same stock.●●●○○
- Flaw three: it assumes a constant capital structure because it is based on past debt-to-equity ratios.●●●○○
- Because the historical beta embeds the old leverage, it is flawed for forecasting when the capital structure has changed or will change.●●○○○
** (SEMI HARD THINK ON SPOT) What is the impact of leverage on the beta of a company?
Not measured yet- Levered beta is the beta of the traded equity, and it is the version leverage affects.●○○○○
- Unlevered beta is beta with the effect of debt stripped out, reflecting only the risk of the underlying business.●●●○○
- Unlevered beta is capital-structure neutral — it does not change when the company changes its leverage.●●●●○
- Debt adds fixed interest obligations ahead of shareholders, so business volatility produces larger swings in the returns left over for equity.●●●●○
- That amplified volatility of shareholder returns shows up as higher market sensitivity, so higher leverage means a higher levered beta.●●○○○
** (HARD - THINK OF DIFFERENT COMPANIES) What is the relationship between beta & the amount of leverage used?
Not measured yet- Beta measures how volatile a company's equity returns are relative to the overall market.●●○○○
- Mature businesses have stable, predictable cash flows, so their equity returns move less with the market.●●●●○
- The stable cash flows of mature businesses make debt service safe, so mature companies can comfortably carry higher leverage.●●●●○
- High-beta companies have volatile cash flows, so fixed debt obligations are dangerous.●●●○○
- Borrowing is less favorable for high-beta firms because lenders price in the volatility, making debt more expensive for them.●●●●○
- The added financial risk from leverage compounds the business risk shareholders already bear.●●●●○
- High-beta firms stay less levered because the cost and risk of debt outweigh the tax benefits.●●●●○
- The relationship between beta and leverage is inverse, and it runs through cash-flow stability.●●●○○
** (HARD - CONCEPT) Which is typically higher, cost of debt or cost of equity? Why?
Not measured yet- Cost of debt is the interest rate lenders require; cost of equity is the return shareholders require to hold the stock.●●●○○
- Cost of equity is typically higher than cost of debt.●●●○○
- Interest is tax-deductible, so debt carries a tax shield that lowers its effective after-tax cost.●●●●○
- Dividends are paid from after-tax income, so equity gets no tax break and shareholders demand their full return.●●●●○
- In bankruptcy, debtholders are paid first while equity investors are last in line and often recover little or nothing.●●●●○
- As residual claimants, equity holders bear more risk and demand a premium to compensate — which is why equity costs more.●●●●○
** If Cost of Equity is higher than Debt, why not only use debt?
Not measured yet- At low leverage, adding debt lowers WACC because debt is cheaper than equity thanks to the tax shield.●○○○○
- Debt is also cheaper than equity because lenders hold a senior position.●●●●○
- Debt is a fixed contractual obligation that must be paid regardless of how the business performs, so as leverage rises the probability that the firm cannot service its obligations — bankruptcy risk — rises.●●●○○
- As distress risk rises, lenders respond by demanding higher interest rates, so the cost of debt climbs as leverage increases.●●●●○
- At some point the cost of debt can rise so much that it exceeds the cost of equity.●●●○○
- Pushing past the optimal capital structure means each marginal dollar of debt hurts rather than helps, because expected distress and bankruptcy costs exceed the remaining tax shield.●●●○○
- Because the tax shield lowers WACC while distress costs raise it, the minimum-WACC capital structure is an interior optimum, not 100% debt.●●●○○
- The 'WACC smile' is a curve plotting WACC against the percentage of debt: WACC falls as you add the first increments of cheap debt, bottoms out at the optimal capital structure, then rises as distress costs take over.●●●○○
** (WEIRD) What is the difference between IRR and WACC?
Not measured yet- IRR is the projected return on a project's expenditures — the implied interest rate needed on the initial investment to match the project's projected returns.●●○○○
- WACC is the minimum required return that the company's debt and equity providers demand, blended and weighted by the capital mix.●●○○○
- IRR is computed solely from a specific project's own cash flows, independent of how the firm is financed.●●●○○
- WACC is computed from the company's capital structure — the proportions and costs of its debt and equity — and is the same for every project the firm considers.●●●○○
- WACC acts as the hurdle rate — a project creates value only if its IRR exceeds the WACC.●●●●○
** (THINK ON FEET) Which would have more of an impact on a DCF, discount rate or sales growth rate? Why?
Not measured yet- A DCF discounts projected free cash flows and a terminal value to present value, and the terminal value typically makes up 60 to 75 percent of the total valuation.●●○○○
- Sales growth drives revenue, but revenue only becomes free cash flow after passing through margins, capex, D&A and taxes.●●●●○
- Sales growth is one driver among many, so faster revenue growth can produce little FCF change if margins or reinvestment needs move against it.●●●○○
- The discount rate is applied to every cash flow in the model, including the terminal value, so it shifts the value of everything at once.●●●●●
- Even a 50 basis point move in WACC swings the whole DCF substantially.●●●●●
- The discount rate therefore generally has the larger impact: it acts directly and everywhere, while growth acts indirectly through a single input.●●●●○
- You would confirm that with a sensitivity table.●●●○○
** What is the argument against using the exit multiples approach in a DCF?
Not measured yet- A DCF is meant to value a company on its intrinsic cash flows, independent of what the market pays for similar businesses today.●●○○○
- The exit multiple approach sets the terminal value by applying a market-based multiple to a final-year metric.●●●●●
- The exit multiple approach undermines the DCF premise by applying a multiple from trading comps or recent transactions to final-year EBITDA.●●●●●
- Because the multiple comes from the market, the terminal value depends on what the market currently pays for similar businesses.●●●●○
- Tying the terminal value to today's market sentiment contradicts the DCF premise that value comes from the company's own cash flows.●●●○○
- Practitioners still use exit multiples because they are easier to discuss and defend — pointing to observable comps rather than debating a perpetual growth rate.●●○○○
- That convenience comes at the cost of defeating the purpose of doing a DCF at all.●●○○○
- The perpetuity growth method keeps the valuation internally consistent by tying the terminal value to the company's own cash flows.●●●○○
** What is the purpose of the mid-year convention? When would mid-year be inappropriate?
Not measured yet- The mid-year convention discounts year-one cash flows at 0.5 years, year two at 1.5, and so on, instead of 1, 2, 3.●●●○○
- The mid-year convention exists because most businesses generate cash steadily through the year rather than receiving it all on the final day, so the mid-point of each period is a more accurate estimate of when the average dollar arrives.●●●●○
- Full-year discounting assumes all cash arrives at year-end, which overstates the waiting time and understates present value.●●●●○
- Because mid-year cash flows are received about half a year earlier than year-end, they are discounted less, so the resulting valuation is higher.●●●●○
- The size of the mid-year uplift is roughly a factor of (1 + WACC)^0.5, and it increases with the discount rate.●●●○○
- Mid-year is inappropriate for highly seasonal businesses — a winter clothing brand like Canada Goose concentrates cash in a few months.●●○○○
- Mid-year is also inappropriate for lumpy project-based businesses, such as construction, where cash genuinely lands at period or milestone ends rather than evenly.●○○○○
How would raising additional debt impact a DCF analysis?
Not measured yet- A DCF values unlevered free cash flow — cash generated before interest payments, available to all capital providers.●●●○○
- Because interest never touches unlevered FCF, a DCF is capital-structure neutral in theory: raising debt changes the split of value, not the enterprise value.●●●○○
- In practice, more leverage raises default risk, so lenders demand a higher cost of debt and equity holders a higher return.●●●○○
- Both components feed WACC, so a riskier capital structure pushes the discount rate up.●●●○○
- A higher discount rate shrinks the present value of the cash flows and the terminal value, lowering the valuation.●●●○○
** (THINK) Imagine that 2 companies had the same leverage ratio (with the same FCF & profit margins). Are their default risks the same?
Not measured yet- The standard leverage ratio is debt/EBITDA, a gross measure: it counts debt against earnings capacity but ignores balance-sheet cash.●●○○○
- Cash is the first resource a company uses to service or repay debt.●●●○○
- A company holding large cash against the same gross debt has a real cushion; a cash-poor twin does not, despite an identical ratio.●●●●○
- Equal debt/EBITDA does not mean equal default risk, because true indebtedness, net debt, can differ widely.●●○○○
- Lenders and credit analysts also use net debt/EBITDA: two companies at 4x gross could be 3.5x and 1.5x net, and be priced very differently.●●●○○
- Default risk also depends on earnings stability.●●○○○
- The same leverage ratio is riskier when EBITDA is volatile.●●●●○
- Default risk also depends on the debt maturity profile.●●●○○
- Default risk also depends on the industry.●○○○○
**When is a DCF inappropriate?
Not measured yet- A DCF is inappropriate in two main situations: when you don't have access to the full financial statements, and when the company isn't expected to generate positive cash flows in the foreseeable future.●●●○○
- Building free cash flow requires line-item detail — depreciation, capex, changes in working capital, taxes — which revenue and EBIT alone cannot provide.●●●●○
- With only revenue and EBIT, public comparables are much easier to implement because multiples work directly off those limited metrics.●●●○○
- Second inappropriate case: the company is not expected to generate positive cash flows in the foreseeable future, such as pre-revenue biotechs, cash-burning startups, or turnaround situations.●●●●○
- Discounting negative cash flows produces a meaningless value, and the terminal value is unreliable because there is no stable cash flow base to grow into perpetuity.●●●●○
- For those companies you'd switch to comparables, precedent transactions, or method-specific approaches instead of a DCF.●●○○○
If 80% of a DCF valuation comes from the terminal value, what should be done?
Not measured yet- A DCF splits value between explicit forecast-period cash flows and a terminal value, so 80% in the terminal value means the explicit period is doing very little work.●●○○○
- First diagnostic: check whether the forecast period is long enough.●○○○○
- If the forecast period is only five years, the company may not have reached steady state yet.●●●●○
- If the company hasn't normalized, extend the forecast - for example from five to ten years - until growth, margins and reinvestment are at sustainable mature levels.●●●○○
- Second diagnostic: stress-test the terminal value assumptions, because they may be too aggressive to reflect stable growth.●●○○○
- In the Gordon growth method, perpetual growth should sit at or below long-run nominal GDP growth; a higher rate assumes fast growth forever, contradicting stable growth.●●●○○
- Back into the implied exit multiple from the terminal value and compare it to where comparable companies actually trade as a sanity check.●●●●○
- An exit-multiple terminal value should reflect a mature business, not simply today's rich multiple frozen into perpetuity.●●●○○
- Run sensitivities on terminal growth and WACC to show how assumption-driven the valuation is, and flag that a dominant terminal value can still be legitimate for a mature, predictable business.●●○○○
**(CONCEPT) For forecasting purposes, do you use effective or marginal tax rate?
Not measured yet- The choice of tax rate for a DCF forecast is really a question about what tax rate the company pays on its cash flows into perpetuity.●●○○○
- The marginal tax rate is the rate on the last dollar of taxable income, so it is a forward-looking number.●●●●○
- Applying the marginal rate immediately over-estimates near-term taxes because companies defer cash taxes through deductions, credits and carryforwards.●●●○○
- The effective tax rate is the historical average of taxes paid relative to pre-tax income, reflecting the tax planning the company actually achieves.●●●○○
- The effective rate is used in the short term because it captures the company's current ability to delay taxes below the statutory burden.●●●●●
- You cannot hold the effective rate long-term, because permanently taxing below the statutory rate implies permanent deferral.●●●●●
- Permanent below-statutory taxation accumulates as deferred tax assets and liabilities on the balance sheet, which becomes implausible over a long horizon.●●●●○
- The practical answer is to use the effective tax rate in early years and normalize it to the marginal rate over the forecast period.●●●●○
- Normalizing matters most by the terminal period, so the perpetuity assumption reflects a sustainable steady-state tax burden rather than today's temporary deferrals.●●○○○
How does a DDM differ from a DCF? Why don't we use the DDM model/ what are the disadvantages of using the DDM?
Not measured yet- The DDM values a company as the present value of expected future dividends grown at an assumed dividend growth rate.●●●○○
- Dividends accrue exclusively to shareholders, so the DDM discounts at the cost of equity, not WACC.●●●●○
- Because the DDM is an equity valuation, a terminal value within it uses an equity exit multiple like P/E rather than an enterprise multiple.●●●○○
- A DCF differs mechanically: it discounts free cash flow to all capital providers at WACC to reach enterprise value, then bridges to equity.●●●●●
- The DDM is highly sensitive to dividend growth, the payout ratio (share of net income paid as dividends), and the required rate of return.●●●○○
- The DDM neglects share buybacks, which many companies now favor as their main form of cash return.●●●○○
- A high dividend payout ratio doesn't indicate quality - poorly run companies with no reinvestment opportunities can also pay out heavily.●●●○○
- The DDM can't value high-growth companies, which pay little or no dividends.●●●●○
- For high-growth firms, expected growth can exceed the required rate of return, making the DDM's perpetuity math meaningless.●●●○○
**How does a lower tax rate impact DCF valuations?
Not measured yet- A DCF is driven by projected free cash flows discounted at WACC, so the tax rate affects both the cash flows and the discount rate.●●●○○
- First effect: a lower tax rate raises NOPAT; after adding back depreciation, subtracting capex and working capital changes, free cash flow is higher in every forecast year.●●●●○
- Higher free cash flows also flow into a larger terminal value, pushing the overall valuation up.●●●○○
- On the discount rate side, the effect runs the other way: debt gets a tax shield, so the after-tax cost of debt is the pre-tax rate times (1 minus the tax rate), and a lower tax rate shrinks that shield and raises the after-tax cost of debt.●●●●○
- Levered beta moves for the same reason: the tax deductibility of interest dampens equity risk; with a smaller shield the equity holder absorbs more risk, so unlevered beta re-levers to a higher levered beta.●●●●○
- A higher levered beta pushes up the cost of equity; together with the higher after-tax cost of debt, WACC rises and works against the cash flow benefit.●●●●○
- The net valuation impact is ambiguous: bigger cash flows versus a higher discount rate, and which force wins depends on how levered the company is.●●●○○
- For a low-debt business, the cash flow benefit usually dominates and the valuation rises.●●●○○
- For a heavily levered company, the discount-rate hit can meaningfully offset the cash flow benefit.●●●○○
**Is it better to have $100M more in revenue or have a $100M lower in OpEx? Why?
Not measured yet- When revenue rises at a constant operating margin, expenses such as COGS rise proportionally with it, so the top line does not fall through to net income dollar-for-dollar●●●●●
- The $100M revenue increase adds only $100M times the margin to net income — at a 20% margin, just $20M●●●●●
- An OpEx cut has no offsetting expense increase, so it flows through to net income essentially dollar-for-dollar after tax●●●●○
- The OpEx reduction is better unless the company's margin were 100%, which no real business has●●●●○
- The caveat is the time horizon: for immediate profitability the OpEx cut wins decisively, but the extra revenue could compound through growth and create more long-term value●○○○○
A company holds Trading securities that rise from $50 to $100 (40% tax rate). What is the immediate effect on pre-tax income and the 3 balance sheet more broadly?
Not measured yet- Trading securities are marked to market through the income statement each period●○○○○
- Even unrealized gains are recognized immediately●●○○○
- These securities are held for short-term resale●●○○○
- The unrealized gain is the $50 increase from $50 to $100, and it flows straight into pre-tax income●●●○○
- At a 40% tax rate, tax expense is $20, so net income rises by $30●●●○○
- On the cash flow statement, net income is up $30, but the $50 gain is subtracted back out●●○○○
- The net effect on cash is down $20 — $30 of net income less the $50 non-cash gain adjustment●●●●○
- On the balance sheet, assets rise $30 net: securities are up $50 and cash is down $20●○○○○
- Liabilities are unchanged, so equity rises $30 through retained earnings and the balance sheet stays balanced●●○○○
Company A owns 80% of Company B and consolidates it. B earns $200M of net income. On A's income statement, the 20% A does not own is
Not measured yet- Noncontrolling interest is the portion of a consolidated subsidiary that the parent does not own●●○○○
- Consolidation means A combines 100% of B's revenues, expenses, and net income line by line, not just its 80% share●●●○○
- Consolidation happens because 80% ownership gives A control of B●●●●○
- The 20% A does not own is deducted as 'Net Income Attributable to Noncontrolling Interests'●●●○○
- The deduction equals 20% of B's $200M net income, or $40M●●●○○
Versus an operating lease with the same economics, a finance (capital) lease will generally make a company's EBITDA
Not measured yet- An operating lease records the periodic payment as a single rent expense within operating expenses, reducing EBITDA directly.●●●○○
- A finance lease treats the lease as a purchase financed with debt, booking an asset and a matching liability on the balance sheet.●●○○○
- Each period, the finance lease cost splits into depreciation, which sits inside EBIT, and interest on the lease liability, which sits below EBIT.●●○○○
- Neither the depreciation nor the interest component of the finance lease cost reduces EBITDA.●●●●○
- For identical cash lease payments, EBITDA is higher under a finance lease than under an operating lease.●●●○○
- The finance lease splits the cost into pieces EBITDA ignores, whereas the operating lease consolidates the whole payment into an operating expense that EBITDA includes.●●●●○
- The memory trick: finance lease — split; operating lease — consolidate.●●●○○
How does a gain in trading securities affect the 3 statements? What about AFS? What about HTM? How do they differ?
Not measured yet- (definition) The three classifications exist to determine where changes in a security's value show up in the financial statements●○○○○
- (condition) Trading securities are held for short-term resale, so they are marked to market through the income statement every period●●○○○
- (mechanism) A trading gain raises net income and flows to retained earnings, and is backed out as a non-cash item on the cash flow statement until cash is received●●●●○
- (contrast) An unrealized AFS gain bypasses the income statement and goes to other comprehensive income●●○○○
- (causal) AFS unrealized gains accumulate in accumulated OCI within stockholders' equity, leaving net income and EPS untouched●●●○○
- (condition) An AFS gain only hits the income statement when the security is sold, when it reclassifies out of OCI as a realized gain●●●●○
- (contrast) HTM securities are carried at amortized cost, so unrealized market value changes are ignored entirely — no income statement and no OCI effect●●●○○
- (definition) For HTM, what hits the income statement is the coupon interest income earned on the debt●●●○○
A company grants an executive $10M of RSUs at a 40% tax rate. Please describes the immediate accounting that follows
Not measured yet- Fully vested RSUs carry no remaining service condition, so the executive has already earned the shares and the entire $10M fair value is recognized as compensation immediately rather than spread over a vesting schedule.●●●●●
- The company records a $10M stock-based compensation expense on the income statement.●●●●○
- At a 40% tax rate the expense saves $4M of taxes, so net income falls by $6M, not the full $10M.●●●●○
- The book expense and the tax deduction land in the same period.●●●○○
- The full $4M is a current tax saving, so no deferred tax asset is recognized.●●●●○
- On the cash flow statement the SBC expense is added back as a non-cash item.●●●○○
- The $4M tax saving boosts operating cash flow.●●●○○
- On the balance sheet, APIC rises by the full $10M, offsetting the expense.●●●○○
- On the balance sheet, retained earnings fall $6M and cash rises $4M.●●●○○
A parent company owns 30% of an "Associate" company, and the stake shows up as an Equity Investment on the parent's Balance Sheet. When moving from the parent's Equity Value to its Enterprise Value to build a clean EV / EBITDA multiple, why do you subtract the value of the Equity Investment?
Not measured yet- An Equity Investment is a minority stake of roughly 20-50% in another company, carried as a single asset line under the equity method●●○○○
- An equity investment is a non-core asset because the associate runs its own operations separately from the parent's business●●●○○
- The Equity Value to Enterprise Value bridge adjusts for non-operating items so the numerator describes only the core business — and EBITDA, the denominator, measures that same core business●●○○○
- None of the associate's revenue or EBITDA appears in the parent's income statement●●●○○
- The parent records only its share of the associate's net income as a single line below operating income●●●○○
- Leaving the investment in Enterprise Value would price the associate in the numerator while the denominator captured none of its EBITDA, inflating the multiple and breaking comparability to peers●●●○○
- Subtracting the Equity Investment strips that non-core value out, leaving a clean, comparable EV / EBITDA multiple●○○○○
How are equity method investments recorded on the parent company on the 3 statements?
Not measured yet- The equity method applies at 20-50% ownership — significant influence without control — and the stake is carried as a single asset line, not consolidated●●○○○
- At purchase the investment is recorded as an asset at the purchase price, with cash decreasing and no expense●●●○○
- When the investee reports positive net income, the parent records its percentage of that net income as 'Income from Equity Interests' near the bottom of the income statement●○○○○
- That equity income is included in the parent's net income, so it flows into retained earnings — but the parent has received no cash●●●○○
- Because the equity income is non-cash, it is subtracted back out as an adjustment in operating activities on the cash flow statement●●●○○
- On the balance sheet the investment asset increases by the equity income, matching the retained earnings increase, so it stays in balance●●●○○
- The income recognized equals the ownership percentage times the investee's net income●●●○○
- When the investee pays a dividend, the parent records its percentage of the dividend as a cash increase — the reverse of the income entry●●●●○
- Dividends reduce the investment asset rather than creating new income, so the asset rolls forward as beginning balance plus share of net income minus dividends received●●●○○
Suppose a CEO literally finds $100 of cash on the street and deposits it into the company's bank account. Ignoring the strangeness of the scenario, what is the immediate impact on Equity Value, Enterprise Value, and the P / E multiple?
Not measured yet- Depositing the $100 raises the company's assets by $100.●●●●○
- Since shareholders own the residual claim, Equity Value rises by the full $100.●●●●○
- The $100 cash deposit is a balance sheet event, not an earnings event, so Net Income is unchanged.●●●○○
- With a higher P numerator and an unchanged E denominator, the P / E multiple rises.●●●○○
- The Enterprise Value bridge subtracts cash (a net debt adjustment), so the $100 cash increase offsets the $100 Equity Value increase.●●●○○
- Enterprise Value is unchanged.●●○○○
Why does issuing dividends lower the P/E multiple and gaining cash increase the P/E multiple?
Not measured yet- P / E is Equity Value — market cap — divided by total earnings.●●○○○
- Equity Value reflects everything shareholders own, including the company's cash, because cash is an asset backing their claim●●●●○
- When the company gains cash, total assets rise.●●●○○
- Equity Value rises when total assets rise.●●●●○
- With equity value up and net income unchanged, the numerator of P / E rises.●●○○○
- A higher numerator with unchanged earnings makes the P / E multiple higher.●●●●○
- A dividend sends cash that already belonged to shareholders out of the company, so Equity Value falls by the dividend amount.●●●○○
- Since net income is unchanged when a dividend is paid, the falling numerator drives P / E down.●●●○○
How does the consolidation method work? Say you had 80% of the company, how would you record that?
Not measured yet- Consolidation combines 100% of a controlled subsidiary's assets, liabilities, revenues, and expenses with the parent's own, even when the parent owns less than 100%.●●●○○
- On the balance sheet you record all of the subsidiary's assets and liabilities as if you own them entirely.●●●●○
- The minority portion of net assets is calculated by multiplying the subsidiary's net assets — assets minus liabilities — by the minority share.●●●●○
- The minority amount is presented as Non-Controlling Interests, a separate line item under shareholders' equity that gets you to Total Consolidated Equity and represents the outside shareholders' claim.●●●○○
- At 80% ownership, you consolidate 100% of the subsidiary's assets and liabilities and show the remaining 20% of its net assets in equity as NCI.●●●○○
- The income statement mirrors the balance sheet: you first calculate consolidated net income assuming 100% ownership of both companies, so every dollar of the subsidiary's earnings flows in.●●●○○
- You then subtract the minority share of the subsidiary's net income to arrive at Net Income Attributable to Parent, backing out that 20% at 80% ownership.●●●○○
Why do you add back non-controlling interests when moving from equity to enterprise value?
Not measured yet- Consolidation pulls in 100% of the subsidiary's revenues, EBITDA, and cash flows even when the parent owns only part of it●●○○○
- Minority shareholders are not shareholders of the parent, but they are genuine shareholders in the fully combined company with real claims on the subsidiary's assets and cash flows●●●●○
- The parent's equity value only reflects its own shareholders' claims, so it covers less than the 100% of operations the consolidated financials show●●●●○
- The parent may own only a partial stake (e.g., 80%) of a subsidiary; the remaining 20% is held by minority or non-controlling shareholders●●●●○
- Enterprise value is meant to capture the value of the entire combined business to all its investors, not just the parent's shareholders●●●○○
- If you didn't add back NCI, enterprise value would cover 100% of the subsidiary's operations while the starting point only covered the parent's share (mismatch)●●●○○
- Adding NCI lines up the ownership: the claim of minority shareholders is restored so the starting point matches the 100% of operations being valued●●○○○
- The formula: equity value plus minority interest plus debt equals the value of the whole enterprise to everyone with a claim on it●●○○○
A company grants an executive $10M of stock options (valued with the Black-Scholes method) at a 40% tax rate. Please describes the immediate accounting that follows & what might happen after
Not measured yet- At grant, the company recognizes total stock-based compensation expense equal to the fair value of the options, measured using an option-pricing model such as Black-Scholes; for these options that grant-date fair value is $10M.●●○○○
- Because no cash leaves the company when the options are granted, the $10M expense is a non-cash charge that is added back to net income on the cash flow statement, so grant-date operating cash flow is unaffected.●●●○○
- At a 40% tax rate, the $10M book expense creates a $4M deferred tax asset, because book compensation expense is recognized at grant while the corresponding tax deduction is not yet allowed.●●○○○
- The company's tax deduction and the associated cash tax savings do not occur at grant; they arise only when the options vest or are exercised and the tax authority allows the deduction.●●●●○
- When that later deduction is taken, the previously recorded deferred tax asset is drawn down and the company realizes the corresponding cash tax benefit.●●○○○
- If the options expire unexercised, the deferred tax asset may need to be written off because the expected future tax deduction never materializes.●●○○○
- If the actual tax deduction differs from the $10M book expense, the excess tax benefit (or shortfall) is recorded in additional paid-in capital rather than in the income tax expense line.●●●○○