Finance and Accounting for Interviews

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1 This document was developed and written by Ian Lee. All information is meant for public use and purposed for the free transfer of knowledge to interested parties. Send questions and comments to Finance and Accounting for Interviews May 31, 2004

2 Table of Contents I. Basic Accounting II. III. IV. Basic Finance Valuation Method 1: Comparable Company Analyses Valuation Method 2: Discounted Cash Flow Analysis V. Additional Resources 2

3 I. Basic Accounting 3

4 The Income Statement I/S INCOME STATEMENT Fiscal Year Ended December 31 (Dollars in Millions, Except EPS) Revenues Net Sales $ $1, $2, Cost of goods sold ( ) (1, ) (1, ) Gross Profit Sales & marketing Research & development (86.182) ( ) ( ) General & administrative ( ) ( ) ( ) Other operating expenses Operating Income (EBITDA) Depreciation and Amortization (2.395) (3.878) (3.400) Impairment of intangibles and other assets In-process R&D (0.670) (10.648) - Acquisition related charges Restructuring charges Other non-cash operating expenses Operating Income (EBIT) Interest Expense (9.689) (2.895) (6.800) Interest Income Pretax Income Income Taxes (27.254) (63.066) (79.748) Net Income (as reported) Basic Earnings Per Share NA NA NA Diluted Earnings Per Share $0.94 $1.56 $1.89 The income statement presents the results of a company s operations its revenues, expenses, net profit or loss, net profit or loss per share (EPS) for an accounting period Basic Earnings Per Share is calculated by dividing net income by the number of shares outstanding Diluted Earnings Per Share is calculated by dividing net income by the number of shares outstanding after accounting for dilutive stock options 4

5 The Balance Sheet B/S Fiscal Year Ended December 31 BALANCE SHEET Cash & Marketable Securities $9.333 $ Accounts Receivable Inventories Other Current Assets Total Current Assets Property, Plant & Equipment (PPE, net) Other Long-Term Assets Total Assets $ $ Accounts Payable Accrued Liabilities Deferred revenues - - Short-Term Debt Other Current Liabilities - - Total Current Liabilities Long-Term Debt Other Long-Term Liabilities Total Liabilities Shareholders' Equity Total Liabilities & Equity $ $ The balance sheet is a snapshot of a company s financial position in a specific point in time, showing its assets, liabilities, and shareholder s equity 5

6 The Cash Flow Statement CFS Fiscal Year Ended December 31 CASH FLOW STATEMENT Net Income - - Adjustments - - Cash flows from Operating Activities - - * (Free Cash Flow = Cash flows from Operations - CAPEX) Adjustments - - Cash flows from Investing Activities - - Adjustments - - Cash flows from Financing Activities - - Change in cash - - Cash at beginning of period - - Cash at end of period - - The statement of cash flows provides information about the cash inflows and outflows from operating, financing, and investing activities during the accounting period 6

7 Pro Forma Earnings Analysis Cash Net Income and Cash EPS CASH NET INCOME SCHEDULE Fiscal Year Ended December 31 (Dollars in Millions, Except Per Share) Net Income (as reported) Non-deductible adjustments In-process R&D Amort. of stock-based compensation Other non-cash operating expenses (non-deductible) Additional Other non-deductible adjustments (d) Deductible adjustments Acquisition related charges Restructuring charges Other non-cash operating expenses (deductible) Additional Other deductible adjustments (e) Amort. of goodwill and impairment of intangibles Cash Net Income Cash EPS NA NA NA To derive the Cash Net Income and EPS figure, you must add back one-time and non-cash charges to the net income amount reported on the income statement (GAAP) Whether or not you must tax-effect these one-time, non-cash add-backs depends on whether or not it can be considered a non-deductible or deductible adjustment Non-deductible adjustments are NOT TAXED. These include in-process R&D expense, option and warrant expense, amortization, change in accounting principles, and impairment charges related to goodwill Deductible adjustments are TAX-EFFECTED. These include impairment charges unrelated to goodwill, transaction costs, a loss or gain on disposal of PP&E, and realized loss or gain on investment 7

8 Key Accounting Ratios Common Measurements of Company Performance Ratio Formula Meaning Gross Profit Margin = Gross Profit The margin available to cover a company's operating expenses and yield a profit Revenue Operating Margin = EBITDA Measures the company's profitability after deducting operating expenses Revenue Inventory Turnover = Cost of Goods Sold Average Inventory Measures the number of times a company turns over all its inventory a year. The higher the turnover, the more efficient the company manages its inventory Return on Assets (ROA) = Profit Before Interest After Tax Measures the return on assets of a business Average Total Assets Return on Equity (ROE) = Net Income Measures the return on investment for stockholders Average Total Equity Current Ratio = Current Assets Current Liabilities A current ratio of more than 1.0 means the claims of the short-term creditors are covered by the company's current assets Working Capital = Current Assets - Current Liabilities Measures the excess of current assets over the current liabilities Quick Ratio = Current Assets - Inventory Current Liabilities Measures the extent to which the claims of short-term creditors are covered by short-term assets excluding inventory. Assumes that inventories would not be sold off to cover these claims Debt to Equity = Total Liabilities Measures the company's level of total debt relative to its equity/capital base Total Equity 8

9 II. Basic Finance 9

10 Key Financial Equations Measure Equation Market Capitalization = Current Stock Price * Diluted Shares Outstanding (Market Value of Equity) Net Debt = Short term and Long term Debt - Excess Cash Enterprise Value = Market Capitalization + Net Debt Earnings Per Share = Net Income Diluted Shares Outstanding Price-to-Earnings Ratio = Stock Price Earnings Per Share 10

11 Key Financial Multiples Multiple Formula Revenue Multiple = Enterprise Value Revenue EBITDA Multiple = Enterprise Value EBITDA EBIT Multiple = Enterprise Value EBIT Earnings Multiple = Enterprise Value Net Income Cash Multiple = Enterprise Value Cash Net Income 11

12 III. Valuation Method 1: Comparable Company Analyses 12

13 Comparable Companies Analysis Simplified Model ($ in millions, except EPS) Company Revenue EBITDA Net Income Shares Outstanding EPS (GAAP) Cash Net Income Cash EPS (Pro Forma) Abercrombie $1,710 $398 $ $2.18 $220 $2.34 American Eagle Outfitters 1, GAP, Inc. 16,170 2,730 1, , Guess, Inc Your Clothing Company Company Current Stock Price Shares Outstanding Market Cap Total Debt Excess Cash Enterprise Value Abercrombie $ $3,424 $0 $521 $2,903 American Eagle Outfitters , ,748 GAP, Inc ,735 2,590 3,280 21,045 Guess, Inc Company Multiples EV / Revenue EV / EBITDA EV / NI Price / EPS EV / Cash NI Price / Cash EPS Abercrombie 1.7x 7.3x 14.2x 16.7x 13.2x 15.6x American Eagle Outfitters 1.1x 9.1x 22.4x 26.4x 20.6x 24.2x GAP, Inc. 1.3x 7.7x 18.5x 19.1x 15.6x 16.1x Guess, Inc. 1.1x 10.6x 49.8x 48.4x 38.8x 37.6x Industry Average Multiples 1.3x 8.7x 26.2x 27.6x 22.0x 23.4x Multiple Used EV / Revenue EV / EBITDA EV / NI Price / EPS EV / Cash NI Price / Cash EPS Your Clothing Company's EV $388 $399 $419 - $374-13

14 IV. Valuation Method 2: Discounted Cash Flow Analysis 14

15 DCF Model The General DCF Model N [ FCF i ] TV EV = (1 + d) i + (1 + d) N i = 0 EV: FCF: Enterprise Value (value of the company in question) Free Cash Flow in year i d: Discount Rate i: Year N: Last projected year TV: Terminal Value 15

16 Estimate the Cost of Capital Weighted Average Cost of Capital The Weighted Average Cost of Capital (WACC) measures the minimum rate of return required to make an investment decision. This is also the discount rate used in the general DCF model (previous page) E d = WACC = K e * + K d * (1 T) * E + D D E + D WACC: K e : K d : Weighted Average Cost of Capital = discount rate (d) for DCF Cost of Equity (from CAPM on next page) Cost of Debt (current cost of borrowing through debt, average yield to maturity) E: Market Value of Equity D: Market Value of Debt T: Marginal Tax Rate 16

17 Estimate the Cost of Capital Cost of Equity The Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model (CAPM) calculates the company s cost of equity the total return expected by equity investors including dividends and capital appreciation. K e = r f + B * (r m r f ) K e : Cost of Equity (into WACC on previous page) B: Company Beta, its volatility relative to the rest of the market If B = 1, it is as risky as the overall market. If B < 1, it is less risky than the market. If B > 1, it is more risky than the market. r f : r m : r m - r f : Risk Free Rate Equity Market Average Return Excess Market Return 17

18 Estimate the Cost of Capital Cost of Debt The cost of debt is the marginal cost of debt after giving effect to the tax shield provided by debt financing K d = Outstanding Debt + Marginal Interest Rate Note: In cases where there is no publicly traded debt, the cost of debt can either be obtained from comparables, or approximated to the Risk-Free-Rate (r f ) 18

19 Project the Free Cash Flows (step two of four) Unlevered Free Cash Flow Leverage in financial terms refers to the tax savings (and therefore cash flow increase) provided by interest payments from Company debt items reported on the income statement Unlevered Free Cash Flow, therefore, refers to the cash flow of a company adjusting out the leverage provided by debt items (interest payments reported on the income statement) EBITDA - Depreciation and Amortization = EBIT - Taxes (at the marginal tax rate) = TAX-EFFECTED EBIT + Depreciation and Amortization +/- Change in Deferred Taxes - Capital Expeditures +/- Change in Net Working Capital +/- Change in other Long-term Assets and Liabilities = UNLEVERED FREE CASH FLOW 19

20 Estimate the Terminal Value Two Methods of Calculation The Terminal Value is the value of the business beyond the specified forecast period (e.g. the projected value of the company for 30 years into the future) 1) Exit Multiple Method Terminal Value = what the business would be worth or sold for at the end of the last projected year Example: Terminal Value = 8.0x EBITDA at the end of year N 2) Perpetuity Growth Method Terminal Value = Free Cash Flows that grow at a constant rate in perpetuity Terminal Value = FCF N x (1+g) (r + g) g = nominal perpetual growth rate r = discount rate 20

21 Derive the Enterprise Valuation and EPS The General DCF Model i = 0 [ FCF i ] TV EV = (1 + d) i + (1 + d) N i > N EV - Debt + Cash = EQUITY VALUE EQUITY VALUE Diluted Shares = EPS Note: EPS for an already publicly traded company means Earnings Per Share, but in this case, where the company has no market valuation, EPS means Equity Value Per Share 21

22 V. Additional Resources 22

23 Additional Resources DCF and Related Material Accounting Understanding Financial Statements (Seventh Edition), Lyn M. Fraser and Aileen Ormiston Financial Markets The Wall Street Journal Guide to Understanding Money & Investing, Kenneth Morris and Virginia Morris Valuation and Analysis Step by Step Business Analysis & Valuation, Krishna Palepu Financial Modeling, Simon Benninga Valuation: Measuring and Managing the Value of Companies, McKinsey & Company Career Guides Vault Career Guide to Investment Banking ( Vault Career Guide to Finance Interviews ( The Fast Track: The Insider s Guide to Winning Jobs in Management Consulting and Investment Banking, Mariam Naficy 23

Corporate Finance, 3Ce (Berk, DeMarzo, Strangeland) Chapter 2 Introduction to Financial Statement Analysis

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