Valuation Questions

Corporate Finance Theory

1. Present Value

2. Equity value
⚠️ Quick Note:
Equity value does NOT include debt or cash. That’s where enterprise value (EV)
comes in
Why do we use diluted shares and not the basic
shares?
3. Fully Diluted num of shares outstanding

Example
Let’s break this down:

1. 🟢 Basic Shares Outstanding

●​ These are the current common shares held by shareholders​

●​ You can find this on the balance sheet or in the 10-K/10-Q​

2. 🟠 Stock Options & Warrants (use TSM)

You do NOT just add all the options — you apply the Treasury Stock Method:

TSM Formula:

Example:
 ●​ 5M options​

●​ $10 exercise price​

●​ $25 market price​

Add 3M to fully diluted shares.

3. 🔵 RSUs (Restricted Stock Units)

●​ RSUs don’t have an exercise price, so they’re always included 1-for-1​

●​ Just add the full number of unvested RSUs​

⚠️ Some RSUs are performance-based and may not vest — in that case,
companies often disclose target numbers for dilution

4. 🟣 Convertible Debt or Preferred Stock

Only include these if they’re in the money (i.e., they would convert into common
shares today).

●​ If convertible → add their conversion shares​

●​ If not in the money → ignore them​

✅ Final Example:
Item Amount

Basic shares outstanding 100M

 Net new shares from options 3M
(TSM)

RSUs 2M

In-the-money convertible debt 5M

shares

Fully Diluted Shares 110M

Step-by-Step Formula:
Fully Diluted Shares = Basic Shares Outstanding + Net New Shares from TSM
(options/warrants) + All RSUs + All other convertible securities (if in the money)
What is TSM

✅ We Only Care About:

The 3 shares now held by investors that weren’t there before​
→ These are the net dilution​
→ These are added to the fully diluted share count​
→ These affect ownership %, EPS, and equity value per share

💡 Think of it this way:

TSM is all about answering:

“How many extra slices of the company pie are now being shared
among investors?”
Fully diluted vs. just diluted

Treasury shares

🔁 What are Treasury Shares?

Treasury shares are:

Shares that the company bought back from investors and now keeps in its
own “treasury”

●​ They are issued shares but not outstanding​

●​ They don’t count toward earnings per share (EPS)​

●​ The company owns them, not outside investors​

🤔 Why Would a Company Buy Back Shares?
Here are the main reasons companies repurchase their own shares:

1. ✅ To reduce dilution
If employees exercise stock options (creating new shares), the company might buy back
shares to offset that dilution and keep ownership %s stable.

Think of it like baking more pizza slices for employees, then buying a few
back to avoid giving away too much of the pie.

2. 💰 To return value to shareholders

Buying back stock reduces the number of shares outstanding, which can:

●​ Increase EPS (fewer shares = higher earnings per share)​

●​ Often push the stock price up​

●​ Signal confidence in the company’s future​

This is like a dividend, but in the form of buying shares instead of paying cash out.

3. 🛠️ To use in the future

Companies often hold treasury shares so they can:

●​ Re-issue them later for employee stock plans (RSUs, stock options)​

●​ Use them in M&A deals (as part of payment)​

●​ Sell them later if they need cash​

It’s like keeping extra slices of pizza in the back room, ready to serve when needed.

👥 Who owns treasury shares?

No one outside the company owns treasury shares.​
They are not held by investors.

●​ They don’t vote​

●​ They don’t get dividends​

●​ They don’t count toward ownership​

They’re basically on the company’s shelf, inactive.

🔄 Summary:
Treasury Shares Are... Why the Company Uses Them

Bought-back shares Offset dilution from stock options

Not outstanding or Boost EPS and share price

investor-owned

Held in company’s account Used for future employee grants or M&A

deals
4. Enterprise value

Explanation and exp

🔍 Breakdown of the Formula:

Component Explanation

Equity Value Share Price × Fully Diluted Shares Outstanding

Net Debt Total Debt – Cash & Cash Equivalents

Preferred Must be repaid before common shareholders; often treated

Stock like debt

Minority Value of subsidiaries not fully owned, but consolidated in

Interest financials
Cash Subtracted because it reduces the actual cost to acquire the
business

📘 Example:
Let’s say a company has:

●​ Share price: $20​

●​ Fully diluted shares: 100M​

●​ Debt: $500M​

●​ Cash: $100M​

●​ Preferred stock: $50M​

●​ Minority interest: $25M​

Step-by-step:

●​ Equity Value = 100M × $20 = $2,000M​

●​ Net Debt = $500M – $100M = $400M​

●​ EV = $2,000M + $400M + $50M + $25M = $2,475M​

🎯 Why Is EV Important?
●​ EV shows the true value of a company’s core operations, regardless of capital
structure.​

●​ Used in ratios like:​

○​ EV / EBITDA​
 ○​ EV / Revenue​

●​ Preferred over market cap when comparing companies of different sizes, debt
levels, or capital structures​

🔄 In Summary:
Equity Value Value to shareholders (just stock)

Enterprise Value of the whole business (debt + equity –

Value cash)

What is Minority Interest?

Minority Interest (also called Non-controlling Interest) is the portion of a
company’s subsidiary that it does not own, but still reports on its
financial statements.

You need to own more than 51% of the company but less than 100%, and
that remaining amount is your non-controlling interest.

👶 Easy Example:
Let’s say:

●​ Jamie Corp owns 80% of PizzaCo 🍕​

●​ The other 20% is owned by outside investors​

Because Jamie owns more than 50%, it consolidates all of PizzaCo’s financials into its
own.

But! Jamie doesn’t actually own that 20%, so to be fair...

We add minority interest into Enterprise Value to reflect that part of

PizzaCo’s value that belongs to other investors.
🧮 Why Add It to EV?
If you're using metrics like EBITDA that include 100% of the subsidiary's profits, then
you need to add 100% of its value — including the minority interest.

Otherwise, you're comparing part of the value (EV) to all of the earnings (EBITDA) →
and that’s not accurate.

Why Subtract Cash from Debt in Net Debt?

✅ Definition:
Net Debt = Total Debt – Cash and Cash Equivalents

💡 Why?
Because cash reduces how much debt matters when valuing a business.

👶 Easy Analogy:
●​ Let’s say a company has $100M in debt, but also $60M in cash.​

●​ If you buy this company, yes, you're taking on $100M debt...​

But you also instantly get $60M in cash to pay down part of that debt.​

So in reality, the company only has $40M "net debt" burden on your shoulders.

EV is considered capital structure neutral, unlike

equity value, which is affected by financing decisions.
Capital structure = how a company is financed

→ how much of it is funded by debt, equity (stock), or other sources

Super Simple Analogy:

Imagine you're buying a pizza shop 🍕:
●​ The shop costs $1 million total → that’s Enterprise Value​

●​ It has $300k debt, and the rest is funded by $700k equity​

If the owner changes the mix (uses $500k debt, $500k equity), the Enterprise Value is
still $1 million — but the equity value changes.

🎯 Summary Table:
Term Includes Changes if financing Capital Structure
Debt? changes? Neutral?

Enterprise ✅ Yes ❌ No ✅ Yes

Value

Equity Value ❌ No ✅ Yes ❌ No

5. Equity value from Enterprise value

6. Net Debt
7. Enterprise value and net debt

8. Enterprise value vs. Equity value

9. Negative net debt, Enterprise value lower than equity value

10. Negative enterprise value

11. Change of Enterprise value with change in debt
If a company raises $250 million in additional debt, how would its enterprise
value change?
Theoretically, there should be no impact as enterprise value is capital structure neutral.
The new debt raised shouldn't impact the enterprise value, as the cash and debt
balance would increase and offset the other entry.
However, the cost of financing (i.e., through financing fees and interest expense) could
negatively impact the company's profitability and lead to a lower valuation from the
higher cost of debt.

12. Minority interest when calculating Enterprise value

13.

TL;DR Answer:
●​ If they're in-the-money (profitable to convert into shares) → treat them as
equity (they increase share count).​

●​ If they're out-of-the-money (not profitable to convert) → treat them as debt

(included in EV as part of net debt).​

Now, let’s walk through it in easy steps:

🧩What are Convertible Securities?
1. Convertible bonds = Debt that can turn into stock

→ Holders have the option to convert their bonds into equity if the stock price goes
high enough.

2. Convertible preferred equity = A type of stock that can convert into

common shares under certain conditions.

🧠 Why It Matters for EV:

➕
EV = Enterprise Value​

➕
Debt​

➕
Preferred Stock​

➖
Minority Interest​
Cash

But convertibles are tricky — they’re either debt or equity, depending on their
current status.

🧮 Step 1: Check if the security is in-the-money

In-the-money = The current share price is above the conversion price​
→ Meaning the investor would actually want to convert it into shares

🔁 Two Scenarios:
Scenario What do you do in EV? Why?

✅ Treat as equity → Do NOT add as Because it will likely

In-the-mone debt. But include in diluted share convert, adding shares
y count (via TSM). instead of debt
❌ Treat as debt → Add to EV as part of Because it acts like debt, no
Out-of-the-m debt one would convert
oney

🍕 Easy Example:
Imagine:

●​ Convertible bond = $100 million​

●​ Conversion price = $20​

●​ Current stock price = $30 ✅ (in-the-money!)​

→ Then:

●​ Do NOT count that $100M as debt​

●​ Instead, calculate how many shares would be created and add them using the
Treasury Stock Method (TSM)​

🎯 Final Summary:
Situation EV Treatment Why?

Convertible bond is in the money Treat as equity Will convert into shares

Convertible bond is out of the Treat as debt Acts like a loan, no

money conversion
 Convertible preferred is in the Treat as equity Will convert into common
money stock

Convertible preferred is out of the Treat as preferred No conversion, stay as

money stock preferred

13. Two approaches to valuation

What is Intrinsic valuation

Intrinsic Valuation - you analyse company’s:​
1. Cash flow
2. Growth
3. Risk
It is designed only for cashflow-generating assets
You can not establish the value of an art piece or of smth that has an subjective value
Discounted Cash Flow (DCF) Valuation - 2 methods
DCF valuation says that a value of an asset is the present value of the expected cash
flows on that asset
It boils down to:
1.​ Estimating cash flows and
2.​ Adjusting for risks

Two ways in which you can set up the risk adjusting DCF valuation:
1.​ Expected cash flow (not risk adjusted) - You get the expected cf over all
scenarios of a business/asset over time

Dsicount rate (risk is adjusted) - riskier assets have higher discount rate and vice
versa.
2.​ Expected cash flow (risk IS adjusted)
Summary of formulas:​

Risk adjusted value - 2 propositions

For an asset to have value, its expected cash flow (ECF) have to become positive at
some point in time.

If in the first few years, business has some negative cf upfront, it doesnt have to be a
bad buisness, it could be a startup.
For a startup to have value, it must have a disproportionately large POSITIVE CF in the
future.
DCF: Equity vs Firm Valuation

When valuing a company, it is better to use a financial balance sheet that an

accounting balance sheet as when valuing a business you are either valuing:
1.​ An equity in the business. You care only about the equity investors and the cf
that is given to them - that is, the CF that are leftover after interest payments,
principal payments, all payments due to the bank. CF to equity are cf that equity
investors can take out of the business. The discount rade used in this case
should be the discount rate if return that the equity investors would need to make
given the risk of that equity.
2.​ An entire buisness - it is like valuing the assets side of the BS instead of the
liabilities side. Here, you look at the collective CF or also called the CF to the firm
(it consists of CF for both the lenders like bank and the investors). When using
the CF of the firm, the discount rate you are using is the weighted average of
what equity investors demand (which is the cost of equity) and what lenders
demand (which is the cost of debt). In corporate finance, this weighted average is
the cost of capital - your DCF to the business at the cost of capital. If you still
want to get to the value of the equity in the business, you can just subtract out
what you owe - the value of your debt.
First principle in valuation - never mix and match cash
flows.

Consistency principles 2 and 3: Nominal vs real terms

1.​ When you do things in real terms you ignore the inflation. So when you do CF
you forecast the number of units you will sell and act like the price is not going to
go up even if there is inflation. If your CF are real CF, your discount rate has
to be a real discount rate.
2.​ If your CF are nominal CF you have a second choice to make - what currency
are you going to do CF in. Currency becomes an issue only with nominal cash
flows. Once you pick up the currency to estimate the cash flows, your discount
rate has to be exactly in the same currency as the CF.
Example on discount rate
The ingredients:

1. Cost of Equity

2. Risk and Return.

When measuring risk, we use the stock prices bc the accounting earnings measure only
once every 3 months for US companies so we dont have a lot of data. Meanwhile, stock
prices are always changing so we can get as much data as we want.

When you look at the risk in a company you are looking at how will those marginal
investors perceive the risk in this company. They change how we think about risk.
*Marginal investors (Маргинальные инвесторы) - are those investors that by buying
and selling their shares directly affect the prices of stocks. They have two
characteristics:
1. They own a huge chunk of shares in the company. We are talking about millions
rather than thousands of shares.
2. They trade those shares.

All the risk and return models in finance are all based on the premise that those
marginal investors are diversified marginal investors (the institutional investors that own
tens or hundreds of stocks)

Risk and Return Models

1.​ The Capital Asset Pricing Model (CAPM) is a standard and the simplest model.
In this model, the risk of an investment is the risk that it adds to the market
portfolio (market portfolio is a portfolio that includes every single traded asset - all
the securities/ценные бумаги that a person/company own). That risk is captured
with a one numer, beta, and the expected return on a risky investment then
becomes a risk-free rate + beta for that investment * (a risk premium you
demand for an average risk investment).
2.​ Arbitrage Pricing Model (APM) - a more creative in measuring market risk
model.
The difference: the APM leaves market risk factors as unnamed factors/statistical
factors.
3.​ Multifactor Model - a more creative in measuring market risk model.
 The difference: This model puts economic names on market risk factors such as
interest rates, inflation and etc.
4.​ Proxy Model - in this model, you give up on risk, you let smth else (we call them
“proxies”) stand in for it. They are either developed on their own or as add-ons to
traditional models (for exp as cap premiums).
Example of 2 widely used proxies:
1)​ Over the last 40 years, the smaller companies are earning higher returns
than the bigger companies (small and large are defined in terms of market
cap). If we assume that markets are right over very long time periods, here
is what we also can assume - the size (in this case a market capital)
measures the risk of a company, that small companies are riskier than the
larger companies.
2)​ Low price to book stocks, stocks with the market value of equities well
below the book value of equity, tend to earn higher returns in companies
with high price to book ratios. We can use that as a proxy.

Risk-free rate
All of these models are buit on a risk-free rate.

The risk-free investment should be default free and you are looking for smth matched
up to the CF that you are trying to discount.
​ If your cash flow is a long term, your risk-free rate has to be long term and that
long-term rate has to be default free.
The tips rate - is an inflation protected treasury bond. It is real interest rate.
They can be used as a risk free rate.
Examples on risk free rates

14. What are the most common valuation methods used in finance?

1.​ Trading Comps.

Key accounting concepts: